February 17, 2016; V is for Volatility

Weekly Commentary • Feb 19 2016
February 17, 2016; V is for Volatility
David McAlvany Posted on February 19, 2016

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

“When you’re put under pressure, what do you revert to? You revert to what you’re most comfortable with. And although they have, in China, expressed many capitalistic characteristics and tendencies, you would have to say that the heart is still command and control. And if you put the political system under pressure, if you put the economy under pressure, where do you revert to? You revert to your safe place. We all do.”

– David McAlvany

Kevin: I’ve got my wish, Dave. I’ve got my wish. You may recall how disgusted I was with the lack of volatility, the utmost certainty of the central banking community.

David: (laughs)

Kevin: We talked about that for months and months, actually, probably for a couple of years, where the volatility index and everything that had to do with uncertainty was just like a dead fish.

David: Which is fine as long as it’s fresh, but after two to three years, I don’t know about you, but to me that begins to stink.

Kevin: It starts to stink.

David: (laughs) So today, we do have volatility. We have volatility in every market. The commodities markets – it’s not common to see copper down 10% in a day, or oil up 10% in a day. And to see 2, 3, 4, even 5 percentage points move in a currency. When you begin to see the equity markets generally move on a normal basis, 1%, 2%, big days are 3%, but you begin to double that? The markets on Monday were led by Japan and Greece. Both were up 7% in a day. Well, they’re up 7% in a day, what does that mean? Does that mean the economic prospects have improved dramatically in both places? (laughs) Not likely.

But you have Greek equities, from a broader perspective, if you’re looking back over the last several years, they’re at the lowest level they’ve been, actually lower than what you saw in the European crisis days of 2011 and 2012 before Mario Draghi stepped in and said, “We will do anything to save the system.” And quite frankly, they’re at a lower level than at any time during the series of restructurings that we’ve seen in Greece in recent years.

Kevin: Yes, and I think we have to take that into consideration. A lot of these drops are not after a real large recovery. A lot of these drops are just a continuation of the crisis that they put on hold three or four years ago.

David: And in the case of Greece, the increase is also off of a very low base. So, in nominal terms, it’s not up that much. In percentage terms, that sounds impressive. But again, it’s a little like talking about one little flip of the tail by the mostly dead fish.

Kevin: There are a couple of indicators that a person can look at that have been very, very reliable in the past. You’ve brought up margin debt. What is the percentage of margin debt in the stock market? Is it greater than 2% of GDP, or greater than 2% of the overall capitalization of the stock market? That happened in 1929. It happened in virtually every pre-collapse.

David: And it got to record levels in China just before we saw a collapse in the Shanghai and Shenzhen markets. And lo and behold, we talked about this all last year, 2015.

Kevin: Yes, so don’t give that this stuff is all unpredictable. It’s not.

David: No, it’s not. When you look at margin debt numbers, it’s an indication of excessive speculation in the market, and excessive speculation in the market really defines the far edge of the pendulum swing. So it doesn’t take rocket science, and it doesn’t take a crystal ball to say, “Look, it does swing both ways. Will it be tomorrow, will it be a month from now? Will it be three months from now? We just know that we’re at the outer edge of the pendulum swing, and the probabilities now exist in the other direction.

Kevin: And there are other guides, there are other things that you can look at that you can say have been pretty reliable from 1929 on.

David: The Coppock guide is one of the technical guides many have used – James Stack drew attention to it here recently – signaling a 75% probability that an extended bear market in U.S. stocks has already taken hold.

Kevin: This isn’t a crash that is being predicted, it’s an extended bear market. That takes the majority of the money. The crash is just what starts.

David: That’s right. This particular indicator was quite accurate leading into 1929, leading into 1969, leading into 1973, the year 2000, the year 2007, which, if memory serves correctly, were all ranges in which the stock market was peaking and a generation of investors began to experience disappointment – began, but also got to experience disappointment for a long period of time. What do I mean by that? Well, for those who signed up for the 86% loss, 89% of you talking absolute numbers from peak to trough, it took you until 1953 to get back to break even from your 1929 peak. So you are dealing with very considerable losses, a range of bear markets through the years that we mentioned, that ate through capital, minimum 36%, to as much as 80%, almost 90%, of an investor’s capital.

Kevin: Usually, when you go through a depression like we went through in the 1930s, and like you said, it took a whole generation just to get back to break even, you see major changes. We saw major changes in the banking industry through the last depression. What we have right now, it seems like we have a fossilized banking system. We brought up last week, a beloved client who is a bank president in the Midwest. I talked to him after the program. I said, “Was it correct what I said?” He said, “Yeah, Kevin, it really is. With all the regulation that we have it’s very, very difficult for us to compete in this world right now.” He would love to put a portion of the bank’s assets into gold. It’s reasonable to him to do that.

David: But the bank board, the regulators – the bank board is going to say, “Look, we can only do what the regulators will approve,” and the regulators would say, “Oh, my word, what are you doing, speculating in orange juice contracts, and now buying gold bars? You’re a part of this lunatic fringe who believes in high leverage and high risk.” Which, of course, is just muddling issues in terms of risk and the prudent man rule.

Kevin: But he’s cornered, because the things that they approve offer no interest, yet they wonder why he’s not earning interest.

David: Right. So, you have massive changes which are coming in the banking industry and what we’re talking about is an entire space, an entire sector, that will have to adapt to lower leverage – and they are adapting to lower leverage, tighter regulations. The big boon, if you’re talking about Wells Fargo, J.P. Morgan Chase – last year both of them made about 25 billion dollars in total revenue. They’ve gobbled up their competition. They continue to grow because they’re basically consolidating the entire banking industry under one roof. What you have in terms of an adaptation is – again, mentioning the tighter regulations – there is a rising cost of complexity, and that is one of the reasons why small banks become targets for larger banks. The cost of complexity has risen to the point where, I think, not only do you see the small getting eaten up by the big, but there is about to be a disruptive event where the big all of a sudden are leap-frogged, because technology is at a point where you are going to leapfrog the entire industry. In Darwinian terms, you may see the banking industry become like a collection of old bones in a dinosaur graveyard, trying to reach clients with irrelevant products, with platforms that are passé, and failing to adapt to what financial technology is providing at a fraction of the overhead cost to your brick and mortar banks. If I were a mid-level guy in the banking industry, and had survived thus far, I would think about professionally retooling, because Silicon Valley is writing a banking industry script that doesn’t include people, and it doesn’t include the venues currently considered necessary for banking operations to continue.

Kevin: You talk about Silicon Valley and how they are retooling. You think of Bitcoin and some of the platforms that are coming out. The banks may become irrelevant at some point. It’s talking to your phone, Siri, “What is my bank balance?”

David: (laughs) That’s right, and she’ll be able to tell us, in whatever accent we would like, and it won’t be an Indian accent, per se, it may be a British accent, we’ll be in charge of that, and it’s not a call center, it’s AI driven.

Kevin: There’s a subject, Dave, that I’m embarrassed that we have to even talk about because it’s so incredibly ridiculous. Every four years we go through an election year and the ludicrous numbers that come across the board as far as just how things have been, and are, getting better for us under the current administration. I’m thinking about the retail sales headline, “Oh my gosh, retail sales – it’s off the charts! What just happened?”

David: (laughs) “January was fabulous.” Our friend, Bill King, suggests that like the December and January manufacturing and construction jobs figures, these were massively influenced, were created, by seasonal adjustment wizardry, and not an actual job count. And again, he asked the question, “Who realistically believes that manufacturing jobs here in the United States hit a seven-year high in January?” (laughs) But with the help of seasonal adjustments, that’s where we got. We had the January retail sales numbers, which are also massively influenced by a seasonal adjustment, as well, and Bill King’s sage advice is, “Remember what year we’re in. This is an election year.”

Kevin: You bring up manufacturing jobs and I think about a conversation that I had yesterday with a client up in Canada. He is part of the Alberta oil fields. He said, “You know, Kevin, at this point, 30,000 people have lost their jobs just in this region in the oil fields.” And I would have to figure, “Gosh, doesn’t that play at all into those numbers?” Granted, we’re talking about Canada, but let’s face it, here in the United States we’re seeing it in North and South Dakota, we’re seeing it in Texas, we’re definitely seeing it in Oklahoma. We had a Thanksgiving meal with some friends of ours on Saturday night, they are from Oklahoma, and it’s just decimated right now. So, where are these jobs coming from?

David: When you look at GDP, you look at the jobs numbers, you look at inflation statistics, there are a couple that are not only easy to manipulate, but are also great PR tools because of their ease of manipulation, and because everyone looks at them. And I think there is a less manipulated data set that comes from the Census Bureau. And the reason why it’s not as politicized is because nobody really looks at it. So, for December, if you’re looking at sales and inventory numbers, they were at levels that we haven’t seen since June 2009.

Kevin: Again, sales being low leads to inventory being high.

David: And the combination, when you look at the ratio of it and see, actually, that ratio is increasing, and that ratio hasn’t been this high since June 2009, we need to recall what was happening in June 2009. We were on the back end of a 12-18 month stretch of economic death. So, fast forward to the present, you have inventories which are up, you have sales which are down, a mirror to the 2009 period, but not to worry, the official unemployment rate is 4%, there is zero inflation, and GDP is going to grow. On top of that, January retail sales were “fabulous.”

Kevin: It’s continually, “Pay no attention to the man behind the curtain. Things are just fine in Oz.”

David: So, if we keep in mind the momentum trends in the gold market, then a price above $1259, which is, some people define a bull or bear market as a market that has moved up 20% or more or down 20% or more. At $1259 gold breaches that 20% market for the year, up 20% in a short period of time, and that’s enough to signal a rising bull market, and I think you begin to see above $1259 a significant increase in, not people who are buying gold for fundamental reasons. What I mean by that is, looking at the economy, looking at the financial picture and saying, “In my appraisal something is not quite right. I think I’d like to have an insurance policy,” if you will. That would be a purchase for fundamental reasons.

This, I think, above $1259 will be for non-fundamental reasons. It will just be momentum players who don’t care about gold per se, but just are happy to ride it for $200, $300, $400, $500 an ounce on the upside, happy to play that game, Mark Cuban being one of the most recent ones to say, “Look, I don’t understand what’s happening in the economy, things are very different than I expected, and I’m not sure what to do with this volatility, but I do think it makes sense to own gold.” Now, he’s not someone who is a broken system guy. He doesn’t think there is anything wrong with the system as it’s operating.

Kevin: He’s an entrepreneur, I mean, the shark tank.

David: Right. No problem there. But he says, “I’ll buy gold calls and play the momentum, because the momentum is going to be up from here.” I don’t agree with how he arrives at owning gold, or even the vehicle that he is choosing, because I do think there is something more fundamentally systemically wrong with the system at this juncture. It is interesting, though, to see the crowd of momentum players beginning to shift in the direction of gold.

Kevin: Let’s face it. Let’s say you walked into the room – just imagine with me for a moment – you had your life savings in your hands, and you had to protect it. On one side of the room you have Abe, you have Draghi, you have Yellen.

David: You’re talking about all the central bank luminaries.

Kevin: Exactly. And they’re saying, “Hey, give your money to us, everything is fine.” Then on the other side of the room you have a pile of gold and you can trade a little of that life savings for gold. What are you going to do? Face it, that’s the choice right now that we’re presented with. Japan was supposed to be the raging new experiment in quantitative easing, lowering interest rates. They’re now negative on interest rates. How is that experiment working out?

David: Abenomics and their three-fold approach to stimulating growth and increasing inflation continues to be a disappointment. The inflation numbers are down, Japanese GDP in the fourth quarter dropped 1.4%. It was worse than forecast by economists, bring their full year number to just over 4/10 of a percent positive, and still, in the disappointing column in terms of investor and economist expectations. So, what do you have in Tokyo? Nobody is running victory laps around the royal palace downtown. This is my question – when will there be a concession speech? (laughs) When will somebody make the concession speech that Abenomics is a failure and that central planning, although it does give the practitioner, the central planner himself, a sense of control? It is, in reality, harmful to the free market, and forces negative behavioral shifts amongst the man in the street, as he or she is forced to adapt (laughs), forced to protect, to reorganize and work around the system that they are subjected to, and the high cost of conformity to that system.

Kevin: You asked, when will the concession speech occur? I think the concession speech never occurs from the people who actually cause the problem. The concession speech, actually, is going to be the crash that we’ve been experiencing.

David: The consumer in Japan is under pressure. It is no surprise they have a rise in sales tax, part of that implemented last year, part of it is supposed to be implemented this year, and you have rates going negative this year. Like their QQE programs, they have a double Q, we have a single Q. Ours are just QE programs. Like the environments that those set in Japan and globally, you have monetary policy accommodation, you have intervention. These are your “normal” modes of operation. And if they don’t work, the conclusion is, a lot more is necessary. It is not, a little is good, a lot is better. A little is not working, let’s just triple or quadruple the dose and see if that does it. So, what we have in Japan is a continuation of the saga of negative rates. That is going to remain throughout 2016. You have a high likelihood of the Japanese taking rates from their negative 10 basis points, negative 1/10 of 1%, to negative 50 basis points, just as the Swedes did this past week. So, here’s your negative rate weekly update: The Swedes lowered their rates from 35 basis points to negative 50 basis points, or negative 0.5%.

Kevin: Wasn’t the Swedish government the first to go negative in the European Union?

David: Yes, and now you have the ECB’s governing council suggesting that there could be a further decline in rates this year from negative 0.3 to negative 0.55, and this is all in the context of a tightening in monetary conditions, and a fall in the inflation expectations there in continental Europe. Of course, they’re failing to connect the dots here, because when you lower nominal rates into negative territory, you are reinforcing the market signal of a deflationary concern, and even though you want loose monetary policies to gin up the system, you have system participants, investors like you and me, who read the negative rates as a further indication of more deflation to come, and guess what happens to our inflation expectations? We lower our inflation expectations, reinforcing the deflationary trend and the disinflationary bias in the market. So, negative rates are altering behavior in the exact opposite direction as intended by central planners, which is confounding all of their models and their theories, which simply hold that if you lower rates you are loosening monetary policy conditions. And what they are actually doing is lowering rates and tightening monetary policy conditions.

Kevin: We have brought out that the Chinese, especially, have saved more and more and more. The lower the rates go, they save more and more. Like you said, that’s exactly opposite the model. The model – this is supposed to be fueling the machine. In fact, negative rates are supposed to be like turbo-charging an engine. You turbo-charge an engine and you’re supposed to get a whole lot more juice through there and get that thing going. It is, unfortunately, more like pouring sand in the gas tank.

David: All this is happening in a certain context, a regulatory environment which is not particularly productive for the banking and financial sector. You have the eurozone acceptance of a banking industry bail-in clause which puts corporate cash balances at risk if there is a decline in bank capital beyond an 8% threshold. So imagine a corporation with a million-dollar cash balance at their bank, and the industry goes through a major revolution. It is hurt. You go below that 8% threshold in terms of losses, and that corporate cash balance now becomes a part of the equity of the bank – 10%, probably something like that. That’s what we saw in Greece and in Cyprus. Just pony up 10%, you’re now an owner of the bank, and instead of a million-dollar cash balance, it’s a $900,000 cash balance and you are a $100,000 equity participant in the bank. What are the implications? Regulation, in this case, is an example of industry strangulation. What was intended for good is producing ill effects.

A minute ago we talked about financial technology, and how behemoth banks, laboring under the high cost of regulatory compliance, struggle. Then you have your financial startups, who are in the process of structuring themselves to be outside of the complex of regulatory pressure. And I think the solution to the malaise of 2008 through 2014 is going to be in innovation. It is going to be in entrepreneurial opportunity. And there are very hopeful solutions which work around central planning and work over that regulated morass. And you’re seeing it. You’re seeing it in the financial tech space where there is just a new way of doing things.

Kevin: And we got a chance to see that when we saw what happened to Bitcoin when Cyprus was going down, and what happened to the price of Bitcoin when Greece was going down. People were finding other places to put their money because the banking system was taking it away from them. But even the top economists right now that are not connected, necessarily, to the central banking community, this elitist community, some of these top economists are starting to say, “They’re out of bullets.”

David: Yes. David Rosenberg is a good guy, a good thinker, and I’ve read him for years. He is chief economist now at Gluskin Sheff. He said this is no longer 2009 to 2014, when central banks could bolster markets. He says, “The laws of diminishing returns have clearly set in. The latest experiment on negative rates – it’s falling flat on its face.” But in a classic case of following Albert Einstein’s definition of insanity, Rosenberg says, “The academics who run the world’s central banks show no sign of backing away from a policy that is undermining the banking system.”

So you have regulatory issues, you have the issue of the bail-in clause in Europe, which is putting further pressure on the European banks. European banks are under an immense amount of pressure. You had Deutsche bank get thrown to the ropes, you had the Italian banking sector, which is on the brink of utter collapse, and again, this is a backdrop to then introducing negative rates.

Kevin: I remember listening to Janet Yellen speak last week and not only did she say, “Well, we’re going to continue on the course that we’re on, but we could also continue off the course that we’re on and go negative.”

David: (laughs)

Kevin: Now, what would be the first signal, if you were somebody here in America and you were saying, “I’ve seen it in Japan, I’m seeing it in Sweden, I’m seeing it in the European community. What’s our signal here?”

David: Last year we mentioned that one of the most significant changes in central bank policy was the increase, the surprise increase in interest paid on excess reserves. So your first signal on a negative rate trajectory in the U.S. would be a reduction in the interest on excess reserves, which is currently half a percent, 50 basis points, here in the U.S. That would have to be reduced or eliminated prior to a negative interest rate policy implemented here in the U.S. And the common theme so far in countries or regions that have implemented those negative interest rate policies, which, again, is a distinction between us and them. These were creditor countries running trade surpluses, and we are a debtor country running trade deficits.

Kevin: So the guys who have gone negative, for the most part, are creditor countries.

David: It is interesting, so as opposed to net borrowers running trade deficits, which is the category we’re in, now you have the tally, currently the stock of negative yielding government debt comes in at 7 trillion dollars worldwide. It is interesting because as that number grows you are seeing pressures elsewhere, and perhaps this is coincidental, but I wonder if there is any connection to the 8 trillion dollars in lost equity values since January 1. We’re up to 7 trillion in negative yielding government debt. What is the cost of negative yielding debt? That would be my big question.

Kevin: The last few weeks – we talked about this last week – when central bankers spoke, almost always the markets reacted positively, because the central banker was going to give them the candy that they had gotten so used to. But when Janet Yellen was talking on Capitol Hill last week everything was happening in the opposite direction.

David: That’s right. She gives a rational explanation of the insane, which is our current monetary policies, and in Janet Yellen’s Capitol Hill presentations last week she left the negative interest rate policy on the table as an option, but then she went on to rattle the market by implying that hikes in interest rates were more probable than a reduction in rates. Then of course, the markets just don’t know what to do with monetary tightening. They have been fed intravenously for so long they don’t know what it looks like to be off the drip and on their own. So the Fed is running a study of projected moves for their interest rate policy, the FOMC decision is upcoming, and it is what some call the dot plot, and that is where you find the projections of four additional hikes in 2016. This is also, I think, what Goldman-Sachs is kind of hanging their hat on and saying, “Look, we’ve got a model, and the model says we should be raising rates four times in 2016. Janet made it perfectly clear that the Fed does not accept responsibility for equity volatility, but it is interesting because tightening monetary policy – it’s like when they lower rates they know it’s going to goose the system and drive asset prices higher, and yet when they start to raise rates they don’t claim any responsibility for volatility in the market.

Kevin: Even though when she raised it 25 basis points, that was the beginning of the dramatic drop in the stock market so far.

David: That’s where it commenced. So, in theory, it’s nice to remain consistent with that plan, the dot plot plan of four additional hikes in 2016, and follow through on a thought-out trajectory. The dot plot and your rate increase reflects a positive view of the economy, and it has embedded in it all of those things we were talking about earlier. It has embedded in it all of those statistics which are, in our opinion, risible.

Kevin: Wouldn’t you say this is a system built on false expectations, on false numbers? If you think about it, they have created almost a straw man of false statistics, of public pronouncements, of Capitol Hill announcements. Actually, it is interesting. They, a lot of times, have not had to do anything. They just have one of their members come out and give an interview with Fox news, or what have you, and they will speak the market – that’s what they’ve done up to this point, but that’s a straw man.

David: That’s exactly what the Bank of Japan and the ECB did this week, Monday. They rolled out Mario Draghi and Kurota, and they basically said, “Look, here’s what is going to happen. We’re going to spend more money than you can imagine. We have more tools that we haven’t used, and we’ll use every one of them if we have to.” And everybody says, “Yes, that’s great, that’s great.” So, you have equity prices in Europe up, you have the Nikkei, as we mentioned earlier, the Japanese stock market up. And going back to the Fed, I’m not suggesting that because there is volatility in the stock market that they should remain accommodative. I’m suggesting that putting too much faith in your own fabricated and fudged statistics may be like planning in a one-dimensional world for a four-dimensional reality. Remember the children’s book, A wrinkle in Time, by Madeleine L’Engle? We live with the idea that the shortest distance between two points is a straight line. And in this children’s story that is told, that is not the case. The straight line is not the shortest distances between two points because there is this wrinkle in time, a fold in the space/time continuum. This is a concept you and I have talked about – you’ve taught me a lot about it – a lot more credibility was given to this notion of a wrinkle in time here recently with the press revealing scientists measuring – this was September 14th – a gravity wave.

Kevin: Right. Space is curved by mass. Einstein predicted that with his equations a hundred years ago. It is very hard for us to get our heads around that, but there was a super nova that occurred 9 billion light years away, that actually had to travel around a galaxy. What was interesting was that the light split and arrived at different times. Scientists actually were able to predict when the other light was going to arrive. Curved space is a hard thing because we don’t experience that, and what you are talking about with central bankers – they have created a one-dimensional world where straight lines are the shortest distance. The problem is, you have actually got animal spirits in the market. You have people and emotions, and you can’t create wealth out of nothing. And that, they have not learned.

David: The point is, academics are working with theories that don’t cross over into economic reality. It’s like living in a multi-dimensional world where there are central planners working on only the X axis of existence. And so you have a flat world, and as it turns out, human behavior ties into something beyond X, Y, and Z space, which is confounding to the pseudo-scientific econometricians at the Fed.

Kevin: Last week, after we had recorded the program, Dave, that is really when gold got fired up. We had already put the program in the can, in the box, and put it out there. But what I loved about it was, the things that you talked about – there was nothing that needed to be changed. When you have the fundamentals right, you can have market moves after the fact and not really have to amend anything.

David: A recap. Gold’s relative performance over the last 15 years has far exceeded equities.

Kevin: By hundreds of percent.

David: Yes, and that trend will continue, as we mentioned last week, until the Dow-gold ratio is at least 3-to-1, that is, 3 ounces of gold basically buys you a share of the Dow. Currently it is at 13, so your purchasing power is dramatically increased in that timeframe, and that is a trend that has been in place for better than 15 years. Secondly, we talked about stepping back from the forest to see the trees, because there are, in that broader context, massive shifts still occurring, started over 15 years ago, which suggests that a cautious stance, a defensive stance, a gold-enhanced stance has and will continue to pay off handsomely. And those trends are still in place. The investor with too short an attention span will have missed it.

It reminds me, do you remember the meeting of the Ents?

Kevin: Yes, the big trees, right?

David: Yes, the Lord of the Rings Trilogy. The modern-day investor is moving too fast, and I think will miss both the meaning and the significance of the conversation taking place. This is a concept that you introduced me to. You have to slow down to speed up.

Kevin: I remember when a number of us took a gun safety course, and the instructor continually drilled into us that slow is smooth, and smooth is fast. Slow is smooth, smooth is fast. Now, that is really helping us right now to train for this long-distance half Iron Man that we’re going to do in Kona, Dave. You train slow, you gain smooth. Ultimately, when the race comes you should have some speed.

David: That’s right. The other thing we talked about last week is a concern about monetary policy efficacy, that what we have sought is patches, not cures, and what we have continued to deal with is major structural issues tied to there being too much debt. The only way forward with monetary policy being inefficacious is now fiscal policy as a means of driving inflation and driving asset price trends in the future.

Kevin: Right, because monetary policy now has to go to negative rates, which you brought out before, is not working.

David: And we’re seeing a negative reaction in the market to negative rates, which we did, we talked about negative rates which is a tax on all flows through the banking system. Negative rates have, and always will be, positive for gold.

Kevin: Absolutely, because one of the great arguments against gold in a normal functioning economy is that it doesn’t offer any interest, which is exactly right. In a normal functioning economy, gold can be like a rock just sitting there, but this is not a normally functioning economy. You can’t get rates out of paper either.

David: So that objection goes away, the asset that doesn’t pay out income, because that same objection can then be raised to bank deposits, or virtually any other form of fixed income. That argument and the math behind it was actually oriented to real rates of return, never imagining nominal interest rates being negative. So, in either case, these are issues which are difficult for the banking system, and actually quite positive for gold.

Kevin: Over the last 15-20 years we have seen the addition of a new asset class. It is called the Exchange-Traded Fund, and gold is now held in large amounts in some of these ETFs. We see outflows sometimes but we’ve seen an increase of inflow into the ETFs here recently.

David: That was something we mentioned last week. The investor vote in the gold market is very considerable. Your industrial demand, your jewelry demand – these are your more predictable elements where you know that the geographies which will always consume several thousand tons a year, have, and always will, consume several thousand tons a year. The swing vote in the market is the investor demand, and the ETF accumulation that we have seen since January 1st would suggest that sentiment has changed, and instead of investors being negative on gold, as they have been from 2003 through 2015, it would argue, in fact, that there has been a sentiment shift, and there is a movement – we see votes of that sentiment shift showing up in the purchase and accumulation of ETF gold and silver.

Kevin: And it’s not just the investor where the sentiment has shifted. You brought out about a month-and-a-half ago, Dave, that the commercials, the guys who actually produce the gold, the guys who are bringing it out of the ground, have gone positive on gold. They have eliminated their hedges, or at least reduced their hedges, and they are playing for the upside.

David: That’s right. The guys who have been very speculatively short gold, your hedge funds, and we witnessed the power of short covering last week. When you see the price of gold move up 50, 60, $70 in a day, and I think that, in a very short time, within the next 24 months, we will see gold moving up $100, $200 in a day, that will be, in part, bid covering, and in part because of investor demand, both of those things converging at once. Now, look, I think in the next week or two we’ll have the COT reports and we’ll see a big shift on both sides where commercials will be hedging a bit more because of the increase in the price of gold since the beginning of the year, and your speculative shorts have been very short, and they have been covering, so that number will decrease, too, in the short run.

Kevin: Just three weeks ago I would have said, “Dave, do you think we’re going to break $1120?” I think we ought to talk about the new levels, because we broke through $1120 just fine and it just went right on up from there. What are you looking at as far as levels right now?

David: We ticked through $1140, $1160, last week $1180, and then $1200, among those key levels. We breached them. Now, you’re in a normal market fashion going to digest those gains and what was previous resistance as you were moving up and didn’t allow you to move higher, theoretically becomes support. So as gold consolidates its recent gains, this would be normal to see gold retest $1200, we actually had that on Monday, and it held, but ultimately, we might see a retest of $1180.

Kevin, I’m confident in saying that the two steps forward, one step back behavior of this move in gold the last week or so, should $1180 test and hold that level, we open up the door for $1350 as a realistic target for 2016. If we get above $1350, we’re talking about upside to $1500 and $1700 next year. And I suggested it last week, and have mentioned it on a number of radio programs and television interviews, as well, in the last week to ten days, 2018 I would expect to see gold somewhere between $3000 and $5000.

Kevin: I’m going to go back in a time machine to pretending like your dad is sitting here with us, and he would be talking about the late 1970s and what he saw with gold, when it started breaking through some of these resistance levels and started creating support at higher levels. Gold moved up quite a bit in the late 1970s, but when it rains it pours. You can have financial inflation, you can have deflation. You can have things going on in economies, and then all of a sudden, you have a geopolitical event. I’m thinking about the Cold War being reintroduced at this point.

David: Right.

Kevin: We saw in the late 1970s, when Afghanistan was invaded by the Russians, it just doubled gold. That was it.

David: And a natural calculus, a natural market analysis is turned on its head when one critical assumption changes, and that is political stability. You have Medvedev who declares a new Cold War this last year, and it reminds me – we exist in a space where we expect, hope for, and men cry peace, peace, and the question is, is there peace? I don’t think so. You have the Chinese, who are trying to forge a way forward. We’re in Asia this week talking about trade deals, and the most significant economy in Asia isn’t even invited to the tables – that is very disconcerting to the Chinese. Of course, their export numbers for January were down 6.65%, their import numbers for January were also down 14.4%, which gives you a hint into global demand for finished and manufactured goods. And of course, Chinese growth, which is on the decline, these are both decidedly negative points.

Why do we mention this in the context of geopolitical change and this notion that Medvedev is declaring a new Cold War? Well, our relationship continues to chill with the Chinese even as their economy goes on ice, and it will be interesting to see what changes politically. I don’t have time to mention today, but probably one of the best articles I read in the last three weeks was by one of our previous McAlvany Weekly Commentary guests, Minxin Pei, and he was, in a very disturbing tone, talking about the Chinese political movement toward control, and toward an eradication of the political elite in China. There is a house cleansing going on which is not making the press, and it is sharp and it is fierce, and it almost feels like, again, you mentioned my dad in the 1970s, it almost feels like a newsletter he wrote in the 1980s dealing with Glasnost and Perestroika, where there is a period of opening, there is a period of reform, or seemingly there is, and a massive amount of foreign direct investment flows in, only for the gates to be closed and there to be a return.

In this case, it is really a question of dealing with countrywide insecurities. When you are put under pressure, what do you revert to? You revert to what you are most comfortable with, and although they have, in China, expressed many capitalistic characteristics and tendencies, you would have to say that the heart is still command and control. And if you put the political system under pressure, if you put the economy under pressure, where do you revert to? You revert to your safe place. We all do.

Kevin: Yes, and your dad brought out, with Russia anyway, that they had had five Glasnost Perestroikas going back into the 1920s, and each time was followed with a tightening of the belt, and a lot of lives were lost, actually, each time that that occurred. Speaking of guests that we have had in the past, one of the most impressive guests, at least to me, was Otmar Issing. He was the head of the European Central Bank for seven years. He was one of the initial brains behind the EU project. There was a little bit of an uncertainty in his voice. He knew that there would be crisis. He knew that there would be some weak links. We thought maybe Greece would pull things down. We saw Cyprus come through. But could it be Italy that breaks the camel’s back?

David: Right. When you think of existential crisis, the Greeks are pretty much in perpetual existential crisis, and it is not an identity crisis, they have a long history, they know who they are. (laughs) Maybe it’s just that they can’t live within their means. Italian banks highlight something very interesting here, because you have the potential trigger for a dissolution of the whole EU project. You have Italian banks which are bust – bankrupt – way too much bad debt on their balance sheets, and they have to do something. They have to restructure them. But the Italian Central Bank can’t do it alone without monetary devaluation tools.

Kevin: Right. And you can’t do that if you’re part of the EU.

David: That’s right. So, you have a problem that can’t be solved under your current circumstances, so do you exit the EU? That’s the nuclear option. Then you have the ECB who won’t bail out the Italian banks directly. So you have this political – not geopolitical because it’s supposed to be in one friendly block – but you have this political game of chicken, and we wonder – we think that the high-minded leadership at the ECB and in Brussels, are going to underestimate the Italian existential dilemma and the Italians may just walk. And look, if the Italians walk, the Portuguese and the Spanish follow. So monetary sovereignty is very close to expressing itself again. And this is in the face of a global elite that prefer one, or just a few, regional block currencies as the ideal.

Kevin: What makes this intriguing, Dave, is that Mario Draghi is Italian (laughs).

David: (laughs)

Kevin: That adds a little bit of drama to this.

David: But I think we know where his loyalties lie.

Kevin: I think it’s at Goldman-Sachs.

David: That’s right. The Goldman blood is thicker than family blood, quite frankly.

Kevin: And Italy is not the only one. We’ve talked about the PIIGS, right? It’s not a very complimentary way of talking about it, but Portugal and Spain could go right after that.

David: I think what you have, if you broaden the lens again, not just to Europe, but the rest of the world, in order to maintain order in this 2016 to 2018 timeframe, you could alternatively see less sovereignty and more centralized tyranny. And that goes for Europe, that goes for China, that goes for, quite frankly – you could spread it out and say, this is the universal playbook depending on the improvement or deterioration in the financial conditions. But just about anywhere you could see tyranny in the form of, “I’m here as a knight on a white horse to save you.”

Kevin: It’s the old, “We need a benevolent dictator, at least for now, then we can get our freedom back later.”

David: But these are fascinating tensions because in the EU, you’re up against it? Do you see the nuclear option because of the Italian bank issue, where they leave and then others at the periphery leave? Of do you see something happen? I don’t know exactly, and none of us knows the script or how it plays out, but this is a very interesting tension. My tendency is to think that central planners don’t give up that easily, and that tyrannical expression is more to be expected than not.

Kevin: We talked about geopolitical unexpected events. North Korea put a satellite in orbit. Orbit is an interesting thing, because once you get to orbit, you can go anywhere you want in the world. Now, of course, the North Koreans being a peaceful sort of folk, they’re probably just putting environmental satellites up.

David: (laughs)

Kevin: But my guess is that they probably boosted something that has about the weight of a thermonuclear weapon.

David: Now we have two things that I think sort of stand as outliers. We can talk finance, we can talk business, we can talk monetary policy and fiscal policy until we’re blue in the face. And again, there are these X factors that act as accelerants and game changers, and two of them, the KN-08, which is the North Korean intercontinental ballistic missile, that has a range of 3500 miles. If I’m not mistaken, that touches our soils here in the United States. And our response here in the U.S. is to put an anti-ballistic missile system known as THAD on the South Korean peninsula.

Kevin: I don’t think they liked that idea.

David: Well, do you know who else doesn’t like it? We are being advised to not do that by the Russians and by the Chinese, and the Russians had given us sort of a unilateral blessing to do whatever we wanted to do in Korea. But look at what we’ve done. We’ve got them under sanctions. We are, as Medvedev said, in a new Cold War. And lo and behold, Russia and China both are expressing concerns over the U.S. deployment of an anti-ballistic missile system. So, maybe Medvedev is right, but the Cold War dynamics are, really, intriguingly spread all over the place. You have Syria, you have Ukraine, you have the Russian sanctions which we have against them, and then now it stretches a little bit further around the globe toward the Asia Pacific Region.

Kevin: Part of the pillars of support that we have had for the last – well, really, since the end of World War II – one pillar of support was a dollar that was backed by gold. When we lost that dollar backing, it was a petro dollar where no one could sell a drop of oil – because of the house of Saud, you could not sell a drop of oil from any OPEC country in anything but dollars. Now, we’re starting to see that challenged. I’m just wondering, Dave, is ISIS eyeing the House of Saud?

David: And I think this is another outlier. Outliers are things that rarely occur, and from a statistical standpoint, almost can’t occur, and yet, often do.

Kevin: An outlier for the space shuttle Challenger, unfortunately, was a frozen O-ring. It was something that was known could happen and could cause a crisis. The problem was, it was so rare you just couldn’t factor that into the plan.

David: Right. So I think when we think of the gold and Dow ratio and this big perspective from a financial standpoint, we get to a 3-to-1 ratio on the basis of economics and finance. What drives it to a 1-to-1 ratio, where there is abject fear in the marketplace, irrational fear in the marketplace, is these unforeseen events in the geopolitical where no one has a calculus, and no one has a solution. It just looks like chaos.

Kevin: And strangely, they usually come at exactly the wrong time for everything else.

David: Right. We already have an economic and financial context which argues for, and will ultimately lead to a 3-to-1 Dow-gold ratio, but you bring in the KN-08 and the testing of the missile – of course they have to do that before it’s fully operational. You have that as one outlier. Another outlier is the overthrow of the House of Saud – ISIS generated. What do you think the world looks like if you put a terror organization on top of an abundant source of financing for a move to expand globally, their idea of a caliphate? Talk about terror financing. It used to be the Soviet Union that funded the PLO. It used to be the Soviet Union that funded the Southwest African People’s Organization. It used to be the Soviet Union that had their tentacles of terror all over the place. Now, all you need is a social disruption that elbows out the House of Saud, and look, ISIS is already there in the region to say, “Look, we’re here, our religion mandates that you follow us. If you don’t bend the knee, we’ll cut off your head.” And guess what they need in order to expand from being a regional issue to being a truly global concern? Funding.

Kevin: Right.

David: Where does the funding exist?

Kevin: Well, lest we sound like Chicken Littles because these things may not play out exactly that way, you have been a good proponent of compartmentalizing in your life. In other words, look at the threats, take a time out of the day, month, year, whatever it is, sit down, look at your portfolio and say, “Okay, if any of these things should happen, am I positioned in a way that I would not be wiped out, and would not be completely surprised. You take action at that point, in that compartment, and then you put it up on the shelf and you live your life. Obviously, you don’t want to live a life of fear of the North Koreans, fear of ISIS, fear of this, fear of that. But you do have to, every once in a while, say, “It’s time now to assess our insurance.” And then once you have assessed your insurance – my wife and I just did that the other day, it’s like, “Do you have enough if something happens to me?” Well, we looked at it. But, I’m not thinking about it every day after that, either.

David: Right. And I can say this emphatically, because I grew up as a five-year-old, six-year-old, ten-year-old – this will speak to all of my neuroses, I’m just laying it bare for the general public – the Red Dawn scenario was breakfast, lunch and dinner at the McAlvany home.

Kevin: Your dad loved that movie.

David: Right. And it was a fait accompli, it was just a matter of time before we had Russian paratroopers and Hind D24 helicopter gunships flying over into the valley, right here in Durango, Colorado.

Kevin: And it could have happened.

David: And Bayfield, just the neighborhood next door to us, you know what their high school mascot was? The wolverines.

Kevin: (laughs)

David: There is so much of this that is packed into, “Why don’t you just go dig a foxhole and jump in it and wait for the end of the world?” The reality is, what has saved America through every issue, thick and thin, has been free enterprise, has been entrepreneurship, has been innovation, has been hard work, has been the ability for the individual to express themselves creatively, brilliantly, and to solve problems.

Kevin: And then for us to come together at the right time. So the individuals do, by their own choice, come together. So there is great hope, but there are also a great many concerns.

David: Right. And there is a nuanced position in what we talked about earlier, with financial technology. Some of that is eerie and speaks to an ability to control our lives. Some of it is also innovative genius which takes an old, staid industry – the financial and banking industry – and like I said, turns it to a pile of dinosaur bones. There is opportunity and this is what Schumpeter talked about in terms of creative destruction. “When one thing goes away, it opens up the opportunity for ten more new, innovative, different, and incredible things.”

Kevin: You just don’t want to be invested in the thing that’s going away.

David: (laughs) Right. So for us, it is an attitude of, you prepare for the worst, you hope for the best, and you’ll be ready for anything.

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