February 22, 2012; The Dollar, Greece, and Stocks: Tragedy Ahead

Weekly Commentary • Feb 23 2012
February 22, 2012; The Dollar, Greece, and Stocks: Tragedy Ahead
David McAlvany Posted on February 23, 2012

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: David, yesterday morning my wife was showing me a cartoon in the paper. It had this gigantic fat lady lying on top of this skinny little guy. The caption said, My Big Fat Greek Wedding. The fat lady was debt, and the little guy underneath was Greece.

We have just heard that there is a solution, again, to the Greek problem.

David: No, the tragedy is supposed to be over, and it’s anything but over, Kevin, because the reality is that the numbers do not work for them. They have too much debt and they still haven’t gotten rid of enough of it. One may think it can work if investors are willing to take a haircut, and banks are willing to take a haircut, and we are willing to extend the terms of the existing loans, and turn them into new products, but Kevin, they don’t have an economy that can support the debt that they have.

It was only minutes after they came to an agreement that a report was leaked to the Financial Times, an official document that said that by 2020, even though the stated goal and our promise and intention is to get us to 120% of debt-to-GDP by the year 2020, it’s going to be more like 160%. If you think about that, here’s how the math works. If you have 60% more debt than GDP, essentially, you have negative compounding.

Kevin: It sounds like you are going backward at that point.

David: You are going backward. Just as you want to grow your assets at a 5%, 7%, 8%, 10% rate of return, and that compounds positively, debt compounds negatively against you. When you have more debt than your economy can support, that, essentially, is a game over. This goes back to the study that was done by Reinhart and Rogoff in which they said, actually, it’s not even 100% of debt-to-GDP where you reach a critical point, it’s 90%.

So 110%, 120%, the Greek admission of 160%, it’s just the fact that they will play this out as long as they possibly can, ultimately either be expelled from, or voluntarily leave the European Union, and then at that point get rid of the debt via either an outright devaluation of the currency, or a default. It’s still in the works, it’s just a question of having one year, two years, three years more, in which they get to siphon off funds from the rest of Europe.

Kevin: What amazes me, though, is the guys who went out and bought Greek debt hedged themselves. They bought insurance. They bought derivative contracts that would pay in case there was a default in the economy. Now they have been asked to take, not a 50% cut, but a 53.3% cut.

David: And the bad news is that those insurance contracts are not going to pay, because there, technically, was no default. So they lose on both sides. They paid the premium for the insurance and there is no compensation for what should be considered a default, but it is technically not, so they lose on both sides.

Kevin: We talk about “they.” We talk about those crazy people who would buy Greek debt. Well “they” is “us,” because there are institutions world-wide who buy debt all the time, and then they insure it. It is a hedging process. Most financial institutions have to hedge their bets, otherwise they do take a 53.3% haircut.

David: Kevin, I think, if anything, we have just moved toward a resolution in the press, and for the next few weeks, perhaps, there will be some respite from the headlines of an imminent Greek demise. We have pushed that off perhaps 12 months, 24 months, or 36 months. Perhaps it becomes on a more accelerated time scale, but I think for the time being they have sufficiently bought time.

Kevin: Let me ask you this, though. I’m Irish. My name is Kevin Orrick – I’m Irish. Let’s say I’m in Ireland and I’m thinking – gosh.

David: Those guys got a great deal!

Kevin: I can’t pay my debt, how about you just go ahead and do it for me, too?

David: Can you reduce it by 50% for me too? I’ll buy you a Guinness.

Kevin: And then Portugal, and Spain.

David: And Greece, and Italy. There really are implications from the negotiations, and we are going to see all of these other countries, again, as you mentioned, Ireland, but certainly Portugal, Greece, Spain and Italy, looking to carve out as good a deal, or a better deal, and they know that they, in some sense, have an upper hand.

Here’s what I mean by that. Essentially, the EU needs them in, more than they need to be in. Does that make sense?

Kevin: Yes.

David: It’s the issue of their being willing to maintain this commitment to the Eurozone project at a very high cost, and we can, to some degree, milk that. That is essentially what has been put into play, with all these other countries still having the same kinds of problems. In fact, it was just over the weekend that Bloomberg ran an article about how Spain’s numbers were deteriorating rapidly. We already know that Portugal, if you look at their CDS spreads, are already in a very precarious place.

Kevin: Italy is a gigantic problem.

David: Yields have gotten better in Italy, so we are back to September levels for Italian bonds, but still, the debts have not gone away. Structurally, nothing has changed. What we have is, again, a little bit of respite, and a little bit of calming of nerves in the market.

I will tell you, Kevin, what has me very concerned is, actually, what is happening here in the United States, number one, in our stock market, and number two, in the dollar, the undercurrents within the currency system.

Kevin: Let’s look at the dollar for a second, because the dollar has had somewhat of a boost with this European crisis. Every time they kick it down the road, people say, “Well, Europe is not going to make it in the long run, but maybe it’s going to now.” But the dollar has not really fallen much because of what is going on across the Atlantic.

My question would be this. The dollar is a reserve currency. It is something that has been solid in the bank accounts, these big central banks, since 1945, basically, but now, David, we are seeing the dollar hollowed out, and people are starting to mistrust the dollar, but they are still holding it because it is what they commonly use for transactions.

David: There are actually two themes in that, Kevin, because on the one side we have the official holding of Treasurys in U.S. dollar-denominated assets. As an example, the Chinese have over 3 trillion dollars in currency reserves, and the majority of that, close to 60%, is assumed to be in dollar-denominated assets, many of those Treasurys.

Kevin: And the European banks.

David: Exactly, and so you have the dollars held as reserves, which are one thing to focus on, and certainly, we look at the TIC flows on a regular basis to see if individual central banks are beginning to reduce their holdings, and we have seen some of that occur on an accelerated basis, but that actually is not our primary concern. We have a very different concern within the currency markets.

Kevin: David, it is interesting, because we look at what is in banks as reserve, and we say, “Well, the dollar must still be solidly holding its place that was put together during the Bretton Woods time, when the dollar was still backed by gold, but there seems to be something happening worldwide right now where people, countries, are starting to pay for things in something other than dollars. They are happy to maintain their dollar reserves, but we just heard that China and India are looking to pay for oil, with gold, to Iran. That’s not the petro dollar, that’s not the dollar monopoly that we wanted to see in place.

David: Essentially, what we are seeing happen, Kevin, and we talked about this when we interviewed Barry Eichengreen a number of months ago, is the democratization of the currency markets, whereas, we have been dealing with a dictatorship in the post Bretton Woods era. We had everything centered on the U.S. dollar following 1944 when we met in the White Mountains of New Hampshire, and all the world central banks agreed to use the dollar as a reference point.

Kevin: It was backed by gold back then. And it was not only the reference point, but it was the currency through which invoices would be settled, through which transactions would be settled, and it set the stage for what you just described as dollar dominance in the world of commodity transactions.

David: We do have two themes here, Kevin. One is the dollar as a reserve asset, which again, if we suggest that the Chinese have three trillion in reserve assets and 60% of that is in dollars, we need to keep them very happy, very pacified. What would happen to the U.S. dollar if they were to dump their Treasury holdings? Let me suggest that it doesn’t matter, because what is more significant is an economy that is close to $4 trillion in total, and is being re-engineered to settle trades around the U.S. dollar, whereas many of those transactions have taken place in U.S. dollar terms.

There was a monumental agreement signed in December, a bilateral agreement between the Japanese and the Chinese, to begin settling their transactions in their own currencies. Of course, this is not the first time. We have seen the Chinese do this with Argentina. We have seen them do this with many of the cross-border transactions in their own neighborhood. When they are looking at Asian trade, when they are looking at trade settlement with Europe, when they are looking at trade settlement with anyone except their trade partner, the U.S., they are interested in settling transactions in a different currency, no longer the U.S. dollar, and this is far more important than how reserves are constituted.

Kevin: David, we talked to Barry Eichengreen, who wrote a book called Exorbitant Privilege, in which he said that the United States has enjoyed something that no other country enjoys, and that is, we can print the world’s transactional and reserve currency, as much as we would like, we buy products with that, and then those dollars come back into our fold. They have to be re-invested in the United States because the Chinese don’t use the dollar in their own economy.

David: Kevin, Jacques Rouffe, going back to the 1960s, made this argument with a number of central bankers at the time. He said, “I wouldn’t be as careful about the number of suits I ordered, if the tailor returned my money to me immediately after paying him.”

Kevin: Right.

David: And this is the issue, we tend to over indulge, in terms of our consumptive habits, and run these trade deficits, and we are allowed to, because the money that we send out is recycled back in, in the form of savings from foreigners.

Kevin: David, let me ask you this. We started out with Greece, we started out with the euro. We have talked to an awful lot of people who have said that you can just count the euro out, it’s not making it, it’s not holding together. You have said something different. You have told all of us, don’t count the euro out, because the world is getting sick of just leaning only on this hollow shell of a dollar. Are you thinking that the euro will be one of the key currencies in the future, even with the problems that they have right now?

David: Kevin, if you look at what has happened over the last ten years, we have seen the value of the euro, compared to the dollar, go from 0.85 up to 1.6, and now it is hovering right around 1.3. To be above a 1-to-1 relationship with the dollar, in spite of all the things that have happened within the Eurozone, it is very remarkable in terms of the support given to the euro.

Yes, the dollar is its own story in terms of any internal weakness, but as I look at the euro, it should be back at a 1-to-1 if it were losing credibility. In fact, it is not losing credibility at all. There is Asian support for the currency, there is Middle Eastern support for the currency, and of course, there is European support for the currency, but essentially, the reason there is support for the currency is this desire to move away from dollar monopoly status, or dollar dictatorship, if you will, and toward currency democracy.

I realize we are borrowing political terms here, but they want more of a fair balance between the currencies and they have decided not to do that via reserve assets, but in fact, to begin to change the plumbing, if you will, within international trade. This is via the transaction settlement and invoice payments which have typically taken place in U.S. dollar terms, thus forcing institutions, whether commercial banks or even central banks, to hold vast stocks of dollars, so that world trade can be settled in this currency.

Kevin: Let’s rewind the tape a little bit, David. Let’s go back almost 100 years, back to the 1920s, 90 years before where we are right now. At that time, the British Empire, and London, in particular, was the financial transactional and reserve base of the world. Countries that wanted to do international business had to have business with London. The British sovereign was the world’s premier currency at the time, which was gold-backed, but there were some cracks showing in London being the financial center of the world.

David: And certainly a part of this was frailty within their own political and geopolitical structure. They were losing a grip that they had had for over 100 years, and they had that, in large part, because of their military, and advancement in the naval project, a secure currency. All of these things played well into their success.

Kevin: Similar to the United States right now. George Friedman said that he who controls the navies and the seas of the world actually controls the world.

David: But in the 1920s, we were already seeing London hollowed out. We were seeing the pound sterling hollowed out. We saw capitulation in the early 1930s and a devaluation of the currency, the pound sterling in the 1930s, and then of course, shortly thereafter, the U.S. dollar was devalued by 65%, almost in lockstep with the pound. But what happened is that in that hollowing out process, the U.S. dollar became the marginal beneficiary of suspicion thrown on the pound sterling, and we are seeing that happen with the euro. It is not necessarily winning on the basis of its own merits, it is just winning on the basis of dollar demerits, and a desire to move way from a dollar-centric universe.

There is a report that I would encourage our listeners to get, because this is an issue that is explored well from a European perspective. I am talking about the Global Europe Anticipation Bulletin, #62. If you go to the Leap 20/20 website, and we have the link available on our web page, you can order the report, either as a stand-alone copy, or subscribe annually, which is absolutely worth it.

One of the things that they ask in this report is, what proportion of the transactions is being invoiced, in which currency? The vast majority, for the last 40, 50, 60 years, has been invoiced in U.S. dollars. The real question here is, why is the world still using the U.S. dollar as a middleman currency? It is no longer necessary. If there is anything that we have learned in this digital age of buying things either via eBay or some other online auction site, it is that you don’t need the middleman. But here we are, transactions between the Japanese and the Chinese being settled in dollars. Why? That is the question asked, and the answer has already been given, and guess what that means? A bilateral trade agreement in which the dollar is no longer the middleman, and in the flow of currency, having our currency available to settle those transactions is no longer required.

Kevin: David, the question has come up many times in the past. Why did the dollar not collapse in 1971 when Nixon closed the gold window? A big part of that was the agreement that the dollar was still going to be the middleman. It was going to be the bridge you had to cross. Let’s say you were Japanese and you want to buy oil, then you were first going to convert yen to dollars, and then buy your oil. The exchange used to be in the World Trade Center, when it was still there, and it was all dollar-denominated.

David: Right. Kevin, I think this is essentially what is changing. We have run huge trade deficits, but the surplus trade partners have sent those dollars back to us in the form of overseas savings. That has acted as a prop for the dollar and perpetuated this cycle of overindulgence. It goes a long way toward explaining why there are reserves held by foreign companies, foreign banks, and foreign central banks, in dollars.

But again, the point here is not that those reserve allocations are necessarily going to shift. They may, and that presents its own set of problems, but that is not, front and center, what is going to cause a significant decline in the dollar over the next 24 months. What is going to cause a significant decline, upwards of 20-30%, in the next 24 months, is the change in plumbing, the substructure of transactions, global trade no longer being done in dollars, but in currencies between individual trade partners. We are losing our middleman status.

Kevin: Do you think maybe this is why the experts who are monitoring the cockpit, let’s say, of the dollar, are still missing this, because they are monitoring bank reserves? You talked about three trillion, the majority being in dollars, and that, of course, is the case all across the world. There are still a lot of dollars in bank reserves. But if you compare that to transactions, actual buying and selling of products around those reserves…

David: And that country, itself, has 3.75 trillion in annual GDP, so we are dealing with an economy that if it can begin to define its transactions in terms of euros, in terms of yuan, in terms of yen, and not in terms of dollars, here is one of the things that is eliminated.

Kevin, again, I like the example, because this is a trade agreement that has already been reached, but these two countries are both taking currency risks by going into the dollar, and it is unnecessary currency risk that both of them have to be subjected to. Ordinarily, only one in a currency transaction will have to take the risk.

Kevin: What you are saying is that in the middle of a transaction, if they have to go to dollars, and then move to something else, they still have to worry about whether the dollar rises or falls during that transaction.

David: You bet, or they incur an expense to hedge that out. You can hedge away the risk, but now there is an increased cost in terms of the transactions, because they are dollar-based. It is a brilliant move. It is a subtle move. It is a move that we are not in control of, because it is not something that is determined by the WTO. It is not something that is determined by the G7 or the G8. These are individual country bilateral trade agreements which are being signed, to the exclusion of the U.S. dollar, and the U.S., and the benefit then to the U.S. economy.

Kevin: So the moral to the story of what we are talking about currency-wise is, don’t count the euro out, even with all that is going on over there, and don’t bet too heavily on the dollar right now, because we probably are seeing a hollowing out, and ultimately a shrinking.

David: Our concern about the dollar has always been long-term. I think you can fast forward and say that 12-24 months is really a wake-up call for us as we see a 20-30% decline in the dollar. And that begins to remake a number of other asset classes.

We are not here today to talk about the metals markets, per se. We are not here today to talk about scenarios that would do, actually, quite well in an adjustment phase to new and lower dollar values. But we do have very strong concerns, in terms of the U.S. equity market, and there are some fundamental and technical dynamics which we should explore.

Kevin: Dave, let’s do. Let’s shift to the stock market, the equities market. We are seeing the stock market rising right now, but there are some particular patterns. Strangely enough, they seem very optimistic. The patterns of bullishness. The patterns of new highs being hit. There are a lot of patterns out there right now that are making people who maybe don’t know that much about the stock market think that maybe we are in the beginning of a new bull market. What are some of the things that you are seeing, Dave, that are causing concern?

David: Kevin, last week we sent out a breaking news flash to all of our viewers and listeners that we are seeing an undercurrent in the market in which there are still rising prices within the equity markets, but on lower and lower volumes. This is usually not a characteristic of fledgling bull markets, but in fact, a rising trend, a rally trend, if you will, in the context of a broader and longer-term bear market. That’s where we have consistently seen these kinds of patterns. If you are looking at a chart, it’s what they call a rising wedge, and that’s what we highlighted in the breaking news release last week, that we are in a very precarious place.

The equity markets either need to break out considerably to the upside, and we don’t see the fundamental reasons why they would at this point, so really, the only thing driving prices higher from this level would be outside stimulus. In other words, an announcement of Quantitative Easing III, further stimulus from the ECB, the Bank of England, and you know what they did just a few weeks ago with another 50 billion in pounds to support the economy there. That kind of an effort is enough to buoy prices, but you have to understand that the fundamentals within the market are actually deteriorating rapidly.

Kevin: David, we talked about this. Right now there is probably about a $10 upside for every $50 downside, as far as the risk goes. It’s about a five-fold risk to the downside, versus maybe a one-times risk to the up.

David: Right. We have a lot of respect for Bill King, he is a guy who has been on the program a number of times, and one of the things that he has highlighted here recently is the divergence between high-yield bond funds and stocks. This is the consistent pattern over the last several years where high-yield bond funds and stocks have moved in lockstep, and in fact, the high-yield bond funds have usually preceded or come before a major move, either up or down, within the equities market.

Kevin: It is a little like the parakeet in the mine. You want to watch to see if that thing is still alive. The high-yield bond fund is the parakeet. If it is going up, the stock market probably is, but if it goes down, and the stock market keeps going up, stop breathing the air in the mine.

David: And that’s exactly what we have. Stocks are still rising, with the high-yield bond market deteriorating rapidly. It is already correcting. Meanwhile stocks are somehow levitating to higher levels. We think stocks will fall in line with that. Again, one pattern to look at is that divergence, currently, between the high-yield bond funds and stocks.

Kevin: Well, and Dave, it’s the law. That is, if you are an executive or a CEO at a company, and you own stocks in your company, you are considered an insider. Now, that’s a legal insider, but you can’t do anything without reporting to everyone what you are doing. When you buy stocks, it is reported. When you sell your stocks, like when Bill Gates sells Microsoft, it is reported. That’s another parakeet, isn’t it? It is something that we can watch.

David: It is, Kevin, and what it really tells us is whether or not someone who is operating the business sees the stock as overvalued or undervalued. If it is undervalued, then it’s like picking up 100-dollar bills on the street. It’s free money. They are going to continue to do their job, ultimately the shares are going to be priced higher, and they are going to make a killing on their stock options.

Kevin: Sure, you want to own stocks in your own company if you think it’s going to do better this year.

David: Exactly. Now, there are a few companies that are an exception to this, where they regularly sell their shares because it’s one of the primary forms of compensation. This is particularly in the technology sector where there is low compensation in terms of dollars, but high compensation in terms of stocks, so people are, including the Gates family, regularly selling Microsoft, and things like that.

Take that out of the equation, if you will, and then look at the top 20 companies in the country, and what you find is that there are about 11.6 liquidations for every purchase. That’s actually a transaction, if you dig a little bit deeper, and look into the shares bought versus shares sold, the actual quantities, the volumes, if you will, of purchases versus liquidations.

And by the way, Alan Newman, in his report, Cross Currents – absolutely vital. I suggest that everyone subscribe to Cross Currents, Alan Newman’s monthly newsletter, and Global Europe Anticipation Bulletin. Both of these are fantastic reads. What I like about this is that he goes a little bit more granular into it this month in saying, “Listen, we have 398,000 shares that were bought…”

Kevin: The 11.6 out there who were buying…

David: Compared to over 50 million shares sold.

Kevin: Which is the 1. So, 11.6-to-1, the 11.6 who were buying only 398,000 shares, the 1 was selling 50 million shares.

David: That’s correct. Just to show you, we said we wanted to take Microsoft out of the picture, which puts it instead of 126-to-1 on the volume statistics, more like 100-to-1, in terms of volume of liquidation by insiders compared to the purchases by insiders. Again, this is just an indication that this has been consistent, actually, for ten years, but it tends to spike in terms of liquidations in anticipation of major declines in the equity markets, when they feel like stocks are actually as high-valued as they are going to be, and you might as well cash in now, because tomorrow, or in the next few years, we are not going to see higher values. That is executives, people running the businesses, saying, “From an operational standpoint, we don’t see upside.”

Kevin: I’ll tell you one that scares me, though, a little bit. A lot of people who are listening right now have an investment advisor. Investment advisors are polled, and strangely enough, any time investment advisors are highly bullish, that is usually the top of a market. Right now the investment advisor polls are showing them to be very, very positive about the market.

David: Yes, close to 55% are bullish today, 54.8, and that’s on par with last July’s numbers. This is the real issue. When you run out of buyers, prices decline.

Kevin: This is the key to contrarian thinking. You don’t want to be buying when the investment advisors are bullish, you want to have purchased when they were bearish.

David: And this is the point. That’s where the best value is, when the market is throwing in the towel, not when the whole market is jumping on board, or when, in fact, the market has already jumped on board. This is another statistic which goes to the point that we are very concerned about equity prices today. If someone owns an equity portfolio, we would suggest they lighten up, they hedge, they do whatever they can, because there is tremendous downside risk and limited upside risk, with upside only being supported by central bank intervention.

Mutual funds. They are nearly invested to the gills. In other words, fully invested, with less cash today than they had in 2007-2008 just before the market crash, fully invested then, with the idea that there was only upside. They are fully invested now, with the idea that there is only upside. The only other time that we have seen this, Kevin, where they had low, low cash reserves, was 1999 to early 2000 before the market collapsed then.

Again, we have seen them make a full commitment, because to be honest with you, Kevin, asset managers, in general, in general, are more concerned about missing the next up-move than they are about protecting the downside, because many of them are very sanguine about what it means to lose money. We are not, but many investment advisors are. If an investment advisor loses money and it’s on par with the rest of the market, then, relatively speaking, they can’t be punished for it. You are not going to move your assets. That investment advisor loses 10%, everybody else lost 10%, so there is no motivation to move money.

But they will find money leaving assets under management if on the upside they only return 10% while everyone else returned 15% or 20%. That is when you see a migration to other asset managers. People, on the basis of greed, will reallocate, and be chasing returns, so what they are afraid of is being left out of the next move higher, more concerned about that than they are the next move lower, because frankly, everybody loses on the downside.

Kevin: That’s a common theme that we hear. We will be talking to clients and they will say, “Well, of course, my assets are doing fine, except in 2008, and of course, everybody lost in 2008.” Now, that’s not true. There were those who did not lose in 2008, who saw it coming. But for the most part, the investment advisors got a break because it was the majority that had lost in 2008.

Here is something that I think is an analogy, though, Dave. We talk about politicians making decisions based purely on getting re-elected every four years or what-have-you. It really hurts the long-term strategy. It is the same thing, I think, with investment advisors. They are looking at the next game, worried that they are going to lose money if somebody beats them.

David: Our concern, frankly, Kevin, is much more along the lines of the major trends, and the major trends which are propelling asset values up or down over a longer period of time. We don’t compete with investment advisors on that basis. The major trend is either at your back, or it’s not. You either have wind in your sails or you do not.

We talked about this when we were down in the Bahamas with a number of clients in recent weeks, Kevin. Trading in the stock market today is like picking up pennies in front a steamroller. There is simply not enough reward in it, given the risk that is right there. Contextually, the risk is too great. Someone at the gathering said, “But if it was kilo bars or kruggerands, we’d be out there.” (laughter) And I said, “Actually, I’d be out there even in flip-flops.”

Kevin: A little bit more reward for the risk. What you are saying is that pennies are not worth risking your life for in front of a steamroller.

David: Nor your savings, and yet that’s what investment advisors are doing today. We have seen a slight improvement in terms of margin debt, and this is another variable to consider when looking at how speculative the markets are today. Margin debt has declined off of its peaks of over 350 billion. It is right around 300 billion today. That puts it right at the same level it was in 1999-2000, right as the tech stocks were cresting, if you will, but it is below the all-time highs that we saw in 2007 and early 2008, when it got stretched, actually to about 400 billion. So the threshold there is about 350, still reason to be concerned. Just note that there is plenty of speculative money, in terms of people borrowing from their advisors to increase their returns, and enhance their returns, by using the house’s money to invest with.

Kevin: Then, if I could give a word picture, here, if you were in Vegas right now, you would see all the mutual funds’ chips on the table, but maybe three bucks in their pockets for every 100 dollars worth of chips, or 97 dollars worth of chips on the table. But not only that, margin debt, in other words, borrowing from the house, is also getting near…

David: Those are also chips on the table.

Kevin: Those are chips on the table. There is no more cash to go into this market. The three bucks that they have in their pocket – that’s it. So again, the issue is, whether we have negative or positive news, there is just no new energy coming in.

David: Right. On top of that, if you look at the bearish bets against the market, you could say, “Well, listen, maybe they are short-covering rallies from here. Maybe there are those who are short the market, who are going to be covering their short positions, and that is going to add steam to the market.

Kevin: Explain that. Explain a short-covering rally, the person who takes a short, who says, “No, I am going to bet against the stock market instead of for the stock market.”

David: And hopes that it goes down.

Kevin: And hopes that it goes down. Something follows that if it doesn’t happen, right? There is a short cover.

David: Right, if I close out that trade, essentially, what I am doing is buying back those shares and adding energy in terms of a purchase of those shares.

Kevin: To the positive side.

David: To the upside. So as you cover a short, there is positive momentum to the upside. The problem is, we have the lowest level of bearish bets, these market shorts, that we have had in ten years! So we have no one who is bearish today. We have the investment advisors who are rabidly bullish. We have mutual funds which are fully invested. We have a rising wedge where prices continue to increase, and yet, volume is falling off. Kevin, we are on the cusp of reversal. We would suggest that we have a 1000 to 2000-point decline immediately in front of us in the Dow, the same percentage declines in the S&P 500, and guess why you can’t go short to the gills?

Kevin: Because the government could print money.

David: That’s the problem. In this environment, in an election year, and not just our election year, but it’s a Spanish election year, it’s an Italian election year, it’s a French election year, it’s a Belarusian election year. Fifty percent of the G20 are in the same throes we are, looking at a punk economy and trying to get re-elected, trying to convince the electorate that they are doing a good job and things have actually improved on their watch.

Kevin: And really, their only tool is to print money.

David: Monetary policy – basically, flogging the money supply. That’s what we have seen happen so far, and we think we will continue to see it – central banks around the world accommodating as best they can. We are looking at incredible frailty, and for us, to be short the market is only to hedge out of the positions. You don’t necessarily want to speculate on the short side, because central bank activity can get ramped up in radical ways, just like we saw the Chinese back in 2009 throw a trillion dollars into the marketplace. That didn’t help stocks in China, but it did stabilize the economy, to some degree.

Kevin: David, just to use a summary quote from Alan Newman from Cross Currents. He says, “For now, we are in a high-risk zone, and you don’t need to know much more.” In other words, you probably ought to keep your powder dry, have your third to 50% in gold in the triangle, have some, maybe, in the equities markets, and some in cash, but don’t go out there and put all the chips on the table.

David: No, I think your best bets are probably in the precious metals sector, and in cash, at this point. Those two give you tremendous buying power in the midst of a decline. Newman’s sentiment indicators are fantastic. He is suggesting that there is a major top, the bears are becoming bullish, and that usually precedes a major reversal in the market.

Kevin, from a technical standpoint, from a fundamental standpoint, who is actually in the market, buying today? We see there being heightened risk, very little appreciation for the risks that are in the marketplace today. Again, there may be a few last-minute suckers who step in and buy equities. The only basis that we have for betting on equities today is central bank intervention. That’s a crap-shoot. That’s hoping against hope that the central banks come out with another bailout strategy, and it just happens that those dollars flow to the markets that you are positioned in.

There is the ability by central banks to create money. There is no ability for them to direct the flow. Unless the central bank is actively purchasing a particular asset class, whether it is mortgage-backed securities or what have you, liquidity is provided, and it doesn’t necessarily have to go where they want it to. We see that in terms of current excess reserves with depository institutions, with nearly 1.6 to 1.7 trillion dollars of liquidity that has been created by the central bank has been taken in by the banks themselves, the commercial institutions, and put back on deposit with the Fed, because they are not willing to risk it in the marketplace today. They are not willing to loan it out, because they don’t think it’s a good bet.

Is that a little strange, Kevin? Banks not willing to lend? That’s how they make their money, by putting more money into the marketplace. And yet, we have record amounts, we have never seen this amount of money, sitting re-deposited with the Fed, by these depository institutions. Does that tell you anything? That, along with insider selling. People who are in the know look at the economy and say, “No, absolutely not. We will not place our money on that particular bet. The only money we are willing to bet is other peoples’ money.” That’s a sad story.

Kevin: So, David, just in summary, we talk about the triangle often, and I am bringing it up again, because really, the triangle forces a person to look at the long-term trends and ignore the short-term fads, let’s call it. And really, the fad right now, David, is this bullishness in the market that really has no support.

David: Kevin, I think there are a couple of other things that are worth addressing here, because if you look at the perspective triangle, part of it is insurance related – that’s gold and silver – at the base of the triangle. If you look at the left side of the triangle, and it may have a growth thematic or an income thematic – stocks, bonds, the typical asset classes – they are on the left-hand side of the triangle. On the right-hand side of the triangle – cash, cash equivalents, foreign currencies – there you have the liquidity mandate being fulfilled by a variety of vehicles.

There are a number of advisors out there today who are suggesting that gold will sell down to $1000 an ounce, silver will sell down to $10, $15, and that is when you want to be buying it. And they are assuming radical strength in the dollar. I think one of the things that they are forgetting is that the dollar is not what it used to be. The dollar is no longer connected to gold in any way, shape, or form, and in a deflationary or de-leveraging event, people move to the best possible credit. That is what has happened historically, and that is what has happened in the 1930s and every other period of deflation leading up to the current situation we have today, and in fact, gold did very well in every one of those equations.

Kevin: Gold did well, and the dollar did well only when it was still tied gold. That is what you are saying. Now that it is not tied to gold, we have to consider deflation from a gold perspective, not a dollar perspective.

David: What we have seen in the last ten years, Kevin, is a radical deflationary cycle.

Kevin: Everything has gotten cheaper in gold terms.

David: In gold terms. Essentially, when looking at equities – listen, you have just increased your purchasing power six times, 600%, with this insurance component in your portfolio. It now buys six times the amount of equities that it had bought, and we are in the cycle where your purchasing power is likely to increase another 4, 5, or 6 times yet again, within the next 2-3 years.

Kevin: Dave, you used the example last week about houses, as well. The same amount of money that would have purchased a house five years ago, the same amount of gold, now buys 4-1/2. That’s an amazing increase in buying power, but you are saying, we are just halfway there.

David: Right. I don’t think anyone wants a dent to their reputation. When looking at these financial matters, and trying to assume that the U.S. dollar has a constant value from then until now, no one should go through that kind of pain, and come out the other side with the realization that they missed one of the great bull markets of all time, and were subjected to one of the great deflations, but were in the wrong denomination for their savings. Kevin, I think that is simply a dent you can’t afford to your reputation.

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