February 6, 2014; Submerging Markets Propel Gold to Haven Status

Weekly Commentary • Feb 07 2014
February 6, 2014; Submerging Markets Propel Gold to Haven Status
David McAlvany Posted on February 7, 2014

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin:  The emerging markets, Dave, have been in everyone’s minds.  Normally not.  Most people just sort of take them for granted, but with the markets falling overseas, the currencies falling overseas, and now the stock market here in America falling in tandem with that, people are starting to pay attention.

David:  Yes, and some would still say, “Why should I care?  I’m not planning on an overseas vacation or travel.  Why does it matter to me?  That’s someplace else.  They don’t even speak the same language.”  We live in sort of an anglophile world where, frankly, why should it matter?

Kevin:  But how much does the emerging market impact us?

David:  It’s a very big deal in the sense that, let me just rattle off a couple of things that I think people may not know.  Emerging markets make up a larger percentage of the global economy than at any other time in world history, specifically, 50% of the total global economy.

Kevin:  So half of the world’s economy is this group of people that we don’t pay much attention to.

David:  Right, so to assume that problems in smaller countries are without consequence is to ignore the scale of the emerging markets in aggregate.  I think the second point is that most of our multinational corporations, if you are thinking of the Dow 30, or the vast majority of the S&P 500, they are receiving, at present, 35%, 40%, 50% of their revenues from emerging market countries.

Kevin:  So Dave, what you’re saying is, an American company like General Mills, or somebody who sells cereal, they’re receiving maybe up to half of their revenues from these emerging markets.

David:  Yes, a third to a half, and this has been an area where they have been able to grow.  You are selling product in the U.S., but you have sort of saturated the market, nobody’s buying any more boxes of cereal, so what do you do?  You go someplace else and try to get shelf space elsewhere.  But just think about this example.  If a currency is declining in an emerging market country, what it ends up doing is impacting the purchasing power of the local consumer, so that box of Wheaties, for instance, maybe with a 10% devaluation in the local currency, puts the price of that box of Wheaties out of reach.

Okay, so that negatively impacts the spending of that person, and thus the revenues of the U.S. multinational.  Ergo, the U.S. stock market can suffer greatly, and there are, of course, benefits, that’s what we’ve been talking about, as well as drawbacks, that’s what we’ve been talking about, from globalization.  Markets are interconnected at every level.

Kevin:  Well, and there is a disadvantage that a lot of countries, actually all countries except for our own, in that they have to borrow in someone else’s currency.  We can print our own.  They have to borrow in someone else’s and pay it back.

David:  Most of your emerging markets borrow, in foreign currency terms, and we’ll talk about that in just a minute.  These foreign currency loans are facilitated by the banking community, and thus you have one more issue of sort of cross-border vulnerability, with concerns being concentrated in the financial sector.

Kevin:  And we’re talking trillions, here.  We’re not talking hundreds of billions.

David:  Right.  Emerging markets have attracted, and this goes back to 2005, not just loans, but mergers and acquisitions, people investing in stocks, bonds, direct investment in manufacturing and services.  You’re talking about 7 trillion dollars of foreign capital that has flowed to the emerging markets since 2005.  If you combine the 7 trillion-dollar investment in emerging markets with the hedge fund community, ten times larger today than it was in 1997 at the onset of the Asian contagion, you have a lot of potential volatility ahead.  These are folks that are happy to short the market, make money as things are falling, go long, do it on leverage.  There is a new element in the market, where any trend that is in play is going to be exaggerated, on the upside, on the downside, because you have leveraged speculators, more of them in the marketplace, than at any other time in history.

Kevin:  But, you know, the data that is coming in, especially this week, is that the economy is not growing.  There is an old saying, “When you’re green you’re growing, when you’re ripe, you rot.”  But the markets are the same way.  If you’re growing, it’s green, everything’s fine, you can get away with an awful lot, but once you get ripe and start rotting, you have to come up with other methods to figure out how to keep this growing.

David:  I think the Chinese manufacturing and nonmanufacturing gauges reinforce what we saw in the U.S. ISM numbers earlier this week.

Kevin:  So it’s not just us, it’s China, it’s widespread.

David:  Yes, and it’s adding pressure to the emerging market declines.  We had the HSBC, PMI, the Purchasing Managers numbers out last week, which were terrible, and then we had the official PMI numbers from China this week, and what it suggests is that Chinese factories won’t need as much aluminum, copper and steel.  So when you look at how the dominoes all fall, if the manufacturing indexes in China decline, that would mean that copper from Chile is not going to be in as high of demand, steel from Brazil is not going to be as in high of demand.  You begin to see why there are linkages and weakness in the emerging market, on the basis of bad economic numbers, whether it is here in the United States, or in China, as we just mentioned.

Kevin:  You mentioned U.S., you mentioned China, but let’s throw Europe in there.  The European banks are very intimately integrated into these loans.  In fact, I think it is larger than the United States, isn’t it?

David:  European banks have lent more than four times the number of dollars to the emerging markets than U.S. banks, right around 3 trillion dollars, and that is a number of consequence.  From this morning’s Bloomberg pages, they say European bank exposure varies from country to country.  You have BVVA and UniCredit, which have big exposure to Turkey, Santander, which is a big bank in Spain, it’s is most exposed to Brazil, Standard Charter in HSBC would be hurt by problems in India and Indonesia, Barkley’s meantime, would be most exposed to South African problems.  So you being to see this 3 trillion concentration in European loans to the emerging markets, and, again, how interconnected the world financial system is.

David:  And we talked earlier about how those loans that they are taking out are denominated in foreign debt, so let’s use Turkey as an example.  If Turkey’s currency falls a couple of percent like it did last week, that is like adding 2% to the principle of the loan.  How long can you do that?

David:  Yes, exactly.  You have the foreign-denominated debt issue.  It’s front and center.  And these countries are borrowing in euros and dollars, and that’s the difficulty.  They have to pay back the loans with a depreciating currency.  This is an issue for a commercial enterprise, and a government, alike, because even a government that has a printing press can’t print someone else’s currency.  You see?  And that’s the problem.  If it is denominated in a foreign currency, it has to be paid back in that currency, not your own, so you can’t print your way to success, as we apparently can here in the West.

Kevin:  So it’s a domino effect.  Here in America we may not pay attention to emerging markets.  They may not even pay much attention in Europe, even if it’s 4 times the loan exposure.  But once one of those dominos falls, you have Turkey and Venezuela, we can talk about China.  You mentioned South Africa.  These are countries we don’t pay attention to on an individual basis, but like you said before, make up half of the world economy, and those are dominos that are falling right now.

David:  You’re right.  Domino effect of currency pressures creating bank solvency issues.  So let’s look at that.  If exchange rate differentials reach a critical level, then defaults become more common.  An increased default rate impacts the lenders directly.  And if you can recall, this is a problem that has really been created in the modern banking era under a fiat money system, because under a gold standard, banking crises and currency crises were rarely connected.

Kevin:  You had both.  You had banking crises and currency crises, but like you said, they weren’t connected, and they seemed to smooth themselves out on their own without having any kind of real intervention.  But now, the coincidence of those two, currency and banking crises, occur too often to be ignored.  It can work in either direction.  So you have bank or financial panic, which can be met with money-printing and currency pressure, or like we have been talking about, currency pressure caused by a mass exodus of foreign investors, what is dubbed as hot money flows, and that can hurt the heavily indebted, with the payback on outstanding loans being more difficult, again, as that exchange rate differential widens, or as credit ratings are negatively impacted, either one.

So, if you are a creditor, an institution lending into the emerging markets, you do so, why?  Because the loan rates you charge are higher.  It is more profitable, potentially.  That raises a question.  Are the loan rates sufficient to cover the additional defaults?

Kevin:  We’ve talked about financial repression, we’ve talked about artificial interest rates.  It is interesting that this market does not yield what it actually should yield based on risk.  Every risk has a price.  Are you willing to loan to a dangerous country for maybe 20% interest?  Well, maybe you would.

David:  There’s a price.  There’s always a price for it.  But that’s the art and science of banking, figuring out what the appropriate rate is to charge, reflecting the risk taken in lending.  Of course, the curse of modern banking is having the big central banks set the benchmark lending rate well below a natural level.

Kevin:  Which does not guard you for the risk that you are going to take in the currency exchange.

David:  When that occurs, whatever loans are made cannot, cannot, account for risk adequately.  So the pricing of risk is critical for lending institutions, so that the compensation for lending adequately accounts for the inevitable defaults.  You are going to have a certain number of people who just don’t pay you, and that’s fine.  If you are making enough money on your other loans, it will make up for the fact that you did have some losses.

Kevin:  It’s like the credit card companies.  Some of these people are charging 21%.  Well, it’s because there is an awful lot of default on the other side of that.

David:  Yes, they know they’re going to have to negotiate some of it to zero, so that’s true, there is kind of a balancing act there.  The banking system may be grateful to the Fed, the Bank of Japan, the ECB, for bailout dollars, but to conduct business as a banker, without an accurate gauge for risk, is ultimately a dangerous environment, and that’s an environment that is created by the central bank policies, of intervention, of rate manipulation.

Kevin:  We’ve talked about retail management, and I was mentioning, when I was in college I was a retail manager, and when inventory wasn’t moving, that would actually show up as an increase, because inventories continue to come in, our trucks continue to deliver goods, but if our sales dropped, inventory was rising.  That was a bad sign that things weren’t going quite as well as we thought.

David:  This week, that is why Goldman-Sachs lowered their U.S. growth estimates.  They were noting that inventories surged in the fourth quarter by 127.2 billion dollars.

Kevin:  That’s the holiday quarter, too.  That’s when it would normally drop.

David:  And this is the largest move in inventory since 1998.  This is somewhat surprising.  But what about the higher equity prices?  I’m thinking of Goldman-Sachs and Lloyd Blankfein.  You’ve said that we’re going to see higher equity prices, but now you’re also downgrading the U.S. economy, and U.S. economic growth?  Okay, I’m sorry, I forgot.  There are two worlds that we live in.  You have the economy, and then you have the markets, and they are not really connected.  Not when the Fed is controlling the system.

Kevin:  Well, then there must be three, because you have also the perception that the Fed is trying to give.  The perception is, yes, we’re going to go ahead and taper because things are growing.  We have no signs of growth, but they’re telling us that they are going to taper.  I think of one of our guests a few months ago who said, “Let’s just go ahead and call it a taper-tantrum, because that’s what the markets will throw.”

David:  Since the Fed signaled a reduction in QE, they promised to remove 20 of the original 85 billion in monthly asset purchases, what the market is having to do is adjust to bad news actually being bad news.

Kevin:  Can you imagine that, Dave?  Look at how many times over the last year we’ve talked about every time there is bad news, the markets surge because they think they are going to give them free money.

David:  It’s one of the memorable themes of 2013 that bad news was good news because it guaranteed the Fed would print more, buy more, do more, and now in the last week to ten days, the market is digesting a Fed which embarrassed itself in the fourth quarter when it flip-flopped on tapering, that was, I think, November, and now feels that it must stick to its guns, for credibility’s sake, even as economic numbers are deteriorating.

Kevin:  Bill King brought this out.  He felt like with Janet Yellen now in, they’re going to have to prove that she is tougher than people really think she is.

David:  That’s right.  Add to that, Mr. Fisher from the Dallas Fed, who is now a voting member, and also somewhat hawkish.  So, let’s go back to this.  Imagine a world where bad news is bad. (laughter) It’s almost like imagining a world with gravity.  Last year was a year of counter-intuitive behavior, often inconsistent with the notion of cause and effect.  2014 might just be more rational.

Kevin:  Unfortunately, that also means paying for the person who doesn’t understand that the change has come.

David:  If it includes a continued decline in equities, I think pundits will pretend that it is the emotions of the investors which are causing a collapse.

Kevin: They always think it is an anomaly when something is falling, Dave.

David:  The truth is quite the opposite.  It is reasonable to expect cause and effect, it is reasonable to sell unsustainable values.  The market is having to recalibrate because the Fed’s activism in the market was leading investors to believe that economic growth and business profitability was an extension of monetary policy, like an investment being underwritten or guaranteed by a large financial institution.  So this is the Fed, now, at present, back-peddling.

Kevin:  I was looking at acronyms.  Sometimes you will see in some of the common blogs that they are using acronyms, and some of them are a little bit rude when you figure out exactly what the letters stand for.  But there are acronyms about just always buying the dip because you know the Federal Reserve is always going to print and infuse.  And that’s changing.  The “buy the dip” mentality may not necessarily pay off this year.

David:  I think you may be right.  Should the multi-day correction we have had become a 15-20% rout in U.S. and European markets, getting up in days, frankly the gains that it took months to accumulate, then I think you will see the Fed, with Yellen at the helm, begin to worry about the reversal of the wealth effect that they have been desperately counting on.  For stocks to give back 3, 5, 7 trillion dollars in value, alongside another bad jobs number, for instance, and we do hear rumblings about Dell kicking 15,000 people to the curb.  Then you have the current calm at the Fed, which might force more desperate measures, so Yellen could come back out with more quantitative easing, more accommodation, but it’s going to have to be at very much lower levels, because it appears she, again, for credibility’s sake, wants to stick to her guns in terms of keeping the QE dial-down on track.

Kevin:  And as we have talked about before, it’s not just equities we are talking about here.  Real estate started to look like there is some stabilization coming into it, but really, it’s because the Fed is owning all of it.

David:  Right, and I think they are realizing that their efforts, the Fed’s efforts, to stabilize the real estate market, had a different effect than intended.  You had private equity buyers that pushed up home values in 2013, and it was not your first-time home buyer, your classic owner-occupied purchase, but investors, instead, that dominated last year’s real estate market.  QE focused on two assets.  The Fed was buying government bonds, and they were buying mortgage-backed securities.  This is where the Fed is essentially underwriting the entire real estate market.  And this is the irony, not to the benefit of the man on the street.

Kevin:  It’s like a hedge fund.

David:  It was to the benefit of a leveraged financial firm, many of them with access to cheap loans.  So it was not as either stated or intended, not to the man on the street, but frankly, back to Wall Street, yet again.

Kevin:  But you have to have the Fed doing this.  You know, there are three characters in this particular equation of world economy or U.S. economy.  You either fuel it with income growth, that’s GDP, or you borrow more money, or you print what you don’t borrow.  Well, income, I think, is now shrinking, Dave, so we’re not getting it from the income side of things.  As far as the borrowing goes, we’ve already talked about it, these countries can’t pay back what they’ve already borrowed, and so we’re having to print.  I mean, where do you get the extra trillion, 1.2 trillion that we’re not actually financing with trade surplus dollars coming back into the United States?

David:  This recalls our conversation with Richard Duncan a number of weeks ago, where, again, you have to expand debt by 2%, at least, or you begin to move toward recession.

Kevin:  Or income growth.

David:  If you can’t expand debt, then you need to see income growth, or it’s just flat money-printing and asset purchases, which make up the difference.  And you’re right, disposable income, that was also a number out.  This week, this is the money left over after taxes.  It dropped 0.2% in December, after adjusting for inflation from the prior month.  It’s the biggest decrease since January of last year.  Over the past 12 months, it has come down 2.7% total.  It’s the largest year-on-year drop since November of 1974.  Income is not the cure-all, it’s not the fix, and if you wanted to see a real estate boom, an actual real estate boom on an organic basis, then you’d have to have income on the increase.  Or, frankly, you could have demography, which is not favorable today, which could substitute for a growth in income, if that was on the rise, either demography or income, certainly you could see a sustainable market in real estate.  Otherwise, it’s just Fed-induced speculation driving investor capital into that little space.

Kevin:  Which leads me to believe that if they do taper, then what we are talking about is a real estate drop as well, I mean there is just no way around it.

David:  When you look at the subsidy that buying mortgage-backed securities, you are talking about tens of billions of dollars per month, what that has meant for the few first-time home purchasers out there, it has been a great surprise and a great blessing, because you are able to finance, or refinance, at well below market rates.

Kevin:  I’m going to assume something, Dave.  I’m going to assume that we can’t borrow that much more, and income growth, since it’s shrinking, we’re going to have to make that up with quantitative easing, or just fall into a severe depression.  So, with that being said, then the dollar over the last few years has really been the place that a person goes if they think they need safety.  Gold, we’ve talked about over and over, but really, if you look at the overall mass majority of the people, they don’t own gold, they’ll go to the dollar.  We haven’t had much of a dollar rally with all of these crises going on, and gold is now starting to recover, so let’s talk about gold a little bit.

David:  It’s an interesting characterization between 2010 and 2012, gold was assumed to be a risk asset.  That’s what the news media loved to call it.  It was the idea that all risk assets were moving in lockstep.  They would sometimes say, ro-ro, which stood for risk-on, risk-off.  And in that context, the price of stocks would move up and the price of gold would move up.  And then all of a sudden there was some question about what the Fed was going to do, and the stock market would sell off, and so would gold.  And then gold moved lower, and that idea was dropped.  So for 2012 and 2013, now your risk assets are just your general commodities, your industrial commodities and stocks.  And lo and behold, they’re moving lower right now.  What are the safe havens that have been bought here in the last ten days to two weeks?  British bonds, euro bonds, U.S. treasuries…

Kevin:  And gold.

David:  And gold.  So I think it is worthy of note that gold stocks are up some 15-20% off of their lows.  You have industrial commodities and stocks which are significantly lower, moving the opposite direction.  Aluminum is near its 2009 lows.  Copper is flirting with a break down, though it’s not quite at that 3-pound critical level, in terms of technical support.  But you have your emerging market currencies, many of them at 2008 and 2009 levels, again, sort of reminiscent of where we were in the context of the crisis, the very peak of the crisis, if you will, in 2008 and 2009.

Kevin:  Yes, but something is different.  In 2008 and 2009, the dollar was rallying dramatically, and right now the dollar is just sort of sitting there.

David:  Yes, it went from 72 on the Dow-euro index, to 87 in a very short period of time.

Kevin:  This was in 2008?

David:  Between 2008 and 2009.

Kevin:  Okay.

David:  And so far it seems that the dollar is not the solo safe haven.  So since that time, the bilateral trade agreements, which are, frankly, too numerous to mention, have been constructed to work around the U.S. dollar, and not direct more traffic to it, and I think along with that has come a sentiment change.  You may look at the dollar market and the U.S. treasury market as a go-to for safety, but not the only go-to for safety.  And that’s a marked difference from 2008.

Kevin:  Which could be very much a marked difference for gold, as you have pointed out, because gold is now looked to, for what is really, traditionally, it has always been for, and that is a safe haven hedge.

David:  And when they were associating it, or characterizing it, as a risk asset, it really was a mischaracterization.  It has been, and I think, always will be, in its simplest form, a form of money, a means of transaction, a store of value.  And this is, I think, the point.  It was confused by an investor community that still doesn’t know how to wrap their minds around what gold is, or why they should own it.  And by the way, most of them have sold it, 869 tons through the ETF were liquidated last year, and that was their vote of, “I guess we don’t need it.”  Interestingly enough, in January, we did see physical demand for gold off the charts, 91,500 ounces sold from the U.S. mint.  A few weeks ago, we mentioned that the Austrian mint was adding a shift so that they could increase production.  The Perth mint added a shift so that they could increase production.  There is sort of this bifurcated world of, “We don’t like gold, don’t need it,” and it’s because they’ve mischaracterized it, and then there is the other side that would say, “Actually, we do need it, and it’s one of the only things that we trust,” in a world where there is so much leverage, and so much counter-party risk, there has to be some way of protecting assets and getting money outside of that network of counter-parties.

Kevin:  So this physical demand really shows what you have talked about with the group here, and that is, there are two types of gold investors.  You have the person who is speculating, and only buying when it’s going up or selling when it’s going down, and then you have the person who is just accumulating.  The Chinese are just accumulating.  Obviously, people around here must be accumulating, too, when you have record numbers of mint coins being sold.

David:  I think there are some people whose general impression, the first thing they think of when they think of any asset is, “What’s the price?”  When I think of gold, I think, “Do I have enough ounces?”  I think in terms of ounces, and not dollar prices, and I think in terms of long-term objectives, how I measure a part of McAlvany Wealth, and it is in terms of ounces.  And if the price was five times higher, or one-fifth the current price, I’m still thinking in terms of, “How many ounces do I have?”  In terms of the asset allocation model, it has a permanent fixture in the portfolio.  That is in stark contrast to the way it is treated as a buy today, sell tomorrow, capture two dollars’ profit, via an ETF, or what have you.  Great product.  We’ve had it proven to us in the marketplace that there was gold backing it, for any of those who had concerns.  Worthy of note, our government can’t come up with 300 tons of German gold.  At least on a seven-year delay we can, that gives us plenty of time to come up with re-hypothecated gold.  But, in ETFs, 869 tons, with the snap of a finger, or the click of a mouse, is delivered to China, liquidated, physically, and then delivered to China.

Kevin:  Before we go on to the stock market, I’d like to ask you a question, and that is, if over 800 tons came out of ETFs and it went directly to China, China is what I would consider strong hands.  They’re not probably speculating on the price here.  So when the public starts going back into the gold ETFs, where are they going to get the gold, Dave?  Is there enough out there to actually cover that?

David:  Hong Kong imports for the year were, I think, 2197, and about half of that, then, went on to Shanghai, both for the Shanghai gold exchange and the jewelry demand that you see there, so the combination of investor purchases and jewelry demand.  But that 2197 tons, there is only about 2500 tons that are produced in a given year, so that’s just mind-blowing, frankly.

Kevin:  That’s a lot of gold.

David:  If you know the numbers, you look at that and you say, “Wow.”  And for those of you who don’t know how many ounces are produced, or tons produced, in a year, maybe that is not surprising.  But that is well over 65% of total gold production, closer to 70% of total gold production for the year, and the Chinese took it off the market.  Your point is very intriguing, because if 869 tons were available to the investor community, and with the click of a mouse you could go back and buy those ounces, you could say, when the investor comes back for any reason, to buy ounces, there is plenty of gold on the shelf to repurchase.

The problem is, it disappeared, and it disappeared for good, as you suggested.  That means that, as and when, or should we say if, the investor community in the West decides that they want to own any ounces, it is going to put a tremendous amount of pressure on COMEX, because now, any gold that is purchased and has to be put into the ETF structure, Exchange-Traded Fund structure, is going to have to come off of the exchanges, both in the U.S. and London, and there is not that much.  I can tell you, combined between those two places, the U.S. and London, you can’t get 869 tons with the snap of a finger.  Not going to happen.

Kevin:  And I’m thinking, China is buying gold the same way the McAlvanys buy gold.  They’re doing it by counting, “Do I have enough ounces?”  Because they have other things that they are planning on doing with that gold, not a speculation on the market and saying, “Oh, at the right price we’ll just throw this back out into the market.  That’s not what they’re doing.

David:  I know that I want to own X number of ounces, so that as and when the market peaks, and I am reducing the number of ounces I have, I still have a significant number of ounces, even after reducing what I once owned.  Does that make sense?

Kevin:  Sure.

David:  I’m predicating the number of ounces that I want on the basis of the number of ounces that I plan on keeping indefinitely, which means that right now I probably own too many, and I’m quite comfortable with that.  But again, that’s with the ideas we suggested last week, with HSBC telling clients what they can and can’t do with their money.  With an individual depositor bank being nothing more than an unsecured creditor, I find there are very few options as compelling as owning gold or silver ounces.

Kevin:  And frankly, where else do you go?  With what we are talking about today, with the emerging markets falling, let’s look at the stock market for a moment.  The stock market’s really had a pretty miserable week, so let’s look at the averages that we are at.

David:  By contrast, I mentioned gold stocks earlier.  I think they move in lockstep with gold and do represent a good value, but on a technical basis, you look at the S&P 500, and where do we go from here?  I want to make two points.  One is the technical considerations.  We have broken through support levels at the 50-day moving average and at the 100-day moving average.  The 100-day moving average had, had, past tense, held up nicely on the shallower declines that we saw this fall, that was September and October.  There are two further levels to look at, 1740 and 1710, that is, the 150-day moving average, and the 200-day moving average, respectively.  In addition, you have broken below (you did this yesterday, you did this this week) the December and November lows.  That’s not good.  And what it tells us is that 1650 on the S&P, and lower, is not out of the question.  That gets us to a 10% correction.  A 20% correction would put us at about 1480.  A 30% correction from the peak would put us at about 1295.  That would erase all of the 2013 gains, and then some.

Kevin:  We’ve had a guest on numerous times, our friend Bill King, and he has talked about overlaying the chart from the 1920s and the 1930s onto today’s stock market.  Dave, I sort of have to go back in the time machine here and reminisce, because my first year, 1987, with the McAlvany family, the stock market was booming.

David:  Yes it was.

Kevin:  Before recording the show I pulled out your dad’s, Don’s, newsletter from that time, and nobody was talking about the stock market falling, but Barron’s had shown the same chart that Bill King was talking about.

David:  An overlay of past market behavior and pricing in the marketplace in the 1930s, with current behavior and trends, market dynamics, growth rates, etc.

Kevin:  And there was a cliff coming.  We’ve all seen those movies where somebody is in a raft and you can hear the waterfall in the distance.

David:  Exactly.

Kevin:  There was a cliff coming, and this is what your dad said in 1987, when the stock market was booming.

David:  August of 1987.

Kevin:  August of 1987, this was before the crash in October of 1987.  He said, “The conventional wisdom on Wall Street now says that the U.S. stock market will not top until 1989 or later.  The great majority of investors believe that armed with that foreknowledge, they’ll get out near the top and make a real killing.  This writer is skeptical.”  He goes on to say, “The U.S. stock market right now is not based on value, but on the greater fool theory.  It’s for speculators, not investors.  This writer has a hunch,” and again, this is August of 1987 before the October crash, “that the U.S. stock market will top out and crash well before 1989, perhaps even the fall of 1987.”

Now, I had clients, even though I was new here, who got out of the stock market because of what your dad said in August of 1987, and they were intact with a beautifully high stock market.  They took their highs and they avoided the carnage that occurred that still is a historic crash.

David:  You are right, that 1987 newsletter is fantastic.  If you go back a few pages, he talks about the coming crash in Japanese equities, and if you recall, they were marching from 30,000 to 40,000, this was the NIKKEI, and after that they took the next 20 years to go from 40,000 to right around 7,000, and that decline, he was talking about it, and it happened just a few months thereafter, so it is a good perspective.

You are right, King overlays the S&P chart of the last two years with that of the S&P from 1928 to 1930, and there is an uncanny similarity.

Kevin:  You can hear the waterfall.

David:  Yeah.  And at this juncture, you should expect a rally, and if you are just looking at the overlay of the charts, we’ve had a decent decline, 5, 6, 7%, a decent rally, but here’s the problem.  Your large investors will sell everything in that rally.  And if the pattern holds, it is followed by a 60% decline.  Frankly, I think that we are going to see a shallower, 30-40% decline.  I don’t think we’ll see as much as 60%.

Kevin:  But that’s still huge.

David:  It’s severe for the investor who is basically repeating their 2008 experience.  And so, if your nerves are still frayed from 2008, and you don’t mind them being frayed further, stick around, you should enjoy this.  Still, it hasn’t prevented the Wall Street powerhouses from proclaiming, trumpeting, getting excited about, what is, to them, another banner year.  Low-side estimates are that the S&P will grow 3%, up to 12%, following what we had in 2013.

So here are the targets:  J.P. Morgan thinks we’ll finish the year at 2075 on the S&P, a 12% gain.  Morgan Stanley thinks we’ll finish 2014-2015 on the S&P.  Bank of America, 2000.  Black Rock, about 1920.  More conservative estimates for City Group and Goldman are around 1900, that would be a 3% gain for the S&P, almost an exact mirror to what they think, at least Goldman, we mentioned earlier, in terms of their growth in the U.S. economy.

You have folks like Mr. James Paulson from Wellington Asset Management, and of course, they always quote him in the number of assets that Wellington has under management, “hundreds of billions of dollars,” and February 30th said, “For the first time in this recovery, we have synchronized global growth.”

Kevin:  Oh, so that’s what this last week looked like, huh?

David:  He goes on to say that, “China is not contracting, they’re just growing slower, and we are seeing a broadening of economic growth.”  Hmm, where does he see that?

Kevin:  I just wonder where he sees the broadening of economic growth.  Okay, then let’s go to those ISM numbers that we talked about earlier.  We talked about a contraction, and this is scaring the guys who actually understand the numbers.

David:  Yes, this week’s ISM stirred the nerves of Mr. Market.  It was the Institute for Supply Management Factory Index, and the surprise drop from 56.5 to 51.3.  What the market had expected was a mild decline from 56.5 to 56.  Getting to 51.3 scared the socks off of a lot of participants on Wall Street.  But perhaps it’s like the December unemployment number, it’s just a one-off deal, an anomaly in the context of an otherwise robust economic recovery.  And again, maybe we should hang our hats on Mr. Paulson’s comment from February 3rd, what we are really witnessing is not an emerging market melt-down, but synchronized global growth.

Kevin: (laughter).  Well, that’s a great way to say that.  There is no man behind the curtain, Dave.  You know.  Yeah.

David: (laughter) What’s interesting to me, Kevin, is that many economists are actually blaming the weather for some of these numbers that are coming out that are negative.  Bank of America is suggesting that for declines in equities here and abroad.  That guy gets six figures a year for coming to that conclusion!  You have Ford and GM, they’re crying about the fact that bad weather made for weaker sales in January, which is odd, because Mercedes posted the best January retail sales in their company’s history.

Kevin:  So what you are saying is, I saw the snowman commercials, Santa Claus going and buying a Mercedes, so maybe those worked.  I guess when they saw the snow, it’s like, “Hey, babe, let’s go buy a Mercedes.”

David:  “Have you been naughty or nice?”  We know that the upper crust has been very nice.

Kevin:  Yeah.

David:  Maybe it’s just the socioeconomic difference.  Well, of course, that may have something to do with the Fed wealth effect working away into the “real economy.”  I guess I’m surprised.  You watched the Super Bowl, right?

Kevin:  Yeah.

David:  Something of a carnage.

Kevin: (laughter) I didn’t want to talk about it on here.

David:  I’m surprised it wasn’t a Maserati record being set in January.  Did you see that commercial?

Kevin:  It was sort of silly, yeah, but I still would like a Maserati.

David:  It was the silliest commercial ever.  It’s when you take something conceptual and make it too conceptual, and everybody scratches their heads and says, maybe somebody smarter than me got it.  But the problem is, nobody got it.

Kevin:  Well, since we’re going down memory lane, I’m older than you, Dave, I get to do this quite a bit more than you, but the year 2000 the stock market was booming.  Tech stocks were booming, Y2K never occurred, the lights never went out, and the commercials during the Super Bowl, in the year 2000, before the tech stock crash in March, those commercials were ridiculous.  They were conceptual, you had really no idea what the product was, but they had so much money to burn, these IPOs and the tech stock boom, they literally purposely burned on commercials that didn’t sell anything.

David:  Right.  Wasted ad money when it was at 4 million dollars for 30 seconds this year, about twice what it was a decade ago.  Again, on that same theme, a walk down memory lane, this week is the first week that Janet Yellen is in charge of the Fed.  If you go back in time, we had Volcker hang up his hat August 1987.

Kevin:  And then the crash in October.

David:  A crash a few months later.  You had Greenspan hang it up in January of 2006.

Kevin:  And then you had the crash of 2007-2008.

David:  Bernanke hung up his hat January 2014.

Kevin:  So what does that mean for 2014-2015?

David:  That’s a good question, and I don’t know what that time frame is, but there is market digestion, or indigestion, when there is a handoff from one Fed chief to the next, as speculators try to figure out what rules we are playing by.  What game are we going to play?  How do we interpret the phraseology?  How do we know what is being communicated, not being communicated?  How do we interpret the silence? There are a number of things that the market has to figure out with a Janet Yellen.  New?  Different?  Better?  Worse?  No one knows, but these transitional phases, note that they came when the stock market was doing all right, but not doing all right for the right reasons.  It was not doing all right for the right reasons through the fall of 1987.  It was not doing all right for the right reasons in 2006 and 2007, and it’s not doing all right for the right reasons here in January and February of 2014.

Kevin:  That’s an interesting observation.  We’re talking, for the last quarter of a century, at least, and a little bit more, any time there has been a Fed Chairman change, we’ve had a stock market crash not long after that.

David:  It’s amazing the difference that a few days make, but blue skies 30 days ago, universal bullishness, the VIX was at 12, gold was on its back, equities were at all-time highs.  Everyone assumed that we were going to see earnings grow from 5% to 8.5% this next year.  The problem was, companies were offering lower guidance in the face of Wall Street saying, “No, no, no, you’re going to be doing that much better.”  And companies were saying, “No, no, no, we’re going to be doing that much worse.”  That was the dialog 30 days ago.  Now we have the market selling off the emerging markets, and all of a sudden a re-emergence of concern.  How fast things change.  Amazing the difference that a few days makes.

Kevin:  January is an interesting month to watch.  We were talking about the stock market, but usually you need January to rise to have the rest of the year have a good year for the stock market.

David:  If you’re looking at the Stock Trader’s Almanac, it sets the tone.  It doesn’t guarantee anything, but nine times out of ten, if you have a positive January, you are going to have a positive year, if you have a negative January, it’s either going to be a flat year, nothing to show for it, or a year of losses.

That’s one of the things in the conversations that I’ve had with Mike Gallagher over the last several weeks on his radio program.  We’re doing a conference down in Greenville, South Carolina here at the end of the month, but we’ve offered to do a risk assessment for his listeners, and I think if you’re not considering your allocations to equities, to bonds, to cash, and how all of that works together in terms of the risks that you are taking in the marketplace, again, you may think of cash sitting in the bank as at risk, but you are an unsecured lender to that institution.

Kevin:  And we should check the ratings of a bank, at least.

David:  Well certainly, that would make sense.  If anyone is an unsecured lender, you should be highly compensated, oops, you’re not.  And you should know what that risk is that you are actually taking.  You can call our office and get a free assessment of the bank that you are in.  My point is broader than that, though.  Take time, here at the early part of the year, and assess the risk in your portfolio.  Something that we do on the back of a napkin is what we call our perspective triangle, where you look and say, “What am I asking my assets to do?  What do I have that is liquid?  What do I have that is helping me cover losses, that acts as an insurance policy against risks in the portfolio?  And where am I taking risks, in fixed income and equities?”  The perspective triangle helps you organize what you are doing with your assets, and helps you understand the risks implicit.  Do you have adequate coverage for those risks?  There is a lot of transition.  And 2014-2016, I think, could be phenomenal years of wealth generation.  But on the other side of that coin is phenomenal years of wealth destruction.  And I think what people do right now, to appreciate their risk implicit in their portfolios, will determine whether at 2-3 years from now, are they able to retire 2, 3, 4 years from now, 10 years from now?  Do they set themselves on the proper trajectory to take care of family needs, meet financial expectations and goals?  I think a serious conversation needs to be had about implicit risk in the portfolio, and how to hedge that.  I wouldn’t delay.  I would do that immediately.

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