September 28, 2011; A European Tragedy of Errors: David McAlvany in Brussels

Weekly Commentary • Sep 28 2011
September 28, 2011; A European Tragedy of Errors: David McAlvany in Brussels
David McAlvany Posted on September 28, 2011

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: David, you are joining us from Brussels, Belgium. You have been in Europe through this really tumultuous time over the last few days. Do you have any comments on the fundamentals? Have the fundamentals in the market changed, based on what you are seeing there?

David: No, I think, in fact, Kevin, what you see is a reinforcement of all the things that have been in place, really, for some time now. I remember doing a radio program with CNBC, going back about 6-8 weeks ago, and they said, “Well, tell us, what is this about recession, and why would anyone be concerned about recession?” As the weeks have gone by, Kevin, here we are with the world reconnected with the idea that risk does abound, that the financial solutions that have been offered by the ECB, and the politicians here in Europe, for the European crisis, have gained no traction. In fact, there is nothing really practical in play at all.

Kevin: David, I’m thinking of contrasting that interview that you did a few weeks ago, when they didn’t think recession was an issue, with the nervous interview of you by Bloomberg on Friday when you were in London. Can you give the listener who didn’t see that on Bloomberg an idea of what you were saying? The nervousness was high at that time.

David: I think the issue is really this, Kevin, and in my opinion, a misappraisal, at this point in time, the market is looking at current events and saying, “Clearly, we need to be taking liquidity into account and preparing for something like 2008. Let’s get our ducks in a row. Let’s get into the most liquid positions possible.” What they should be looking at, Kevin, is not just liquidity, but solvency, as well, and the underlying stability of the instruments they are choosing is, I think, fatally flawed.

Kevin: One of the things that we have seen in the past, David – you and I have talked about this – when the world gets scared, they try to go liquid, and when they try to go liquid, the first thing that they try to do is get dollars. What we saw last week was an unusual sign of people fearful of a system, or a solvency crisis, yet they were moving into one of the very items that they thought was ultimately going to be an issue, and gold sold off. Why don’t you comment on the liquidation of gold last week, David, and explain to the listener who hasn’t seen this type of rush to liquidity before, what was actually occurring?

David: I think one of the things that you should keep in mind, and this is borrowing from John Exter, who was head of the Federal Reserve Bank of New York back in the 1950s, and was very adamant about the role of gold in the money system, that it should be there. John Exter had what he called the inverted liquidity pyramid, very different than today’s appraisal, and I must say that today’s appraisal, by the average investor, is a very trained behavior, to think in terms of both the dollar and Treasuries as the ultimate source of liquidity, but he actually had cash and dollars as a less liquid item than gold.

It is an interesting perspective from a Federal Reserve Bank President. Anybody who wants to look at that can google John Exter, inverted liquidity triangle, or pyramid, and get an idea of what he considered the pecking order, if you will. The most stable, but also liquid, asset on the planet for this Federal Reserve Bank President was gold, not dollars.

Kevin: I remember seeing the pyramid presented 25 years ago, David, and I remember municipal bonds and government bonds and stocks, all at the top, quite illiquid when you have a crisis, and as it worked its way down through, I think of it as a liquidity funnel, where money can actually flow through and continue. But he then shows Treasuries, and then cash, and then you are right, the most liquid item, the first one to be sold when there is a real need for liquidity, strangely enough, is gold. That is, of course, repurchased, when things start to settle down a little bit.

David, we know that large hedge funds have pretty strong positions in gold and have had pretty strong positions in gold, as well as having a lot of stocks and other things. They were pretty much fully invested. But there is a rumor that those large hedge funds were going to gold, and selling that off first. Is that rumor true?

David: Let’s look at that, because I think there are some interesting observations there. Before we do, just to reiterate, the fundamentals have not changed. In fact, if you wanted to view them as being changed, you would just have to say that they have gotten stronger. We have government spending, we have bailout liquidity provided on both sides of the pond. We have monetization of financial instruments, both here in Europe, where I am today, as well as in the United States.

There are really no solutions crafted by bureaucratic socialists in the United States or here in Europe. And at the same time, we have artificially suppressed interest rates driving real yields for investors into negative territory. So yes, we have a selloff in the last few days, in this last week, and the selloff is rumored to be large fund holdings implicated in the CME’s change in margin requirements, which is effective as of the close of Monday.

Kevin: Why don’t you elaborate on that change, David?

David: This is something that applies for a speculative player. It applies to someone who is playing with paper gold, probably the most loose form, if you will, of paper gold, wherein you are buying a futures contract – a contract to take future delivery, of X number of ounces of gold or silver, and you can do that on a highly leveraged basis. This is a world where 3, 4, 5 times leverage is common, if not more, and so what you have is the CME trying to moderate and control the amount of speculative juices that are in a particular market. They are responsible not only for the precious metals, but for orange juice contracts, and copper contracts – all of these things are under their purview and scrutiny. What they chose to do last Friday was increase the amount of money that you had to have on the table, by 21% for the gold contract, and by 16% for the silver contract. So if you owned those contracts, or had some money down, they basically said, “Now you have to put that much more money down if you want to keep those assets still in play.”

Kevin: And David, it should be pointed out that this is not the actual sale of physical gold. You are in Europe right now, one of the places that the company buys its gold is in Europe, and you have found that to be quite tight. What we are talking about is paper gold contracts. This is not the common person who is hedging for the future. These are traders.

David: I have made calls and contacts, and made efforts to buy a good degree of gold while here, and that is from Zurich, that is from London, that is from continental Europe, as well, right here in the EU, and we are looking at premiums on very common products. In London, trying to buy kilo bars, and finding the cost to be 6% and 7% over the spot price. That may not sound like a tremendous amount, but for a kilo bar, which is very commonly found, and very accessible the world over, I found it to be a little bit out of line. The same is true in Zurich, and on and off here in Paris and Brussels, wherein the man in the street is taking an appraisal and he is looking at things very differently than your average investor stateside. He is not moving to Treasuries. He is moving to gold. He is moving to gold, primarily. So very little is available without paying pretty significant premiums. The smaller the item, the higher the premium, because that is what is accessible to “everyman.”

Kevin: David, with that in mind, too, when we were talking about gold falling last week, you can’t find it while you are in Europe, or you are having to pay premiums for it, I think that takes us back to these large hedge funds. They were almost fully invested funds, very little cash. Is the approach of the end of the third quarter affecting the price of gold right now? Is that part of the rush to liquidity?

David: Yes, I think there are a couple of things going on with that. The market, by the end of last week, was faced with a very ugly choice. If you are a hedge fund manager, or an asset manager of any sort, you are coming into the end of the third quarter, and your numbers are either going to look pretty bad or pretty good, depending on the kind of profits that you can book before the end of the quarter. If you are already taking losses on your equities, you may have liquidated those at losses, but anything that you have that has gains, you want to go ahead and book those gains.

I think that is what we had, in addition to the CME changes. And it is very interesting, Kevin. The selloff began in earnest well before the CME announcement on Friday, which certainly implies that there are plenty of people at the Chicago Mercantile Exchange who have loose lips and they are not sinking their own ships. In fact, I think under normal market conditions you would look at that and say, “That’s got to be illegal activity.” That is operating on the basis of inside information and pre-released data.”

The selloff in the metals began before the CME announcement, as if someone knew, and that carried through Monday. That was just in time for firms to alter their books and eliminate leverage, if needed, to get in line with those increases – again, 21% for gold, 16% for silver. That is the main reason for selloff, and notice, in subsequent days the market rebounded smartly. In fact, look at silver, for instance, at a low of $26, rebounding to over $32. Very interesting volatility – par for the course for a mega bull market – to be expected, I wouldn’t be afraid of it, but certainly gut-wrenching at the same time, to within a 24-hour period see that kind of a swing, both on the downside, and then again, on the upside, in terms of recovery.

I think what it argues for is, essentially, the fundamentals have not changed. We are looking at more than a technical glitch, but a change in the rules as they apply to the paper trade – not the physical markets, but the paper trade, and a knee-jerk reaction to that. The markets have now found their saner selves again.

Kevin: The long-term prospects for the dollar had been downgraded by Standard and Poor’s just a few weeks ago, and yet, it looked like it was playing a safe haven role – that, and the Treasuries playing a safe haven role. Is the dollar a safe haven right now, and are the Treasuries a safe haven? Is that a correct way to perceive this, especially in light of what is going on in Europe?

David: Kevin, the dollar is weak, all things considered. I think Treasuries are being, really, the safe haven of choice, and they have been the safe haven for just about everyone. The dollar, and Treasuries, as you say, have been seen as a safe haven, but I would prefer to categorize them slightly differently today – not as a safe haven, but as a liquidity haven, and the preference is for Treasuries, even over dollar-denominated cash.

Kevin: What would you say the difference is between a safe haven investment and a liquidity haven investment? A safe haven would probably be a longer time frame to hold. A liquidity haven – that’s pretty rapid, isn’t it?

David: Yes, I think that is exactly right. When you are looking at a liquidity haven, it’s the choice of, “Where can I go today, and leave tomorrow?” Whereas a safe haven really is, “Where is my port in the storm?” It’s probably a slightly longer-term commitment and it is concerned with more than just being readily available. Something like gold would be a safe haven, dollars and Treasuries more of a liquidity haven, and they are serving that purpose well at this point, but there is a difference between the two. In my opinion, the market is misjudging the severity of what is happening here in Europe, and it is misjudging the stability of even the U.S. balance sheet, and essentially, what they are considering to be safe for liquidity purposes, is anything but safe, and I think, ultimately, may be tested, in terms of liquidity, at some point in the cycle. Whether that is 12 or 24 months out, we will have to see.

Kevin: David, we have talked a little bit about gold, we have talked a little bit about the dollar, but here lately, we have seen interest in other currencies, and is there a distinction between one currency versus another, and when people are moving toward safety or liquidity, where do they go other than the dollar?

David: Well, let’s paint with a broad brush stroke, and then get more specific. The broad analysis is that they are all fiat, and worth less and less every day that you own them, because you have people who are managing the value of those currencies, sometimes managing up, sometimes managing down, but over a long period of time, we have seen all fiats being managed to lower values. Having said that, painting with very specific and small brush strokes, there are several resource currencies which have reasonable fundamentals. But they are, at this point, trading in line with the global recession expectations and the impact that that is likely to have on commodity demands.

A Canadian dollar, an Australian dollar, a New Zealand dollar, a Swedish krona, a Russian ruble, a Brazilian real – all of these have had some play to the upside, as a “dollar alternative,” “inflation hedge,” and I use that very loosely, but just in the context of a dollar alternative, having an economy that is based on resources which seem to be doing very well over the last 2, 3, 5 years.

That has been the analysis of those alternative resource currencies. They are suffering, at present, and they are suffering because they are being lumped in together, again, as I described it, a global recession expectation. Things are slowing, and it appears that they are slowing not only with developed countries. The hope was that developing countries would be doing much better, and that perhaps China would be a major contributor to growth in terms of global GDP. As it turns out, they have their own issues. As we expected many months ago, China has many, many issues to deal with, and they are now facing the same sort of recessionary pressures.

Kevin: David, before we talk about China, which just a couple of weeks ago was being perceived as the bailout masters for Europe, you are in Europe right now. China doesn’t seem to be there ready to write a check. You have likened this whole Greece situation, and actually, Portugal, Italy, Spain – the PIIGS countries – you have likened this eurozone and this crisis to the reactions of a manic-depressive, where one moment they are just absolutely exuberant, and then the next moment they are completely depressed and suicidal. We have seen this just in the last couple of days. We saw people rushing to safety and liquidity, as we talked about with the dollar, and now all of a sudden there is a rumor, that there is a rumor, that there is a rumor, that maybe something positive is going to happen for Europe. Do you see the eurozone solving the problem any time soon?

David: Kevin, there is no one here that has a clue. This is, I think, one of the failures of the news media, in portraying anyone in the EMU as having real leadership ability. We are not talking about people with vast business experience. We are talking about petty socialist bureaucrats, who have no idea what it takes to make decisions, and take risk in the context of making decisions, or even risk being wrong – the reputational risk, the professional risk, and all that comes with the simple decision-making process.

The eurozone estimates are now about 2 trillion euros which would be needed for their shock and awe backstop to European banks that are holding sovereign paper. So we have Greek 2-year notes trading at a 70% yield, and they are scrambling, at present, to make their October payments. After their October payments, there is the next big hurdle, which is the December maturity, and they have to come up with about 5.23 billion euros to pay off that debt.

If they are able to dodge the October bullet, this is something like Russian roulette. There will be great relief, and there will be great celebration, if they can come up with the October payment. The problem is, that is one chamber of six, and we are continuing to play this game of roulette here in Europe. In the December maturity, again, they have 5.23 billion euros coming due. They will have to come up with those euros, also.

Kevin: You talked about it being one chamber of six, but there is a whole carton of ammunition afterward that has to be refilled. It is just completely unpayable. There was an agreement on July 21st for private parties to share some of the risk in Europe, and it sounds like they are even second-guessing that at this point. Does that have to do with the credit default swaps? What was agreed on July 21st in Europe that right now is coming into question?

David: Over the weekend, the G20 leaders were getting together and discussing the fact that this probably wasn’t going to be a tolerable solution and they would have to put their minds together and come up with something better that was more palatable, etc., etc. Should there be participation in losses, in the event of a default, and to what degree should there be a participation? This is where we are not out of the woods yet, because, again, it is not just a question of Eurozone “leaders” or bureaucrats, we are talking about an entire world which is full of people who have no idea what it looks like to make critical decisions at critical points in time. They would rather get together as a committee, and, I don’t know, just mutually admire each other, feel important?

This is really getting to the point of utter embarrassment, wherein the people around the world who these G20 leaders represent should be up in arms saying, “Just make a simple decision, will you? Dammit, the world is getting ready to go to hell in a hand basket, and y’all are just sitting there patting each other on the back for, really, platitudes, and nothing of substance. If you are going to do something, do something, even if it is the wrong thing. But don’t tell us over, and over, and over, and over again, that you have agreed to create a concerted effort and put your real shoulder into it this time.” I think one of the things we are watching happen is the discrediting of this type of leadership by committee. It just simply doesn’t work. It doesn’t work in Europe. It doesn’t work anywhere in the world.

Kevin: I think it is quite obvious that the IMF and the World Bank don’t have enough money, and probably never will have enough money, to solve this problem. What do they have right now to throw at the problem? And then, what are they asking for?

David: Christine Lagarde has already said this week that they have 384 billion in cash to handle the bailouts, and that that probably won’t be sufficient, so they will be looking for greater contributions from their members. And this is, I think, what is shocking. We are talking about the U.S., we are talking about Britain, we are talking about some of the countries, who, themselves, are having a hard time making ends meet – sort of an interesting irony – the bailout of others when you can’t pull yourselves up by your own bootstraps.

That is essentially why we look at this and say, “This is not feasible.” All we are doing is adding more layers of debt to pre-existing layers of debt, and calling that good. This is why we were discussing with Hunter Lewis, a few weeks ago, the frailties of Keynesianism, because the leadership is assuming, both here and in the U.S., that if they buy time, saner minds will return to the marketplace, that the consumer will begin consuming again, and we will all go back to this peaceful, blissful Utopia, where no one saves, and everyone spends, and government is happier for it. Everyone focuses on getting their government cheese and living a day by day, paycheck by paycheck existence.

At the IMF, at the World Bank, certainly, they have reason to be concerned, because they know that they are going to buzz through that 384 billion over the next 12 months without skipping a beat.

Kevin: David, you know the saying, “Fool me once, shame on you. Fool me twice, shame on me.” In reality, these guys are just fooling, and fooling, and fooling, and fooling, and the markets continue to react as if there is maybe going to be a solution, but this deleveraging has to occur, and these guys aren’t willing to live with that.

David: I think you are right Kevin, that we will see a deflationary spat in here. The deleveraging she described is going to be selective to certain asset classes, and I don’t see a general deleveraging across the board. Certainly, the consumer, and we pointed this out a few weeks ago, the consumer is working on deleveraging. They have gone from 130% of debt to disposable income, to now 115%, with the mean number being closer to 75%. So certainly, we will see the consumer continue to deleverage. I think you have already seen a good degree of deleveraging in corporate America. If you look at balance sheets today, they are healthier than they have been for some time. That doesn’t mean that I would go out and buy equities, in general. Valuations are still very high, and are unattractive, from a fundamental standpoint, very unsupported by the market fundamentals. But that will happen.

The point is this, Kevin. We have the IMF and the World Bank saying, “We need more money.” We have the eurozone saying, “Well, we’ll borrow from Peter to pay Paul. We’ll steal from Peter to pay Paul.” They have to come up with money out of nothing. This is the ex nihilo creation of fiat currency. This is where we would continue to argue that there is, from a monetary standpoint, an inflationary impact. There is a downgrade to every currency, with every country who is not willing to tighten their belts, who is not willing to implement fiscal austerity measures, who can’t get that done, who can’t do that, in the context of a voting public, a democracy which won’t allow for it, and is thus forced to inflate, and inflate, and inflate, and inflate. We are not talking about the kind of inflation that would necessarily be positive to all commodities, but one that is very negative to the value of the currency, and we think is one of the good reasons for continuing to own gold, at this point, and into the future.

Kevin: You talked about not buying equities, but gold shares are extremely cheap right now, at least they seem to be. They have come down, they have made some correction. What is your thought on buying gold shares, at this point?

David: Kevin, I think with a 2-3 year view, they are very cheap, and I think that we are likely to see them as the new dividend players. If you move out over the next 3-5 years, I think they are likely to be significant income generators. The volatility is painful, they are attached to the metals market in a very volatile way, and I would just note that a company like Newmont has been very stable through the last week’s correction, relative to its peers, in light of its dividend policy, increasing its dividends, and obligating an increase of dividends with the incremental growth and the price of gold. With $2500 gold we are talking about a company that would be paying over 7% on its dividend, and that is nothing to sneeze at.

Kevin: If you think about putting money in the bank right now, maybe you get 1%, maybe you get 2%, but you are talking about actually having a 7% payout. This reminds me of what gold shares used to be known for back in the 1970s. They were huge dividend generators. A person could actually live on income just by owning their gold shares. That seemed to go away for years, but it looks like we have the return of the dividend payoff in the gold share market.

David: And what is a modest 2% today, will grow, as they continue to pay out more and more, and on a reasonable cost basis, I think that will be a huge benefit to investors. So, yes, I think they are cheap, I think they are just about as cheap as they were in 2000, just about as cheap as they were in 2008. You could say that this is probably the third cheapest they have been in a decade, and I would have to take a strong look at those.

This is one of the reasons why, as a company, we prize the availability of cash. We have stubbornly kept cash in our managed accounts, between 30% and 50%, and so the volatility which we have seen of late – not only does it not hurt us, but with this break in prices to lower levels, for us it is a very happy affair. We look at pricing and say, “This is fantastic.” The profits that were generated between 2008 and 2011, were, in large part, because of the liquidity variable, and the ability to put money to work for you at an opportune time, so what appears to be a noninvestment is absolutely one of the most critical investments that you can make, and it is simply having liquidity when it counts most and that is what this last week has been about. We really enjoyed it.

Kevin: I think about all those hedge funds last week, that we talked about, that were almost fully invested, that had to just do whatever they could – sell gold, or whatever, just to generate a little bit of cash. Then I think about McAlvany Wealth Management, and the fund was very flexible because of this 30-50% cash position. It allowed you not to have to liquidate when everybody else was, and to go in and buy after everyone had liquidated. Isn’t that the primary goal of being ready to invest on the dip?

David: Yes, Kevin, and I think this is where the whole philosophy at most hedge funds is just so aggressive, when they are playing with other people’s money – and that is exactly what they are doing – they are playing a game, and they are playing as fast and as loose as they can so that they can retire when they are 28, or 32, or some stupid number like that, and they are invested, not 100%, where they would have zero cash – they are invested to the tune of 110%, 120%, 130%. So they have leveraged portfolios with no liquidity at all. If there is a hiccup in any way, shape, or form, you have forced liquidations, and it is a very speculative way to live and invest, and in this market, a very speculative way to die. A lot of hedge funds have been crucified over the last year-and-a-half to two years.

Our management style is very different. We have been able to make money through 2008, 2009, and 2010, and we are doing quite well this year. Even with the volatility of the last week or so, we are not in a position where our hands are tied. In fact, we are able to allocate assets very, very effectively here. So the hedge funds that are liquidating gold today, to book profits, and to have something to show to their investors to justify their existence – we are just not in the same position, where forced liquidations are the measure of the day, because someone outside of the firm, like the Chicago Mercantile Exchange, changes the rules, requiring us to get in compliance – we just have a safer margin for that kind of volatility, and are very comfortable with the kind of cash positions we have been acquiring.

When I was at the Bloomberg studio there in London this last week, they were asking me some pre-questions, saying, “Hey, listen, we have talked to a lot of fund managers, and it seems like they have wanted to increase their cash to 5% and 6%, up from 2% and 3%.” I just kind of shook my head, and I said, “Yes, but we’re at 30% to 50% already.” I guess they don’t really understand what’s happening, 3% to 5% is not enough to get anything done, unless you are going back to that 110% or 120% invested on a fully-leveraged portfolio.

Kevin: David, that brings us to a point. You have the luxury sometimes to stay in 30% to 50% because you have had commodities rising. When we think of the triangle, part of the triangle rises when the other parts sometimes just sit liquid. We have talked about a third in gold, a third in growth types of assets, and a third in cash. But for the person who is retired – I am just thinking about my mom, and my grandma who is 92 years old. When she was building up her asset base to live off of, she was assuming that she was going to get a little bit of interest.

You have talked about financial repression. What was announced last week by the Federal Reserve was just one more example, I think, of financial repression. They are basically saying, “Look, if you thought interest rates were going to rise, we are going to see to it, even artificially, even with your money, that interest rates don’t rise.” Is this something new, this financial repression, or have we seen stints of this in the past? And is there an end?

David: We have seen it in the past, Kevin, but never to this degree. To define what we are talking about, in the current environment, 2007-2009, we have had zero interest rates for the last 33 months, and the commitment from the Fed is to continue that forward for at least another 24 months. The reason we call it repression is because it is taking the interest rate and pushing it below a natural level. It is a suppression of this form, which has never been done on this grand of a scale, but it has been done before.

If you go back to the early 2000s, the Fed dropped interest rates to 1% for about 12 months, and it was very stimulative to the economy. That is what they are trying to do, is stimulate consumer activity, and business borrowing – borrowing and spending. Of course, rates were manipulated lower in an earlier period of time. If you go back to the 1989-1991 period, it was just a different interest rate environment then, so rates were lowered significantly to what were very low levels then, at 3%, and they kept them there for about 17 months.

Kevin, I guess if you want to look at financial repression this way, imagine a Keynesian with an imaginary gun in his hand, going to your grandmother and saying, “You will spend every last dime, or we will punish you for it, and punishment comes in the form of nonpayment of interest.” Essentially, it is the Keynesian gun in hand, saying, “We’re not going to pay you one lead cent, therefore you get out there and spend. You do your job.”

According to the Keynesian model, that’s what every person is supposed to do, and that is contrary to what you just described, Kevin, where you mother or your grandmother may have put away for a rainy day, and needs the interest income just to live on, just to pay bills, never wanting to dip into principle, because it gives them the insecurity of feeling like, “What if I end up on Ramen noodles or Vienna sausages in my latter years, and that’s all I’ve got? I don’t want to starve, I don’t want to be out in the rain. I want to be able to take care of myself. That’s why I forewent those present pleasures for some future reward, and now that reward is being taken from me.”

I think it is the right description, Kevin – financial repression – and I think that is something that, for the average investor, whether they know it or not, is being done to them, not for them, and a low interest rate environment certainly helps certain financial players in terms of being able to borrow at very cheap rates and speculate. That is actually a part of the reason why we have seen the dollar do what it has been doing here recently, with this “operation twist” from the Fed, you have something of an unwind of the carry trade, and as short-dated paper is moving the opposite direction, and as the dollar is appreciating, we are having these leveraged players having to pay back the dollars that they have borrowed, as they are watching their profit margins get squeezed.

Kevin: David, the carry trade is sort of a complex thought process. It is something that we saw with Japan a decade ago, and now we are seeing the carry trade here. Without going into great complexity, maybe that is something that we could spend a show covering down the road. Would you be willing to explain that in a little bit more detail later?

David: Oh sure, because it certainly is a dynamic that has fueled speculation and creates instability in the marketplace and that is something that should be well understood.

Kevin: In the meantime, I think one of the questions that needs to be addressed that I am seeing our listeners come up with is that the Dow has just been stuck in this range for, it seems, forever, really. I look back 10-11 years ago, when the stock market was at 12,000 points, and here we are in the 10,000-11,000 range, and it just wanders around. How long are we going to be range-bound in the Dow?

David: Kevin, there are some dynamics that are changing in the marketplace that are frankly very unhealthy, because while the Dow is range-bound, there are investors who are pulling funds because they are just reaching that state of demoralization. They don’t want to do this again, so we have seen upwards of 375 billion dollars in withdrawals from equity mutual funds. In their place, and the reason we have described, in the past, the stock market as something of a ghost town, high-frequency trading has taken the place of the general equity investor.

High-frequency trading today accounts for over 75%, almost 80%, of all volumes on the New York Stock Exchange. If we are looking at the dollar values involved in this churning process by high-frequency traders, we are talking about 66 trillion dollars which is being turned over annually in the stock market, to generate somewhere between 5 and 10 billion dollars in profits. On a percentage basis, that is just nothing, it is absolutely nothing.

What is interesting is that we have basically eliminated the average investor from the marketplace. They are now playing for pennies, and trends and long-term issues really don’t matter to the high-frequency trader. So the pricing mechanism within the stock market, I think, is fairly inaccurate. Just as we have seen suppression in the interest rate market, and bonds, the U.S. Treasury market does not, today, reflect the solvency risk associated with the U.S. balance sheet, we, too, look at the stock market and say, “Things are not reflective of value, and what you see in terms of price is really a misrepresentation.”

A lot of that has been confused, starting about six years ago. Since 2003-2004, we have seen a tripling of volume on the New York Stock Exchange, and we have been range-bound. Obviously, there are different elements that go into a historical appraisal of this, but the Dow has been range-bound before. It was between 1966 and 1982, and that period, like this period today, was also a period of negative real rates. When companies are cheap, when yields are considerably positive, when inflation is falling, then you have an environment where markets can recover, where companies can prosper, where business cycles can resume and uptrend, and frankly, in that environment, the need to own gold becomes less important, and that is not the environment we are in. We are still in that range-bound, 1966-1982 market, not a bear market where it is catastrophic, à la the 1930s, but you just get ground down and you can’t handle it anymore because it’s just so cotton-pickin’ boring.

Kevin: David, that is the glass half empty portion, and yes, a Dow that is range-bound does seem like the glass is not only half empty, but even more empty. But the glass half full portion of that 1966-1982 period of time was that gold went from a ratio of 30 ounces of gold equaling one share of the Dow, to 1-to-1, during that period of time. You were saying that that is when the need to own gold occurs; there are great gains in other areas when the Dow is range-bound, and I am thinking of this time period that we are in now. We have been range-bound for ten years, but gold has gone from about 42-ounces-to-1, on the Dow, to where we are now, which is in the 6-7 ounce range, probably on the way to 1-to-1, wouldn’t you say?

David: Yes, and the real gain that you are describing, Kevin, is in purchasing power of real assets. I think that is what becomes very compelling. As more and more people exit the market – I mentioned 375 billion dollars being taken out in equity mutual funds – this is a sign of the times. This is what is involved in the slow, bleeding process, where, ultimately, we will see a period of capitulation, and price shock, to the downside on the Dow, and we will see the market so bombed out, the general public so uninterested in equities.

But we will still be looking at companies like Johnson and Johnson, and Bristol-Myers Squibb, and Caterpillar, and Illinois Toolworks, and the Heinz company – these are companies that still are going to be selling soup and ketchup and Band-Aids, and yellow iron. They are still in business, and they are still moving products all over the world, and they are still making money, and they should be owned intelligently, and they are owned particularly intelligently when you can buy them just for pennies on the dollar. It is what is developing, Kevin. I think if there is anything encouraging to me in the context of a, frankly, fairly dark period of time, it is that these are the necessary steps, the necessary events, that get us to the point of compelling value, and we are getting closer and closer to that.

I would be remiss in not mentioning China in today’s program, Kevin, because this is an area where I do not see compelling value, have not seen compelling value, and don’t see stimulus as effective for long-term growth at this point. Move out 20 years from now, and I think you and I would both be China bulls. But over the next 20 months, probably more China bears, the only exception to that being if the government is going to spend, literally, trillions of dollars in a very short period of time, and then, just like a small child on a candy bar, we are talking about spastic behavior. I guess if you want to view that as positive, you can, but it is certainly not lifeless. That is not really a growth story, in my opinion. I want to see something organic and fundamental before I am shelling out hard-earned dollars to risk in capital markets that, today, are too opaque to be investing in with serious money.

Kevin: David, I know we joke about your dad saying that China is the next thing, and I think he would admit, too, that a little time needs to pass. You feel more time needs to pass, I think, than he does, but just think about Mercedes saying that growth in luxury vehicle sales has really slowed through the summer months up to present time in China. The Chinese economy seems to be slowing. The excess funds that seemed to be so readily available, seem to be tightening up a little bit, in the face of, maybe, 14-15% inflation in China right now. So if we have a contraction, maybe this is more of an inflationary contraction.

David: It is, and their official inflation is closer to 6% to 6½%, but they have tortured their statistics like they have tortured a lot of other things, and they can make them sing, so 15-16% is a real-world number, with 6% being the reported. Kevin, it was in the spring of this year that Fitch said they expected 30% of the bank loans in China to be nonperforming. Now that we’re seeing a slowdown in China with the purchasing managers index under 50, I think what we are likely to see is a lot of real estate developers go to the wall, and that is a 12-18 month period of time as they scramble for borrowing abilities in lines of credit. But barring another trillion-dollar stimulus, we are going to see major hiccups in the banking arena in China over the next 18 months.

Kevin: Would you say that is the case for the emerging markets, as well, David?

David: It is interesting, Kevin, this idea of decoupling was, and is, a fool’s errand, in my opinion. The emerging markets are far more dramatically impacted than the developed world markets. You could say that future growth is going to be predicated on the developing world, not the developed world, and if you look at Western Europe, if you look at America, that we have seen our growth cycle, and we are likely to see better growth elsewhere.

But that doesn’t mean that it is going to be tomorrow, and it doesn’t mean that they are on a platform to do that at present. Remember, it was England that was an emerging market when Italy was the banking center, and it was America that was the emerging market when England was the banking center, and yes, China, and many of these emerging markets, are likely to be very successful, including Brazil, as we pass the baton.

But these are things that don’t happen very quickly, and not usually on a voluntary basis. The U.S. doesn’t want to give up its preeminence on the world financial scene. That is something that is usually ripped from a country, just as the British didn’t voluntarily give it away, it was taken from them through multiple world wars and true bankruptcy.

But Kevin, the risks are there. We have the currencies in these developing countries which are under pressure, and as you know, trade is the predicate for growth in the emerging world, and when world trade slows, so does the cash flow to these little outposts, and we are not talking about only little outposts. Brazil is a giant – but the Brazilian real, their currency, is off 16% in less than a month, Kevin, and as commodity prices are under pressure, that trend will stay down.

Kevin: What about Asian currencies? You talked about the South American currencies, but the Asian currencies – are they as volatile?

David: They saw their worst week, last week, since 1998, in what was then called the Asian flu. Different dynamics, today, than there were then, but we are seeing weakness in the currency markets the world over. I would like to be able to say that there is a better story to tell, even in our own economy, but new home sales are down, we have prices dropping from last year by about 7.7%, from 2010 numbers to today. It only costs you 125 ounces to buy the average single family home, whereas it cost between 500-600 ounces at the peak.

Kevin: David, what you are talking about is 125 ounces of gold would buy a home right now, which is really about one-fifth of what it was cost just a few years ago.

David: That’s right, and we may ultimately see that target at 100 ounces, at 50, maybe even 25, in select areas. Again, when we were talking about equities a moment ago, and certainly real estate is in the same camp, we are talking about an increase in purchasing power. When I look at gold, I don’t look at it as a growth asset. I look at it as the ability to preserve value, to insure that you protect and preserve wealth through a period of extreme financial contraction, and then are able to redeploy assets when those other productive assets are selling at a discount, so it serves a function, like a life-boat, like a life-raft, like a life-vest. We are not talking about winning fashion shows, we are not talking about pleasure cruises, we are just talking about something that is highly functional in a dysfunctional world.

That is why I look at where we started our conversation today, Kevin, and say, “Is the world any more functional today than it was two weeks ago, two months ago, or two years ago?” I think we would both agree that it is far more dysfunctional. That is why I think that the role of insurance is ever more important, and it is going to dawn on more and more people around the world that that is what they need – not gold as a speculative investment, not silver as a growth play, but money – money which has been a form of wealth for 5,000 years, and has stood the test of time, whereas every other asset class has been through the ringer, to one degree or another, and has, at different times, because of liquidity concerns, or solvency concerns, or the combination of the two, been priced at zero, and that has just never been the case with gold.

That’s where we are, Kevin. The rising price of gold represents failing trust in fiat currencies. And I can tell you, having spent some time in Brussels, and I am here again today – I have never been more scared in my life. Brussels is the belly of the beast, and the EU. I hope next week I can have a better comment for you on Europe. We will be talking to some folks that spend their lives here. There are 15 different analysts from around Europe who compare notes, and as part of a think tank we will be participating in two days of meetings with them this next week. Perhaps they can change my view on this, but it appears to me that the grand social experiment here in Europe, something that could have been a test case for the world, is in the process of failing.

Kevin: David, going back to the beginning of the program when we asked, “Have the fundamentals changed?” For the listener who has been listening for 2, 3, 4 years, and they do have a position in physical gold and silver, and they do have a position put aside for growth and some cash, would you say, with the volatility that we saw over the last few days, the drop in the gold price and the silver price, is there something that they should be doing differently? Or is this the time to hold tight and maybe even add more?

David: I wouldn’t change a thing, Kevin. I wouldn’t change a thing. I would pick some particular prices to come into the market, and add, if that is your prerogative, but the fundamentals, if they have changed, have just gotten stronger. That would be my only point, that if they have changed at all, they have simply gotten stronger. The argument for owning gold, in particular, Kevin, has never been more compelling.

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