The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: I was reading the Economist magazine on Sunday night right before I came in and it struck me, the Economist magazine tries to be fair, and they try to understand both sides of the issues. I consider it relatively socialist because it’s still European, even though they try to set themselves apart, but I read an article, Dave, that just made my blood boil. The article, for the average person, probably very balanced, but they had no idea, really, what they were saying. They were talking about just pure theft becoming the norm in our society. This gentleman was saying quantitative easing, really, no longer is just an extraordinary measure, it’s something that central banks probably will be doing for the next 10-20 years. We may have reached a turning point where we have realized that this is something that central banking is just going to do.
David: Crossed the Rubicon, so to say. Do we live in a new era of central planning? That’s sort of the question suggested in the article. There is this growing presumption on the part of the market and market practitioners that the central bank activity used to be extraordinary and daring, and it’s not so very dangerous and daring anymore. Merely, now, the new era’s boring and highly scientific approach. And by scientific, it sorts of builds in the credibility to it, right? Because that’s the age we live in, one of science and clear understanding.
Kevin: They are assuming that there is no consequence any more. They’re saying there’s no inflation. We’re printing money and it’s really just turning into growth. That’s their attitude.
David: Right. So, A, it works without a hitch, and B, it has no unintended consequences, and we can conclude these two things because in the rear view, and granted, we haven’t gone very far down the road, but in the rear view, there have been no hitches thus far, and we have not seen any unintended consequences thus far. I would tend to agree with you, Kevin. I would suggest that the market concluding these things is completely delusional.
Kevin: Has there ever been a time in history when printing money out of thin air hasn’t turned into a negative consequence? I was just looking back at the end of a book that you’ve recommended over and over, David, When Money Dies, by Adam Ferguson. It’s about the hyperinflation, as you know, in Germany in the early 1920s that just devastated a country. Yet, when he was writing his epilogue, he was amazed, and here’s the quote: “Their total blind refusal to connect the mark’s depreciation with money supply was amazing. Knowledge of currency laws, particularly of quantitative theory, was incredibly absent from German mindset.”
David: I’m impressed by the candor of one of the Fed presidents, the CEO and President Richard Fisher, from the Dallas Fed. And please, those of you listening, avail yourself of the nine-page speech he gave in Hong Kong last week.
Kevin: Was that April 4th?
David: Exactly. Follow the link on our Commentary website, and you’ll be able to read that. You will find several points of concern in that speech, which we have highlighted on the program, including equities being overvalued, margin debt being at record highs, loans being made with very little documentation, like the covenant-lite loans of 2005-2007, those vintages, and the junk bond yields, now declining below 5.5%, currently near-record lows. Also, he echoes William White’s very candid reflection that the work of a central bank committee is not a hard science, as it is now being commonly perceived, and as the Economist is suggesting it should be, contrasting Fisher’s experience as a money manager, because remember, he was a money manager prior to being a central banker. We then have a very different character, the academic reflections of Ms. Janet Yellen.
Kevin: It’s such a contrast. I’ve got to admit, Dave, I’m not a real fan of central bankers, and we have had central bankers on the program. Nice guys, but they have this view of management from the top. What I like about Richard Fisher’s speech, honestly, I thought he had been listening to the Commentary, Dave, to be quite honest with you (laughter). I mean, the things he listed in that speech as a concern, and I have to give this guy credit. If this guy would run the Fed, I’d be a voter, how about you? I’d say, yeah, put him in.
David: Still not a huge fan of the Fed, except that if you had somebody in charge who was making very clear market-oriented decisions, instead of decisions which were primarily oriented to models – I think that is the real danger that we have today, the hubris, and assumptions that go into the models that drive the Fed’s analysis. You’ve got Yellen: She said this last week that the work of the Fed is really for the children. This is her quote: “Our goal is to help Main Street, not Wall Street.” And I could go on and one with that particular quote, because she illustrates over and over again how the work of the Fed is for the common man. And that, my fellow Americans, is why interest rates are at record lows. It’s not, I repeat, not to rebuild bank balance sheets.
Kevin: Oh, of course not.
David: It was not, I repeat, not, what those academics call financial repression.
Kevin: Oh, of course not.
David: Income is diverted from households and savers to act as a subsidy for financial interests, both private and public, and of course I’m talking about the discounted interest payments for the national debt, that’s the public benefit, then the private benefit being companies which have been given near-interest-free money by the Fed, that’s your banks and financials.
Kevin: And of course, we’ve seen how much wealth has been distributed to the high side, the wealthy side, through this. Let’s just look at New York. My daughter lived in New York for a couple of years.
David: One surprising data point for 2013, the average cost of a Manhattan condo, per square foot, rose 20%. Now, this is in a single year. And according to an April 1st Bloomberg report, I want you to guess what the cost per square foot is for your average Manhattan condo or co-op. Drumroll … put a number in your mind. What’s your best guess? Cost per square foot?
Kevin: I think it’s like $1,000 per square foot.
David: (laughter) If you guessed $1,363 a square foot, you were correct. So, basically, a million dollars buys you just a skosh below 750 square feet. Think about that!
Kevin: So she did do that for the children.
David: Yep. Janet is driving asset prices higher for the children, and the man in the street.
Kevin: The man in the street, it’s Main Street.
David: A different kind of man, perhaps, or woman. Home prices here have rebounded on the back of interest rate suppression. Okay, we know that. It is a bought rate, compliments of the Fed and the QE program, wherein they have been buying anywhere from 85-100% of mortgage-backed securities. Of course, the other asset that that is benefitting, for now, from Fed policy, is the stock market. The Fed has created a context where values and equities are equal to, equal to, what we witnessed just prior to the bear markets of 1907, 1937, 1968. Kevin, there are only two periods of time when stocks have been in extremis, more overvalued, 1929 and 1999.
Kevin: I think this is worth going back and looking at this. 1907 was the financial crash that ultimately led to the “need” for the Federal Reserve. It was a huge crash. And 1937, that was then the stock market turned back down again, and 1968. But 1929 is the crash that was supposed to rock the world and never be repeatable. But, actually Dave, look at what happened in 1999. The NASDAQ was over 5,000 points, and even though the NASDAQ has roared back from its bottom, we’re still not even where we lost ground from after 1999.
David: This gets to the point that was made, I think, very eloquently, by Andrew Smithers. We’re 70% over-valued in the stock market. And it doesn’t mean it can’t go further, and these kind of valuation metrics are not a timing mechanism that tell you, “Okay, now that we’ve hit 71% over-valued, it’s time to sell.” No, you can go to far higher levels of over-valuation, but you are playing a fool’s game in terms of momentum carrying you forward, not necessarily value purchases or value propositions.
Kevin: Let’s address that, Dave, because so many people say, well, if you’re just in the stock market for the long haul, you really don’t need to look at those types.
David: Ask yourself this question: Are you an investor or a trader? Traders will consider themselves nimble enough to exit the market in time, prior to a crash, and all traders think the same thing. The vast majority, you know what they end up doing? Riding the wave up, and all the way down again. The momentum is intoxicating. The thoughtfully planned exit? You know what? It is very, very rarely executed. Now on the other hand, you have the investor who says, “I own stocks for the long run. Temporary price corrections, they don’t faze me. Mine is a cast-iron stomach.” And I would say this to you, Mr. Investor, Mr. Cast-Iron Stomach Man? Order your bottle of Pepto-Bismol. An adventure is brewing. I would suggest that between now and 2016 you’re looking at 30-50% declines in the current stock market. You’re talking about, again, 30-50% of those current values up in smoke.
Kevin: It’s been amazing how this quantitative easing and the cooperation between Wall Street and the Fed has kept things going.
David: And the Fed, frankly, in a similar vein, sees the affordability of cars for the masses at zero percent: That’s a gift to the children. For those families that will now be able to make it to a new job, and this is from last week’s jobs number, the birth/death model and created, so from last week’s job number you’ve got the birth/death modeling which created 75,000 jobs last month.
Kevin: Well, that’s just an accounting change, Dave. Those were not real jobs, they just did that on paper. They did that for 600,000 jobs last year.
David: Right, and these are not the kinds of jobs you drive across town to, because they don’t actually exist. Before we move past the Manhattan co-op, I forgot to mention that that $1363 a square foot, that’s not a luxury accommodation, that’s an existing old building, an existing co-op or condo. New construction? And this stuff is in high demand. Wrap your minds around this. Selling from between $1800 and $3,000 a square foot. I just want to stop, and pause, and say, “Thank you Ben.” I want to say, “Thank you, Janet.”
Kevin: Maybe you should have your children say thank you, as well.
David: Children, say thank you. Thank you, Janet. Children, say, “Thank you.”
Kevin: So, if, indeed, they’re trying to drive the economy, and trying to drive new spending…
David: (laughter).
Kevin: And even though you and I don’t agree with debt spending, necessarily, where is the debt going right now? Where is the consumer borrowing?
David: 98% of new consumer credit has been in two areas: Car loans, with a large percentage of those being at zero percent, and student loans, the majority of which have an interest component that is deferrable for many years. A common characteristic between these two kinds of consumer credit, again, autos and student loans, is that they draw consumption forward in time, in a far more dramatic way than credit cards or other consumer credit, because these are big ticket items. You’re talking about things that can be $20,000 – $60,000 if you’re talking student loans, a car. Again, it could be $20,000, $30,000, $40,000 for one single item. And what they are doing is creating a sense of obligation for many years to come. Zero percent financing for 2, 3, 5 years, that’s just one example of autos allowing for an affordable purchase up front, but with the sting of owning, frankly, a depreciated asset. And yet…
Kevin: You’ve said often, Dave, don’t borrow, especially for a depreciating asset. There are times in a business when you may borrow on something that will appreciate, or you have potential future growth, but depreciating an asset…. Most of us will go out and borrow for a car, but what you are saying is, this is, between student loans and auto loans, that is making up almost all of the borrowing right now.
David: And the variable you just mentioned, it’s a very important financial principle. You don’t want to borrow for a depreciating asset. This is, I think, is one of the Achilles’ heels of the middle class. You want something you can’t afford, so you borrow it, and then it’s worth half of what you paid for it. But wait a minute, it’s not just what you paid for it, you paid twice that number, because interest had to be imputed to the total cost, too. Never a good idea to borrow money for a depreciating asset. Now, here’s the thing: Unless, of course, the money is free. And that’s where Fed policy has changed the dynamic here and taken what is a clear financial principle and said, well, but there’s an exception. Here’s the car value.
Kevin: Yes, because you’re not paying interest.
David: Exactly. The other example is student loans, which can be deferred for a period of time, and students can even seek forbearance, in which case principle payments are suspended temporarily. In that period of time interest continues to accrue and it’s added to the principle balance. The point being, here, is that consumption is being drawn into the present, from the future, and an interest component is then added. So all these students who are now happy with having a degree, something they can put up on the wall, guess what they don’t get to do? Now that they have tens of thousands, in some cases hundreds of thousands of dollars worth of debt, but usually tens of thousands. They don’t get to be the next generation of homebuyers. So the Fed’s great efforts to help the middle class, to help the man on the street, interest is cheap, everyone deserves an education, and everyone should be putting it on a tab to get an education? You’re basically, again, drawing what would have been future consumption, that of a whole generation that would have been buying homes, and now they are servicing debt on their Sally Mae loans. It’s a wreck. It’s a train wreck.
Kevin: We look at these interest rates and we say, well gosh, if they stay at zero, maybe we’re going to see a dynamic change, a paradigm shift. But interest rates go up, and you talked about this generation not being able to buy a house. Right now, mortgages are just about as low, this last few years, as we probably will see in our lifetimes.
David: Yes, 4.4% is about the 30-year rate, and it has bounced between about 4% and 4.5%. I remember 25 years ago my parents sold a home in the Denver area and at closing, I was there, and listening to the disclosure. This is when you had both parties in the same room, now they separate you out. And we looked at how much interest was going to be paid by the new owner at the end of 30 years, and the interest piece was equal to the amount being paid for the home. I mean, it was a total shock to me. It was a total shock to them, too.
Again, this is consumer credit. It is exactly what it says. Normal consumption, with an interest payment attached to it. Whatever is purchased on credit, if carried for any time at all, will have a far greater economic cost to the individual. You’ve heard it said, “Never pay retail,” right? Well, try paying retail with interest. You can think of interest payments this way. You walk into a store to purchase something and the store-owner says to you, “Oh, do I have a special deal for you. I have a special deal for you. You could pay retail, but why not pay even more than the sticker price? Why not pay twice for the same item, double the cost?”
Kevin: It reminds me of the old encyclopedia salesman, Dave. You don’t really feel it if you’re just giving up a coke, or two cokes a day. You can afford these encyclopedias. But are people actually going into debt right now on credit cards? At least for decades, that was the issue, people were just running up their credit cards. But I wonder if this financial crash sort of took the air out of those sales?
David: Yes, there is not a lot of activity there, in terms of the growth of consumer credit, 2%, it’s a very low number relative to the rest of total consumer credit. The only places people are regularly duped is in education, ironically, and automobiles. So, back away and just listen. To understand the great divide between rich and poor, you have to appreciate the difference in resource management. There is a difference between creating liabilities, that is, borrowing to consume, which represents a financial boat anchor, and on the other hand, creating assets. They could be tangible assets, they could be financial assets, which, in theory, leave open the opportunity for further growth of those assets, in a parallel track, while you are still adding savings, and boosting your overall net worth. So just reflect on that. Debt is the means by which individuals live the life they want, but cannot afford at this particular juncture.
Kevin: David, one of the things we pride ourselves on in this nation is our freedom. But if a person is deep in debt, and they are living month to month, and just continuing to take from the future what their earnings would be, and applying them to the current, isn’t that a form of servitude? Isn’t it a form of slavery?
David: I think so. Again, you’re bringing future consumption and pleasure, of the enjoyment of goods and services, into the present, and in return, you’re signing on for a subtle form of servitude. The borrower, servant to the lender, that person could certainly wait to consume at a time in the future when savings are sufficient for purchase, but that’s not the modern zeitgeist. We want what we want, and we want it now, even if it costs twice as much, when you impute the credit, or the interest costs. So the issue of wealth disparity is really central to our current Fed policy, because while Miss Yellen may say it’s for the families and for the children that rates are this low, a market practitioner will tell you all you’re doing is enticing a greater number of people into debt servitude, a move toward negative net worth, with equal and opposite impact in the market being asset price appreciation. This is a boon, of course, to owners of assets. Thus you have the rich that are richer, the poor that are poorer, not because of the evil of the market, or the evil of Wall Street, but because there are dots to be connected. They have to be connected. The dots between Fed policy and market pricing. There is an impact, there is a consequence.
Today, we have the American Dream, which was never one of servitude, and yet it has been repackaged in the modern era. It’s a dream that has obligation and expectation implicit in it. It’s not a vision of freedom, as you mention. This is the notion of the American Dream. It is one of freedom, and yet today it’s been converted, it’s been polluted, it’s been distorted, and it’s been done via the appeal of consumerism and the materialist delusions of personal well-being and significance. Somehow you can buy yourself into happiness.
Kevin: Dave, isn’t this the message of Keynesianism? Granted, Keynesianism is many things, but one of the things that Keynes talked about was having zero interest rates as long as you possibly can, and try to keep people consuming. I remember after 911, Bush came out and, as a patriotic act, he told us to go spend money. Now, that, to me, was just an amazing thing. We had built this country with savings, and now we were being told that it was patriotic to go spend and borrow.
David: Again, when you think about the consumerism, the materialistic delusions I was just alluding to, it’s in this context that I can’t help think that Mrs. Yellen is almost like, and I know this isn’t entirely respectful, so forgive me, but like the witch in Hansel and Gretel…
Kevin: Just the metaphor.
David: Exactly. The children are lured by candies and other sweet delights. There is something that is deeply appealing at just a basic level, even a base level. And yet, the witch is, in fact, doing it for the children. And she’s going to cook and eat them. (laughter)
Kevin: That’s the borrowing side. We have the witch who is offering candy and the candy actually is debt servitude. But the other side of that equation, and there are always two sides to an equation, is the lender. The bond market tells us an awful lot about risk in the market, normally, unless it’s being artificially changed.
David: The key word you used there is normally, and it has been changed. So let’s revisit what has taken place in the bond market in the last few years. You roll the clock back to 2011 and you had the crisis in Europe. On the basis of that you had interest rates on European debt which were 5-7% higher than the equivalent U.S. debt.
Kevin: They spiked because of the risk.
David: So what changed in 2011 was a comment uttered by Mario Draghi in 2012, promising to do anything needed to stabilize the market. Words. The power of words. Spanish debt is now, fast forward to the present, is now within half a percent of the U.S. 10-year treasury. French, German and British 10-year paper trades, actually lower levels than U.S. debt. (laughter) Germany is actually cheaper on a basis point comparison, 117 basis points difference. Their debt is cheaper.
Kevin: How far we have come, Dave. The shows that we were doing a couple of years ago were about the possible non-survival of Europe. There were people that we had on that said, “Look, the euro is probably not going to make it,” but they bought time with Draghi saying, “We’re going to do what America did. We’re going to do what Abe did.” Quantitative easing seems to, over and over, be the only answer that they are coming up with, the printing of money.
David: What they are dealing with is such a low inflationary environment in Europe that at present they are concerned they may slip into outright deflation, and Draghi has commissioned the ECB to go ahead and study what it would look like, what the market impact would be, to move into a similar quantitative easing that we have had in the United States for treasuries and mortgage-backed securities, in this case, buying corporate bonds, in Europe, to the tune of about a trillion euros. What will the impact be? Again, we’re talking about a distortion of pricing because you have this outside buyer. It’s unnatural, and ultimately unsustainable, but in the short run, there is a major impact.
Kevin: And what does that do to high-yield bonds, because if you know the government is going to come in and start buying corporate bonds, then they feel like they’ve got a backstop there, too.
David: There is a knock-on effect throughout the credit structure, and the Fed president, I mentioned Fisher’s speech from Hong Kong, you have to read the speech. It’s excellent. High-yield bonds trade with interest rates near 5.5%. He mentioned it, we’ve mentioned it before. What this implies is that the Fed’s policies of interest rate suppression have had a major impact in the investment markets.
Kevin: They’ve removed the perception of risk.
David: Yes. It’s been tremendously inflationary for asset price, that’s stocks, that is real estate, that is bonds. They’ve boosted the values of bonds higher, and interest rates have thus fallen to the floor. But now you have income seekers, investors looking for income, that are scouring the earth for something that is very hard to find.
Kevin: Sure, the retired class.
David: Yield income, it’s basically gone the way of the dodo bird, it’s very hard to find, so now we’re witness to an epic distortion of investor behavior. These are folks that are generally risk-averse, and yes, they’re seeking a very predictable outcome. Just let me clip my coupon, let me have my 3%, let me have my 5%, let me have my 7% income on savings. They’re still seeking the old income levels, but they are in a new world of underappreciated risk and overpriced assets. Recall, this is our newest and most important money mandarin that has told us this, that has told us that it’s good for Main Street, thank you Miss Yellen, it’s good for Main Street, not Wall Street, not Wall Street. Never mind that the U.S. and Europe issuance of junk bonds is going through the roof. Yes, it’s going through the roof to meet investor demand, and I want you to recall that when we’re talking about junk bonds we’re talking about companies that are either poorly run or have rotten credit risks.
Kevin: Let me just ask, though, Dave. If this doesn’t work, and it has never worked before, where you can just print, for free, your solution, print your wealth for free, then what we have is the collapse, or the nonpayment back of principle. I think of what Will Rogers said years ago. He was a man of many wise sayings, but I love the one where he said. “I’m not so concerned about the return on my principle, but I definitely want the return of my principle.”
David: And that’s where the carnage the fixed income investors will experience, as unsuspecting savers right now, squeezing into investments that are quite risky. I think this is where they’re going to be astounded. We talked about potential risk and downside in the stock market earlier. You can expect 40-65% losses in high-yield products, as interest rates normalize, and that may end being a conservative estimate of losses. And by the way, you don’t have to be a junk bond investor to lose in the fixed income space. You just have to be on the wrong side of an interest rate trend.
Kevin: And I think we should point out, Dave, that the trend has been for lower rates because the government has been the buyer. They create the money, they’re the buyer. How much do they own, like mortgage-backed securities, the mortgages that are out there, and the treasuries that even the government is borrowing, themselves? The Fed owns a lot of that, don’t they?
David: Right, and this is just one last point on the losses in fixed income. Why do we think you should be on the right side of an interest rate trend, not on the wrong side? This goes back to Knut Wicksell’s comments. He was an 1800s, 19th century, economist in Sweden. Basically, he said, if you suppress interest rates, if you keep them too low, too long, they will end up going significantly higher, and you won’t be able to control them.” That was his conclusion, and his work has never been refuted. So the idea that somehow we can keep interest rates low forever, there are other variables that make that possible.
Kevin: So it’s an illusion.
David: I mean, it’s a reality in Japan, but you also have a very compliant culture in which savings are virtually mandated in Japanese yen terms. You look at the average U.S. investor, and it’s a very different character. We think for ourselves, we’re much more cowboys, you could say. And no, we do not succumb to social expectations and pressures the same way you do in a place like Japan. I’m not trying to be rude or anything, I’m just saying that there are elements afoot that allow for a low interest rate environment to still capture the interest of Japanese investors. We noted this about two months ago, but even that is beginning to fade. They’re now advertising Japanese bonds. If you want to be the sexiest guy on the street, if you want to attract the ladies, you should be investing in Japanese government bonds. They’ve actually had to move to sex appeal with Japanese government bonds, because actually, that traditional go-to of local or domestic consumption for those bonds is waning.
Kevin: So what you have is a new generation who may not, just out of their cultural need, buy bonds.
David: It’s just a question of how long they can keep them suppressed. They can do it longer than we think? Certainly. But when they lose control it’s going to be a very, very big deal. Fiscal disaster, monetary disaster, market disaster, both in the stock and bond market. Having said that, today, the trend is lower rates, and I think everyone is aware that the trend is utterly manipulated by the Fed buying the benchmark in order to lower those levels. They’re buying, as Fisher says in his speech, 85% of all mortgage-backed securities paper. Well, that’s today. Yesterday it was 100%. Today it’s only 85%. And it will end up being a total of 40% of all mortgage-backed securities, in aggregate, that the Fed sits on, as an asset on their balance sheet. They’re going to own 40% of the market. But if you think about that, it’s preposterous to think that home-buying today is somehow a market activity. It’s not a market activity.
Kevin: It’s just directly out of the Fed.
David: Bank-rolled directly from the Fed, that has their own printing presses, how convenient. And then you’ve got them also going to end up, according to Mr. Fisher at the Dallas Fed, with 24-25% of all treasury debt by the end of this QE project.
Kevin: You keep saying, the end of this QE project, and Fisher is talking about the end of this QE project, and Yellen, Bernanke, were talking about the end of this QE project. But who’s going to buy this stuff at zero rates, or low rates? If the Federal Reserve is not buying all this, Dave, who’s going to be the buyer?
David: Well, if you don’t have the buyer, this is the problem. If it’s not the Fed, then it’s the foreigners, if it’s not the foreigners, then it’s us here in the U.S. Keep in mind, the one way you can convince Americans to buy treasuries, what in past eras have been called certificates of confiscation, is under the auspices of war, and your support of a nationalist effort. There is no doubt you can roll that drumbeat and basically say, “You have to do your patriotic duty. Help us fight the bad guys. Help us fight the evil. Help us win the victory. It’s now or never.” That kind of language and ethos and pathos gets tied up into the selling of government paper when worse come to worst. And one of the things that you can ask is when we get to the end of it and no one is willing to buy our treasuries, is this not a point in time where in times past, history would say, ‘Yeah, it’s about time to start a war. It’s about time to start throwing mud. We’re looking for more heat than light, in conversations, diplomatically speaking. Why? Well, because it solves some domestic problems for us.”
Kevin: The way the market would work, if it was normal, and quantitative easing had ended, and you wanted to inspire the buyer, if it’s not sex appeal in Japan, like you said, it’s actually going to be higher interest rates. That’s what that market is. You pay a certain amount of interest rates.
David: And it’s more appealing.
Kevin: Exactly.
David: And you know what? There’s nothing wrong with higher rates, we would end up probably with a higher dollar, as well, in terms of values, but it’s only healthy, and you can only move rates higher if you don’t have a huge stock of debt already, and a fairly short maturity structure for that debt. In other words, we have a lot of implicit rollover risk in our treasuries, and that’s a tough thing to do, because yes, interest rates moving up might be fine for the dollar, but it’s not fine for our fiscal picture, because, again, what we saw last year, we mentioned this before, is the interest line item on the national debt went from 250 billion to over 400 billion, 9% of total tax revenues, to close to 15% of tax revenues. And that was just the minor hiccup in interest rates May and June of 2013. If you go back to more normalized rates and we’re 200-300 basis points higher than we currently are…
Kevin: It will take our revenues.
David: It will take our revenues, and then when we have to refinance that debt, it’s going to be at considerably higher numbers, and then the question is, is this really the event that S&P, Moody’s, and Fitch have been looking for? Downgrade potential, then you have a non-virtuous cycle, reinforcing a negative feedback loop, if you will.
I want to go back to the junk bonds and high-yield paper, because this is a critical thing and I think it relates to where we were last year with the gold market. Better than 10% of the junk bond market today, what they call high-yield trades in exchange-traded funds.
Kevin: ETFs.
David: That’s right. So you have J&K, HYG, a couple of ticker symbols. There are a number of other bundled consumer products that you can buy and sell and you basically are buying a basket of junk or high-yield bonds. As we witnessed in the gold rout last year, April to June of 2013, the ETF liquidations extended a trend and exaggerated price volatility by concentrating volumes in a very short period of time. A key distinction with the coming rout in high-yield bonds, with that of gold last year, is that China and India stood ready to purchase any quantity of tons at lower prices.
Kevin: Yes, 700-800 tons came out of the ETFs and 700-800 tons went straight to China and India. But a junk bond fund. Who buys junk bonds when they come out in that kind of level?
David: It’s unclear who the buyer of last resort is, not only the bond market, but specifically, the high-yield or junk market. In that space, you are dealing with credit ratings that are as low as they go, and you are dealing with enterprises who have raised the capital, they’re already paying premiums in those high-yield offerings. And frankly, they’re not likely to be going concerns in a period of high stress. So who dreams of junk? I don’t know. I don’t know who dreams of junk, but I know a lot of cultures that prize gold, that dream of gold, and don’t treat it like junk. When it’s on sale, they buy it hand over fist. When junk goes on sale, it basically is circling the drain.
Kevin: And it can go to zero. Gold has never gone to zero. This is why the Chinese were buying it. But a junk bond purchase from China, I seriously doubt it when everybody is flowing out.
David: I’m not quite sure how we do this, but yields are, today, almost exactly where they were last April, near-record lows, and interest rate volatility, the stuff we saw last year, it was due to the announcement of a reduction in Fed quantitative easing measures, the famous taper. Markets, I just have to ask the question: Are they ignoring the risks? Do markets believe that the Fed is here to stay? That they are actually not going to ease off? Well, they already have. They were promising 85 billion to the market, now they’re promising 55 billion, and that may wind down to nothing by October. So, again, do markets believe that the Fed is here to stay? Do they believe that some other central bank is going to continue an extraordinary asset purchase? Or, and this, I think, is where the answer is, are investors doubly blinded by the belief that, number one, central banks have all the power in the universe and they’re exercising it for the “good of the people?” And number two, are they being equally blinded by their need for income. I see this happen so many times where someone prioritizes their financial need and ignores fundamental variables in the market in order to get what they want. And they’re not respecters of the marketplace, because I can tell you this. The marketplace is no respecter of you as an investor.
Kevin: And the Federal Reserve has really retrained people. I had a client send me an article from a broker that writes a newsletter, that said, “You know, we really are not giving the Fed enough credit. We really need to pat them on the back. Not only did they save us from a financial catastrophe, but they’re really managing things quite well and inflation is really not an issue. So it seems that even the pros, at this point, have been retrained to eliminate risk. There’s just no reason to pay for it.
David: Kevin, I think it’s utterly delusional. Where we started this conversation, we’re assuming that there won’t be a hitch with the current policies, we’re assuming there won’t be any unintended consequences, and we’re looking in the rear-view mirror, a very short gap in time from when these policies were implemented until now, and we’re assuming that we have an insight into the future based on what has happened just immediately in the past. I think you have more activity coming from the central banks in Europe. You have Draghi, who is, as I suggested earlier, buying down rates, or suggesting buying down rates in the corporate space, and it is periods of time like this, Kevin, when you have so much distortion in terms of price, that it seems the better time to be moving to cash. It seems the better time to be denominating that in a currency that has stood the test of time. I’m regularly asking myself the question these days: Do I own enough ounces?
Kevin: Right, because you say, cash is ounces.
David: And that’s the way I treat those ounces. I don’t treat them as a potential growth asset. I’m looking at the rest of the world as incredibly overpriced, and I want out. But I look at the dollar and I look at how it’s managed, or mismanaged, by the central bank, not only in a long period of time, losing 97% of the value of its purchasing power, but even in a short period of time, the last ten years. On a Greenspan/Bernanke/Yellen watch, we’ve lost 33% of the value, that’s just in a 14-year stretch. Kevin, I don’t want my savings managed by Ph.Ds. I want something that has stood the test of time. And so, do I own enough ounces? And I personally continue to add both to gold and silver. I just feel that in a world of inflated values and contrived prices, compliments of the Fed, you really should go back to the basics.
Kevin: Well, and one of the things you’ve talked to all of us about is, set your goal. You say, “Guys, set your goal on how many ounces of gold you want to have, and how many ounces of silver.” It’s a different way of thinking for me, because I’ve always drawn the triangle for clients and I would say, okay, one-third of the portfolio definitely goes into precious metals, the other two-thirds are in the other things.
David: Stocks, bonds, cash, what have you.
Kevin: Exactly. But you’ve sort of changed our mindset around here. We still go for the third, but you also said, for a metals position, how many ounces of gold is the right amount of ounces, and set a goal.
David: Yes, think about it. An owner of 30 ounces of gold is in the top 1% of all gold owners in the world.
Kevin: So a lot of people listening already know that they are in the top 1%.
David: (laughter) On a per capita basis, given the number of ounces in the world, 174,000 tons, you could only own, if it was proportioned equally, you could only own about 0.69 of an ounces, less than 1 ounce of gold. So to own 30 ounces, you are a big owner of gold in the world. This is how scarce it actually is. What is your goal? Is it 30 ounces? Is it 300 ounces? Is it 3,000 ounces? What about the silver category? Do you want to set a long-term goal? Maybe this is a high bar for you to get to. 100 ounces of silver? 1,000 ounces of silver? 100,000 ounces of silver. Stop thinking in dollar terms and try to make progress toward that goal. By the way, when the price gets cheaper, do you know how much easier it is to attain your goal? You can buy a few more ounces at $20 silver than you can at $40 silver.
Kevin: So you’ve changed your thinking. When the market goes down, I’ve noticed, you’ve changed your thinking.
David: I do like to get closer and closer to those goals. But two years ago, I knew what my goals were. I had them on paper at that point, and I was trying to figure out, what would that look like at $36 silver? I feel like a pig in slop being able to buy at 20 bucks.
Kevin: So, thank you Goldman-Sachs, thank you Merrill Lynch. It really was not that bad…
David: Yes, at least on the gold side, thank you CME Group, and thank you, those very connected into the inner workings of the silver market for precipitating… listen, I don’t think that the market is entirely manipulated, but I do think there are reasons to look at strange behavior and policies that are done, whether it’s margin requirements that increase when they should decrease, decrease when they should increase. These things do represent a plot that is, in my mind, thickening. The bigger plot is, how do we survive the final throes of a socialist experiment? That’s where we are today. We have a central bank, serving a central government, that assumes that they know best, they always know best, and that we should just play along. It brings me back to that whole issue of, do I own enough ounces? Because this is all a grand experiment. We haven’t been here before, in exactly this way, but I’m not convinced it’s going to end well, and I continue to ask that same question: Do I own enough ounces?
