Podcast: Play in new window
If the Federal Reserve cannot bring inflation back to 2%, could it simply change how inflation is defined? This week, David McAlvany explains why a new inflation framework might improve the official numbers without changing the prices people actually pay. David also continues the listener Q&A, covering when to sell precious metals, swapping silver for gold, the effects of higher interest rates on real estate, holding cash during a market repricing, retirement allocations, Basel III, and more.
To watch the full webinar recording click here
“Returning to the question, if prices are expected to be higher, should I give 100% exposure there? The easy answer is no. Expecting something to be higher and it actually going higher are two very different things. Most professional money managers create a thesis and on the basis of that thesis, put capital to work, put capital at risk because they expect prices to go higher. The smartest investors in the world are typically wrong 50% of the time, which is fine as long as you have limited your position size and as long as you have active risk mitigation rules that get implemented to limit losses when you’re wrong.” —David McAlvany
* * *
Kevin: Welcome to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany.
David, every year, we do question and answer at the end of the year, but it’s July moving into August. How about Christmas in July/August, and we continue some of the questions?
David: After last week’s blend of current market considerations and the entree into the Q&A, I realized that the questions submitted online and following the presentation from our wealth management hard asset strategy were more extensive than I recalled. That level of engagement was both shocking and encouraging. So thank you for listening to the call, and my apologies for only now completing the Q&A. There were a lot. There are a lot of questions.
Kevin: What an honor, though, to have people who want to ask you questions, Dave.
David: Yeah. Well, I’ve learned through the years that when one person voices a question, frequently others are entertaining the same or something similar. And so I appreciate your stimulating the repartee and expanding the conversation. Let’s dive in.
Kevin: Let’s do. Okay. Basic question. “How do you know when to sell precious metals? Are there specific guidelines investors should follow?”
David: I entered the family business in 2003. What became compelling to me at Morgan Stanley was the math of the Dow/gold Ratio. Gold is beginning a long-term structural bull market. Since that time, the Dow has given up more than 70% relative to gold. We’ve got gold up over 10 times. I mean, it’s gone from $350 an ounce to over 4,000 an ounce. It was a great career call. It was a great investment call. And that ratio is still, after this 23 years, central to my thinking.
So when to sell, it’s not in a price. It’s relative to other financial assets like the Dow. So at a 3:1 Dow/gold Ratio, you take the Dow Jones Industrial Average, divide by the current price of gold. At a 3:1 ratio— We’re currently 13:1. Started this journey at 43. We’re at 13:1 today. At a 3:1 ratio, you’re taking gains and determining how many ounces you want to keep forever.
So perhaps if you’re overweight gold, you start that process at a 5:1 ratio or a 4:1 ratio. Again, the math is quite simple. We may see 1:1 on the ratio, but you don’t know when it turns and the markets move in favor of financial assets, but this has been and continues to be a golden era.
Kevin: Well, and we have to remember what it’s mandated for. If you’ve got a preservation or an insurance mandate for some of your gold versus a growth mandate, that’s part of the question.
David: Well, redeploying some of your ounces from an insurance mandate to a growth or income mandate can be very helpful as you approach retirement. I think a reduction strategy is really what I have in mind, not an exit strategy. So the ratio gives you guidelines for when to gradually or incrementally reduce your metals exposures.
In the context of a bull market, keep in mind that when we often reference the Perspective Triangle, your max allocation of a third of liquid assets in metals will grow substantially more than that third allocation. So bringing it back in line is basically taking some gains off the table. The ratio allows you to know when the trigger is there, when it’s reasonable to do so.
Kevin: Well, and that brings us to the next question. The question says, “For clients in their mid-50s who still have near-term spending needs, how do you balance liquidity against inflation, protection, and long-term wealth preservation?”
David: Well, again, I think of the Perspective Triangle. And Kevin, why don’t you explain that?
Kevin: Sure. Well, it’s one of my favorite things. When a client asks me exactly this question or what about precious metals, I just have them draw a triangle. And I learned this from your dad, actually. The base of the triangle is like the foundation of a house. It’s for preservation, and gold goes on the base. And the left side of the roof going up would be growth and income. That would be more stocks and bonds, annuities, that type of thing. And then of course, cash on the right side.
And through the years it’s been amazing, Dave—the clients that I have who do the triangle—how resilient it is, but you talked about sometimes having to reallocate. We do something called triangle updates. So if the base over time gets to be more than a third, let’s say it grows to half or three quarters, we do triangle updates and we wrap the profits to the other two sides or stock market or what have you. The cash will never do that for you because it’s always devaluing, but the triangle is a great way to balance assets.
David: Yeah. I mean, where cash would grow is in the event of a liquidity event. You sell a house, you sell a business, and now all of a sudden your liquid assets are disproportionate to the right side on the liquidity side of the triangle. So just keeping that balance is a great way if you’re in your mid 50s balancing liquidity, inflation protection, long-term wealth preservation, and growth.
Kevin: Yeah. And when we talk about the base of the triangle, the gold also includes silver. So I’m going to move to the next question. At what gold to silver ratio would you consider transitioning part of a silver position into gold?
David: Yeah. Like the Dow/gold ratio, you don’t know what the ideal transition point is until after the fact. So you incrementally approach that transition from silver to gold or vice versa. The first question is, what was the ratio at the time of your original purchase?
Kevin: Right.
David: We can provide that for you or help you figure it out. Then you can consider what the ratio is at the present and if you have an accretive trade at the present time. We generally want to see 20 to 30 points of a move in the ratio for it to be beneficial, perhaps even wildly beneficial to you. But once you have at least 20 points of gain in the ratio, you should swap from silver to gold a particular percentage. For instance, 10% to 15%, maybe a max of 20%, and then do the same thing every time the ratio improves by another 5 to 10 points.
Kevin: Well, and you’ve done us well, Dave, by having the software given to us to allow us to look very quickly at what the ratio was when our client purchased and what it is now and what the gain can be. So thank you for that.
David: We actually prepare a report which demonstrates the math, nets out the tax. If you have to pay taxes because it’s outside of an IRA, of course that’s not factored in, and you gain that much more horsepower in the transaction if you’re not sharing the gains with Uncle Sam. But very simple worksheet that gives all the math and demonstrates the accretiveness of the move.
Kevin: Well, and I should mention for this next question before I read it, when we do the liquidity triangle, we’re not including real estate, not because we don’t recommend real estate, but because it’s not necessarily considered quick liquidity. So the liquidity triangle is one thing, and then real estate’s another.
So this takes us to Mitchell’s question. And he says, “How do you see inflation and possible rate increases affecting residential and commercial real estate prices in the coming several years?”
David: Real estate is rate sensitive as an asset class. If inflation persists and interest rates continue to rise, that changes the math for profitable real estate investment. Most people own residential and commercial real estate using debt to some extent. So the profitability of a real estate investment that does not have fixed rate debt can be dramatically impacted. And of course with commercial real estate in particular, the terms of debt are typically shorter term, could be 5 and 10 year, which means you’re going to have to refinance at some point. So it’s very relevant, the direction of an interest rate trend.
So this is less applicable if real estate is held free of debt. But in a rising interest rate environment, the liquidation value of real estate, you can even look at it through the lens of a cap rate, it’s directly affected by the move-in rates, which means that if you’re looking to turn over your real estate holdings, you have some serious issues. But if you’re buying and holding residential or commercial real estate for its income, are not concerned about its liquidation value or potentially depressed prices for a period of time due to a rise in interest rates, then your considerations could be different.
Kevin: Thank you. Yeah. The next question is from Kimberly, and she said, “What percentage of each portfolio do you allocate to commodities? If prices are predicted to be that high, should I put 100% in?”
David: It is easier to answer that question with respect to gold and silver than it is commodities in general. Gold in particular has a unique quality of being minimally correlated to traditional asset classes. And it actually becomes negatively correlated to stocks and bonds in the context of financial market pressures like a bear market.
Silver’s more correlated to both the equity markets and economic growth, but does, over longer periods of time, move in line with gold, even if those moves are on a delayed basis. So those lags in performance, that’s what provides the opportunity to compound ounces in the precious metals space, shifting from the leader to the laggard and allowing for that catch-up to create alpha, or extra growth if you want to put it in layman’s terms.
Kevin: That’s that ratio trade.
David: Yeah. When you start considering a broader list of commodities, there are so many different idiosyncratic factors that drive price appreciation, all ultimately tied to some version of supply and demand in excess of current supply. So it can either be a production issue on the supply side or a consumption issue on the demand side. And of course there’s a host of factors that impact those. Think of political choices, social preferences, environmental considerations, and many, many more.
I would urge you to consider a modest allocation to commodities in general and also consider a different allocation for precious metals. They perform a different role in a commodity portfolio. Although they’re broadly speaking commodities or hard assets, each commodity has its own unique volatility profile.
So for instance, in our broadly diversified hard asset strategies today, we have close to a 35% allocation to a variety of precious metals thematics from operating companies to royalty and streaming names, and of course the raw commodity itself. This is distinct from what we hold in a broader list of commodities, including energy, agriculture, industrial commodities, sometimes thought of as CapEx commodities, which is more like 15% to 20% today.
And we also have an exposure to infrastructure as a hard asset, which is not strictly a commodity. It can be associated with commodities in some instances, but when market conditions are appropriate, also we will have an exposure to real estate. We don’t have an exposure to real estate today. Just note that our current exposure to that specialty real estate being at zero, it’s been that way for three or four years in anticipation of higher rates. And of course, those higher rates negatively impacting the value of real estate. We eliminated those exposures altogether.
Kevin: Well, and you were answering that question a little bit with the other question on real estate.
David: Yeah. So returning to the question, if prices are expected to be higher, should I give 100% exposure there? The easy answer is no. Expecting something to be higher and it actually going higher are two very different things. Most professional money managers create a thesis, particularly hedge funds. And on the basis of that thesis, put capital to work, put capital at risk because they expect prices to go higher.
The smartest investors in the world are typically wrong 50% of the time, which is fine as long as you have limited your position size—obviously that means 100% is not a healthy position limit—and as long as you have active risk mitigation rules that get implemented to limit losses when you’re wrong. So there’s this acceptance of, “I’m going to be wrong a good bit of the time, but I have rules in place to limit those losses.”
Kevin: This is also why you have a team that can challenge each other, right?
David: Yeah. So it’s never a question of if you’re wrong. You will be wrong, frequently. And that’s okay. No one knows the future. So you develop the best thesis possible. You maintain risk controls to limit downside. And if you are wrong 50% of the time, you let your profits run where you’re right, and where you’re wrong you manage your downside losses. And on a net basis, you’re going to be a successful investor.
Kevin: It’s interesting, this next question sounds like a repeat of a question earlier, but almost everyone owns real estate. And so the question goes back to that. It says, “I would love to hear your thoughts on how the housing market may be affected by inflation or rising interest rates.” So Dave, this affects everybody who owns a house.
David: Yeah. If you can imagine a seesaw, the housing market sits at one end and interest rates sit at the other. So a low rate environment drives the value of housing higher, and a high rate environment drives the value of housing lower. Exceptions exist where the math related to borrowing costs and retail pricing gets overridden. And that’s where you’ve got demand being greater than supply. Or alternatively, if you’re in a depressed environment, supply being overridden by demand.
Take, for instance, Miami real estate. If you’ve got a 30-year fixed rate mortgage close to 7%, Miami home prices are setting records. If it was just about the math and affordability, you could expect to see home prices fall. High rates and high prices are ultimately not sustainable. But if there is a global mass of buyers, which in the case of the Miami area would include folks from Europe.
Kevin: Central America.
David: Central and South America.
Kevin: Yeah.
David: Certainly there’s buyers that are wanting to escape the social and politically frigid climate of New York City.
Kevin: That’s happening a lot right now.
David: Right. So price is a secondary consideration. And what is unaffordable simply becomes even more unaffordable because demand outstrips the limited supply. I mean, in that case we’re defaulting to the old adage location, location, location. But ordinarily speaking, the relationship between borrowing costs and the purchase price are pretty straightforward. I believe that any lingering period above 7% on your 30-year fixed rate mortgage, you’re going to begin to see a discounting of price, perhaps a very significant discounting of price.
Kevin: Right. So don’t be too far in debt when that happens. So the next question, “How does Basel III affect the market?” So explain first what Basel III is, Dave.
David: Yep. Basel III is a global set of banking regulations, and it’s designed to make banks safer. This is in the post-2008, 2009 global financial crisis era. Lessons learned from that period requires them to hold more capital, maintain stronger liquidity, and rely less on leverage. So these rules are intended to strengthen the financial system and reduce the risk of banking crisis. They can also make credit somewhat more expensive, and it encourages some lending activity to move outside the traditional banking sector. Of course, we’ve seen that. We’ve seen the proliferation of private credit. That’s an expression of non-commercial bank lending that is not subject to Basel III.
Kevin: Well, and I’m wondering if the person asking the question wonders what the precious metals or how that factors in to Basel III.
David: Yeah. For precious metals, Basel III distinguishes more clearly between physical allocated gold and paper or unallocated gold exposures, generally giving more favorable regulatory treatment to physical bullion because it carries less counterparty risk. Basel III doesn’t require banks to buy gold or doesn’t guarantee higher prices, but it does reinforce the appeal of holding physical gold as a high quality, low counterparty risk asset within the financial system.
Kevin: So that could factor in tier one type of classification. Next question, “What do metals look like in the new banking system that’s coming? When the new banking system comes into being, what happens to old paper fiat?”
David: Well, that’s a great question, but we don’t really have a clear answer because we’re still largely dealing with the old banking system. With Basel III changing, it certainly curtails some commercial bank profitability. And so there’s some shifts in how commercial banks operate.
Kevin: Well, and you addressed this last week. The banks are going to fight hard to keep the old system going.
David: Yeah. And if you note the blowout of financial performance with a number of the big banks in recent quarters, looking at their profitability, if the profit objectives can’t be met via traditional lending, and this is the net effect of Basel III, commercial banks, the big ones seem to be shifting focus to proprietary trading. So in my view, along with Basel III we need a new Glass-Steagall or we’re going to find a proliferation of conflicts of interest with the trade desks at many of these big banks and retail clients.
Kevin: Right. So next question. “I just retired. Best way to allocate my portfolio for liquidity and cash flow to continue to grow and not to lose the principle, basically.”
David: Well, Kevin, I come back to the perspective triangle. Maybe you can share your thoughts, and then I’ll add a few.
Kevin: It seems like such a resilient plan. I liken it to a sailboat sometimes, too. When you sail, you only see the top part of the boat. You see the sails, you see the hull. But actually underneath, what’s actually allowing the sailboat to do what it’s doing is the keel. It’s this heavy thing that— Actually you and I owned a sailboat one time, Dave. And the keel fell off and sunk to the bottom of the lake. It’s hard to control a boat after that happens.
David: A little less stability with the boat, with no keel.
Kevin: That’s right. So I would say the Triangle.
David: Yeah. It’s underappreciated. The power that you capture in the sail, which for us, if you’re looking again at that Perspective Triangle, you can capture the wind and the propulsion. But what really allows for that is the fulcrum effect where you’ve got the keel under the water and the resistance from the water allows for the energy generated in the sail to—
Kevin: That’s your physical metals in a portfolio.
David: Yeah. And we’ve done a number of backdated studies, regression analysis to see the contribution of gold to an equity portfolio. And the math was optimized. I’m setting cash aside here with the only objective being growth—which goes beyond what this question is,—which wants to continue to see it grow, wants to manage the liquidity. There’s a safety factor there too, not wanting to lose the corpus.
But if your only objective was growth, a 75/25 mix between equities, gold, 75% equities, 25% gold in an annual rebalance allows for you to increase your growth over time with that equity portfolio, reduce risk, and be in a position where you’ve lowered total volatility in the portfolio with that annual rebalance. So again, we’re talking about the power of the keel, and it actually seems like you’re taking money off the table. It’s collecting dust, not interest, when in fact it is one of the things that propels more growth in an equity portfolio.
Kevin: Just don’t let it fall off and sink to the bottom of Navajo Reservoir, right?
David: That’s right. Did we ever recover it?
Kevin: We had to buy a new one. I think you were part of that too. I think you pitched in on that. Yeah.
David: Yeah. No divers looking for the keel.
Kevin: No, it’s still down there. All right. Next question. “Given the reason that most people hold metals as a hedge against significant market dynamics, not limited to collapsing fiat or government response, what are the safeguards of vaulting metals in Canada given their recent history of seizing bank accounts? Are there plans to open vaulting locations in the US and Switzerland?” I think this question is about Vaulted. Is that what you’re reading out of that?
David: Yeah. And we’ve also provided other services in Canada. But yes, we are open to maintaining vaulting with the Royal Canadian Mint, but have other options in motion. US locations make more sense, but as you have administration changes here in the US, we’ll always want the option of burying a bone in other backyards.
Kevin: Sure, sure. Diversity is always, it’s great. Right?
David: Geographic diversification.
Kevin: There you go.
David: For sure.
Kevin: Next question. “What happens when the Federal Reserve is merged into the Treasury?”
David: Well, I think we can expect increased coordination, but not a merger. We don’t see a path towards a single entity managing both our money and our IOUs. I think the global bond market would consider a move like that highly suspect. And the net effect would be demanding considerably higher rates that frankly are not sustainable with 40 trillion in debt. And that number is of course growing.
Kevin: Okay. So this was a two-part question, so I’ll move on to the next. “Based on the current trajectory of precious metals prices, it would seem that the market is pricing in expectations of a high interest rate environment. This is potentially validated by my understanding that Warsh will try to judge inflation by the increase in commodity prices. Does this seem to be what MWM is also seeing?”
David: Yeah. And I think some validation is there outside of our house. We’ve got Morgan Stanley putting together a new portfolio structure. Instead of 60/40, 60/20/20—reducing the bond exposure by half from 40 down to 20. And, yeah, you want to reduce your bond exposure if you’re moving into a high interest rate environment. Implicit to that move in the model is the assumption of higher rates, widening credit spreads, and things of that nature.
So when you look at Warsh and how he’s reading inflation, the current proposal is in fact to alter the definition of inflation in order to gain the market’s perception of inflation management. This should be implemented by September, but a redefinition of what inflation is. You alter the weightings so that achieving the 2% target is easier, essentially lowering the bar. Put simply, it’s a lie.
Real world inflation will continue to negatively affect households even as the Fed proclaims victory hitting its 2% target. If inflation is not well understood by the general public—which of course Keynes used to say that one in a million understand it—this is where our government intends to exploit public ignorance on the topic. And I don’t think that’ll change the reality on Main Street.
I think it’ll ultimately backfire—this sort of redefinition or tinkering with the component parts of inflation. But the revisions are intended to go back to 2021. Goldman Sachs estimates it’ll reduce inflation measures by roughly 20 basis points out of the gates on a revised basis. So everything’s going to look better. What you’ve experienced over the last four to five years will be something of an illusion. You didn’t really experience inflation to that degree. We just misunderstood what inflation was.
Kevin: So you’re prettying it up, right?
David: Yeah. It’s basically lipstick on the pig.
Kevin: Right. Right. Next question. “If rates continue to rise, is it reasonable to assume that at some point there will be a market repricing event to the downside in equities and real estate? And if so, wouldn’t it be better, short term, to sit in cash only?”
David: Well, we agree with part two of the question. Across both companies, McAlvany Precious Metals and McAlvany Wealth Management, we recommend a cash target of 30%, roughly a third. Again, going back to the Perspective Triangle. In our managed equity strategies, we’re already above 40%. The question would be “cash only.” And I’d say no. You’ve got inflation risks which are on the rise, and real assets are a reasonable way of offsetting that risk. So 100% cash, that would be a definitive no.
Kevin: This next question is interesting and it’s loaded, Dave, because you’ve got to give the right answer on this. “What is the best financial plan for elderly widows to follow?”
David: I could say there’s no right answer. In general, you keep your allocations conservative. Plenty of short-term T-bills, balancing out the currency exposure with physical metals. Of course, we’d have to consult with you on a one-to-one basis to kind of appreciate nuances, particular needs, which we’re always available to do that. If you haven’t spoken to one of our advisors, I encourage you to do so, and I’m happy to consult with you directly.
But generally speaking, just keep your allocations conservative. And you’re going to have to redefine conservative because if you talk to a financial advisor, conservative is increasing your bond allocations relative to stock allocations. And again, I come back to Mike Wilson’s 50% reduction in bonds. Most people are dealing with conventional wisdom in that respect, and would see bonds as a less vulnerable allocation. We saw how that did not work in 2020.
Kevin: That’s dramatically not true sometimes.
David: Right. And in a rising interest rate environment, you’ve got most financial advisors operating according to conventional wisdom, which is merely looking in the rearview mirror. The last 40 years, that works. How did it work for the last 40 years? We were in a disinflationary environment where interest rates were coming down. We’re in an inflationary environment today where rates are rising. And so conservative, I’m just going to qualify that. Make sure that as you’re talking to a financial advisor, that you’re on the same page in terms of the definition of that word.
Kevin: Yeah. And I think one of the attractions into the bond market is the income that it provides, and elderly widows, that would be one of the attractions. So it is really important to understand where that income’s coming from and how sustainable it is.
So the next question. “If silver starts a dramatic rise, would it not be better to hold onto silver in that case rather than swap?” That is a good question, Dave. I mean, we really never know the top on something, do we?
David: Yeah. It’s a dramatic rise that would give way to a change in the relative relationship between gold and silver. So a swap from one to the other is just a way of banking profits. Knowing that silver, like any other volatile asset, moves both ways. A dramatic rise up is generally followed by what? A dramatic rise down. And so the swaps are to reduce your volatility and increase or compound your ounces using gains from that dramatic rise.
Kevin: Right. Capturing your gain in something real, right?
David: Correct.
Kevin: Even with the Dow/gold Ratio, it’s the same type of thing.
David: Yep.
Kevin: We have asked the question, and we’ll ask the question to you right now. Is there a specific topic or concern you would like us to address at some point in the future? So feel free to let us know if you do have further questions.
Dave, I’m wondering if we should take the next set of questions next week, and maybe wrap the show up this time. What do you think?
David: We have so many questions. And again, I appreciate the degree of engagement here. It’s an honor and a privilege for us to be engaged, and I just love the fact that so many people have curiosity on these matters.
* * *
Kevin: You’ve been listening to the McAlvany Weekly Commentary. Join us for questions next week as well. You can find us at mcalvany.com and you can call us at 800-525-9556.
* * *
This has been the McAlvany Weekly Commentary. The views expressed should not be considered to be a solicitation or a recommendation for your investment portfolio. You should consult a professional financial advisor to assess your suitability for risk and investment. Join us again next week for a new edition of the McAlvany Weekly Commentary.
