About this week’s show:
- Inflation: Time to start counting food and fuel
- Does the “Inner Circle” want a return to Iraq?
- Efficient market hypothesis: Could it be wrong?
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: You know, it’s strange, Dave. I’m told that inflation is just almost a nonevent, as long as I don’t eat and count food prices, as long as I don’t drive, because we don’t really count gas prices, as long as I don’t use health care, etc., etc. I’m wondering what I really spend my money on.
David: Do you remember when we had Dave Stockman on our program?
Kevin: Oh, yeah.
David: Fun guy to talk with. If you go to his website, davestockmanscontracorner.com, he has a fascinating chart. It is titled, Let Them Eat iPads. What inflation shortfall, is the question. He lines out on a grid the various things that show change in price from January, year 2000, to March, 2014.
Kevin: Okay, so from the turn of the millennium until now, 14 years.
David: Yes. And so you look at various things like the PCE. We have talked about the PCE. That is the Fed’s preferred measure of inflation. That’s also what gets counted into the discounting, if you will, of inflation in the GDP statistics. Our economy, as it is growing, factors in this inflation component. They take that out, so we understand that they say, “No, we understand that there is an inflation component in growth, we don’t want that to confuse the issue. There is real economic growth, and then there is inflation set alongside it, let’s take it out, so we need a discount.” PCE is what they use as the discount mechanism in the GDP. That shows a 31.65% increase over a 14-year period. You go to the opposite extreme, and you have a barrel of oil which has gone from $24 to $100, about a 314% increase.
Kevin: It’s tripled.
David: Fuel oil, 242%. A dozen eggs, 106% increase. You were talking about triple the PCE deflator, right? So what they consider to be the inflation problem is not an inflation problem. Look, 31% divided by the 14 years, you’re talking about roughly 2% per year inflation, and they say that’s totally modest, it’s normal, not to be worried about.
Kevin: For people on social security and who really need to have those increases be accurate, they would say that’s exactly what they’ve been doing. They just increase slightly. These people use gas, they use food. We’re not talking about something that no one uses, here, Dave. They leave the oil off, they leave the fuel per gallon off, a gallon of gas.
David: Well, this is a great acknowledgement. This is directly from the St. Louis Fed’s website.
Kevin: Okay, from almost the government.
David: Well, they basically say, traditionally, economists have excluded food and energy prices in their filtering process, but we find that by filtering out food prices, we might be losing valuable information about inflation. Wow! Really? That’s so interesting.
Kevin: Thank you. Well, that took a doctorate in economics to figure out.
David: I’m just glad that it’s transparent, and they are willing to say, actually, this is an important part, and it should not be ignored. They go on to say, the CPI, that is, the Consumer Price Index, recorded by the Bureau of Labor Statistics, was created for the specific purpose of adjusting veterans’ pension benefits for inflation following World War I, while the PCE, reported by the Bureau of Economic Analysis, is used to compute the nation’s gross domestic product. We mentioned that earlier as a side note. Both indexes measure the rate of inflation faced by consumers, but the PCE is more comprehensive. 25% of the items in the PCE basket are excluded from the PCI basket, so they really do like the PCE basket and (I’m adding my comment, here, of course) they have a better leg to stand on, intellectually, using the PCE. They go on to say, “Since the 1970s, core inflation has typically been measured by excluding food and energy from the basket of goods. That’s because the early 1970s saw high volatility in food prices, and soon afterwards, a rapid rise in the price of gas, oil, and other energy products.”
Kevin: Well, can I make a comment there? We’re talking about 1970s. Of course we saw a rise in gas prices and food prices. That’s when we last experienced high inflation. Isn’t that what they’re trying to measure?
David: And they conclude by saying, comparing the past year’s inflation, in food prices, to the prices of other components that comprise the PCE, we find that the food component still ranks the best among them all. One of the most important pieces in the puzzle. They’re saying it is the most valuable information feed and it’s not included. Don’t let that disturb you. Don’t let that detract from the value of either the CPI or the PCE.
Kevin, where does the rubber meet the road, here? We all experience a disconnect between the statistic which says inflation is 2% and what we pay out for goods and services on a daily basis.
Kevin: And David, you have met with some of the top money managers of the world, and these guys have said to you, “Look, we know they are inaccurate figures, but because the markets actually pay attention to them, we have to dance to that music. So in a way, you have a world which is saying, “No the king has plenty of clothes on and we love the song.”
David: For all practical purposes, we have to assume that he has clothes on because that is the way everyone is behaving. So, in the marketplace, we adjust our thought patterns to social behaviors rather than the truth.
Kevin: Well, then the timing of this is probably pretty good, because gas prices right now are very high. Debbie, my wife, called me a couple of weeks ago and said, “Kevin, go fill the car up, I’ve just heard that gas prices are going up.” So, is the Fed, with the way they measure, getting behind the inflation curve at this point?
David: I think they absolutely are. I think they’re behind the inflation curve. Gas prices jumped last week to the highest level since 2008, and so, yes, we think the Fed is behind. There are several signs of that, as well. You have the precious metals, which may very well be turning a positive corner.
Kevin: And silver is outperforming gold all of a sudden. That’s an inflationary sign, isn’t it?
David: These are things that are indications to us: The gold-silver ratio is contracting. It was 67-to-1, now it’s closer to 62 or 63-to-1. So that indicates to us silver outperforming gold. You also have gold shares moving up rapidly. Those are the companies that mine the metal, tend to be more of a speculative play on the metal, itself. And we’ve seen gold go up and the shares stay flat, and it’s almost as if one market says, “We don’t buy it.” In this case, gold has gone up and the shares have gone up simultaneously. It’s supportive. It’s a sign that we may have a cyclical low in place.
Kevin: That’s what I was going to ask. We know that that we haven’t changed the long-term bull market in the metals, but we have had a cyclical bear market, which is the shorter term. So you’re thinking, Dave, maybe we’ve got a low in on the metals at this point.
David: I think so. Again, what is our recent low, $1240? I would say this. Don’t delay. If you’ve considered adding to a physical metals position, call our offices and get it done, whether it’s the European gold coins we’re excited about, whether it’s gold kilo bars on a larger purchase, whether it’s silver bags or silver bars, you should do as much buying before August as you can, and the reason I say August is because after that point, I think you’ll be chasing, chasing, higher prices.
Kevin: Dave, there is a big question mark in a lot of peoples’ minds, because the Federal Reserve has been having to come in and buy, not only our treasury bonds, but they are buying mortgages. They’ve continued with the tapering. They’ve gone from almost 100 billion dollars a month, down to where we are at now, which is 35 billion, but if they are not in there, if they’re not in the market buying those bonds and those mortgages, what happens to interest rates?
David: It makes me smile, Kevin, just to think about the fact that 35 is now a small number. This is really sort of the conditioning that takes place in the market. If you went back to the year 2000 and told someone that a gallon of gasoline was going to cost them, on average, $4, they would have thought you were mad, because they were used to paying $1.19, and now, anything that is anywhere close to $3 seems like a deal. It seems very small because we’ve adjusted our mindset completely in a 14-year period and a tripling in price, 2½ times the price, we’re thinking that $3 to $3.50 is cheap, and it’s $4 which is expensive. 35 billion. That’s the new, “We’re not spending money we don’t have.”
Kevin: Right. “We’re being disciplined.” (laughter)
David: So what are the implications for the world? You’ve had artificially low rates. We’ve talked about this until we’re literally blue in the face, and I think we have to come to terms with an adjustment in the value of the assets which have benefitted the most from this low rate environment, so we really are talking about the bond market. Last week we talked about the Financial Times article discussing the Fed’s proposal to have an exit tax for bond fund holders because they don’t want to see major flight from bond funds, they would like to frankly count on that as sort of a captive audience, if you will, literally captive.
Kevin: What would cause that, other than higher interest rates? People flee the bond market when they think interest rates are going to rise.
David: That’s right, because rates go up and the prices of bonds go down, which means that the value of those bond funds will be going down in a rising interest rate environment. Central banks, in fact, are getting an early start. This is from this week’s Financial Times. By the way, I think this is one of the best newspapers to read. If I had to choose between the Financial Times and the Wall Street Journal, hands down, Financial Times, every time.
Kevin: That’s the salmon colored one, when you’re in the airport.
David: That’s correct, that’s correct. The Financial Times from this week looked at a survey, an HSVC and a central bank survey – central bank reserve managers, these are the folks that are sitting on the reserve assets, 6.7 trillion dollars in assets. The consensus was that it was time to reduce bond exposure and that they needed to do this before we had tighter Fed monetary policy. So again, the warning bells are going off, higher rates, the Fed’s talking about the notion of an exit tax for bond funds, central banks are already hitting the exits before there is much public discussion of stress and strain in the bond market. Why? Because they are the insider’s insider. With 6.7 trillion dollars in fixed income assets, yes, they want to be early. They can’t be late, because you’re talking about revolution. If they get things wrong and they start losing hundreds of billions of dollars, they are accountable. They are accountable to the masses. And I think this is where we see them early this time around.
Kevin: Well, okay, so let’s say money does come out of the bond market. It’s the largest market in the world, Dave. There is nothing that compares to the bond market. Where does that money go? Yeah, it can go into precious metals. Maybe it’s going to go into other things, but the stock market right now, gosh, it seems like it’s just defying gravity. It just goes up, it doesn’t matter what the news is.
David: Well, that does bring an interesting point. Some of that money could trickle into the stock market. Bond liquidations are going to boost risk assets. You could certainly see stocks, you could certainly see commodities move, if there is a growing concern about inflation, circling back around to the idea we mentioned a bit ago, about the Fed being behind the inflation curve, other central bankers can sort of front-run that and basically say, “If inflation is going to catch up in a nasty way, how do we buffer, how do we hedge that inflationary consequence?” They would look at stocks as a way of buffering it, of hedging it, they would look at gold as a means of hedging it. And we already talked about this, April was the second consecutive meeting at the University of California, Berkeley, the World Council sponsored an event there with UC Berkeley, and brought in all of your junior reserve asset managers, the same central bankers who are selling bonds are talking to them about how to integrate gold as an asset into their reserve asset base. If you’re expecting inflation and you’ve got a large fixed income portfolio, you know you can’t exit all of it, but you’ll take away some of the sting. What do you do with the rest of the assets?
This was the conundrum my dad faced in the late 1960s. He was dealing with folks with lots of tax-free municipal bonds. Late 1960s, early 1970s, there was no big increase in interest rates, no real concern about inflation, except amongst the very intelligent, horizon-seeking investor, who said, “I don’t care what it is today, I care what it is tomorrow, and how do I create a hedge for my portfolio?” Gold started to become the conversation point amongst those fixed income muni-bond holders. Why? Well, they were engaged. And so I think these central bankers are engaged, they know they’ve got a problem, it’s a 6.7 trillion dollar problem. They can’t completely exit the bond market, but they can certainly sell off at the margins, and then create a hedge, and I think they’re going to do that.
Kevin: So a person hears about the stock market possibly going up higher. We’ve talked about the danger because of the Shiller PE index being north of 26, but that’s not unusual, is it? You can see the stock market go far higher than you would imagine before the big crash. What is the danger right now for a person to walk in and try to get those gains?
David: Two dangers. One is missing the opportunity, plain and simple. You could see the Dow go past 17,000, and very quickly be at 17,500 or 18,000, and that would, to our mind, be very much a blow-off phase. Is it getting there on a justified basis? We would have to say no.
Kevin: But Dave, sometimes you have to weigh the upside versus the downside, and what you just now mentioned is probably 5-7% higher, when the downside is what, 25, 30, 40%? Smithers was thinking it could even be more.
David: Smithers is a good example. You have to keep both of those things in balance, risk and reward. I could say the stock market is going up and you could risk missing that gain. What are you also risking? You are also risking downside. What is the potential downside? If we’ve got 5-10% upside, I would argue we have 40-50% downside, maybe even 60% downside. So, on balance, are you justified at stepping into the equity market? Sure, if you’re a day trader, go for it, because you probably do have some gains to pick up. But it is, proverbially, like picking up pennies in front of a steam roller. Very concrete rewards, but with a consequence if you should slip up, in any way, shape or form.
Kevin: And they are not gains based on increased earnings. Look at some of the companies that are showing losses now, but their stocks are still going up. That’s repurchase, isn’t it? They’re just going back and buying their own shares.
David: That’s right, classic blue chip. Caterpillar sales dropped 12%, and yet the shares hit a record high, so you have 12% year-on-year decline in sales, and yet their share price hits records, and I guess you can thank the executives for their buy-back schemes. This was Andrew Smithers’ big point, saying, “Listen, there is such a distortion in value in the equity markets today, in part because you have a distortion in the motivating factors of company managers. They want their big bonuses, and they know they’re going to get their big bonuses if they can manipulate their earnings numbers. They get to manipulate their earnings numbers because they control the number of shares that they are buying back.
Kevin: Whereas in the old days they would maybe put that into research and development, or some sort of plant and equipment, correct? Just to grow the business.
David: That’s right. So why don’t you put the money that is in the company coffers into R&D? Why don’t you put it into capex? That’s because there are no real growth prospects right now, and it makes more sense to someone who wants to retire, a year from now, two years from now, three years from now, to exercise as many of their stock options as possible, get the share price up as high as they possibly can through these share buy-back schemes.
So what is just an absolutely horrendous example of this? You have Oracle. Oracle has, in the last 24 months, spent 21 billion dollars on share buy-backs, and they have expanded their business through capital investments, capex, by 1.2 billion.
Kevin: Just a drop in the bucket compared to 21 billion.
David: Yes, and this is where, again, you get to listen to what an executive says, and it is really important, in the context of communication, to not only get the verbal piece, but also the nonverbal piece. When you are reading body language, you can get a different message, and to me, this is the body language of the market. You have Oracle saying, “We’ll buy back shares, improve our earnings per share numbers, and wow the market with this quarter’s results. They’re actually not wowing the market with this quarter’s results, but nonetheless, they are better results than they would have been otherwise because of these share buy-backs, and they’re not investing in their future, so if you’re a share-holder and you’re saying, “Wait a minute, this looks like executive compensation packages. People are cashing out while they can, and they’re not investing in my future as a shareholder looking for a future return on investment – why should I be owning this?”
Kevin: It’s short-sighted thinking, that’s all it is. You know, Dave, when you talk about reading body language, you’ve shared with us over and over that the financial moves to the economic, which moves to the political, which turns into this geopolitical, geostrategic. I just read something that gave me a chill, and frankly, I don’t know that I would have fully gotten this unless I had worked with the company for the years that I have, but Foreign Affairs is a magazine that is printed by the Council on Foreign Relations, what I would consider, in many ways, I hate to say it, the bad guys. These are the guys who want to run the world. You read Foreign Affairs, I subscribe now to Foreign Affairs, because I have to keep up with you in some ways. The head of the CFR, President Richard Haass, noted that it was an 11-year, 2-adminstration war, where 4500 lives were lost, 2 trillion dollars is what it cost. Iraq is now dominated by Iran and it’s a terrorist haven. What he said was, it’s a policy fiasco.
Now, here’s what gave me the chill. I agree with him. It’s a policy fiasco. But these guys are the elite. They are sort of the movers and the shakers, so to speak. Are we going back into Iraq? Because, usually, when these guys start talking about it, it’s as if they want to go back in.
David: I think there are a couple of things. You had also this week, in a Politico article, a great article, by the way, Elliott Abrams. The name of the article is “The Man Who Broke the Middle East.” He is a senior fellow in Middle Eastern studies, also with the Council on Foreign Relations. I think when you compare both Richard Haass’s scathing review of where we are in terms of our Mid East policy, and then look again at sort of the Mid East studies expert from the Council on Foreign Relations, I think we see, as a turning of the tide, you have the intellectual and the political elite, which have had enough of the current administration, and it’s really interesting, because I don’t know why they are distancing themselves from the current administration, but they are, and I would encourage you to read the article from June 22nd from Politico. The second undertone in the article is that Clinton, while in the state department, was following the Obama vision of the Middle East.
Kevin: And this is Hilary you’re talking about.
David: Right. So Hilary somewhat gets off without responsibility. Now, that’s an awfully convenient conclusion to come to.
Kevin: So, they’re going to throw the blame on Obama, who, I must mention, was a Nobel Peace Prize winner before he even really had done, or messed up, anything.
David: I can’t believe you reminded me of that. (laughter) He’s a Nobel Peace Prize winner, for what?
Kevin: Yeah, for what?
David: For what? The number of things that have been cheapened, not just the U.S. dollar in the last 10 years, but the value of a peace prize? Maybe that was cheapened a long time ago, but still, this took the cake. This last gift of the peace prize to a man who, great, community organizing. Wonderful. Thank you so much. That has changed the world utterly for the better, and brought about the peace that we now know throughout the, oh, no, not the Middle East…oh, not Russia… oh, not Asia… well, okay, never mind.
This is the issue. You have the heads of the CFR, very powerful. They wake up every morning, I think they look at themselves in the mirror and say, “We’re the good guys.”
Kevin: The world is their chessboard, Dave.
David: And honestly, if you were in their shoes, playing the chess game that they’re playing, how would you play it? I don’t know. Perhaps with a few different principles in mind, I think you and I might. But they are distancing themselves from the Obama administration. They are aligning themselves subtly with Hilary Clinton. One of the things that I like about subscribing to Foreign Affairs is that in many respects you get a preview of coming attractions. There are discussions, there are articles that express the mind of today’s ultra-connected. It’s not just a magazine for policy junkies. It really is the voice of the elite, published by the CFR, as you mentioned. That is, in my mind, the most concentrated group of movers and shakers in the world.
Kevin: Dave, I think there has also been some concern here recently as people have taken a peek behind the curtain, they’re finding that the collateral for loans isn’t really there. Maybe it’s spoken for multiple times. I’m thinking of what’s going on in China right now.
David: Yeah, it’s not Japan, we can’t say, “peeking behind the kimono.” (laughter) The copper and aluminum stocks that were stored at a port in China appear to have been pledged more than once as loan collateral. You are talking about an asset that someone says, “Hey, I need a loan, here are my resources, can you give me a percentage of those resources as a loan?” And a bank comes along and says, “Sure, we’ll give you 50% of the value of that asset as a loan, and they go on down their way. Now the same group comes back around with the same asset to another bank and says, “Here’s my asset, and I need to take out a loan.” You do that 2, 3, 4, 5 times, and the question is, who actually gets a piece of that asset, in the case of you not being able to make payments on, not just one loan, but 2, 3, 4, or 5 loans. This is a form of trade financing, where assets are pledged in exchanged for a loan. The rub is that some of the assets have been counted twice, and on top of that, you’ve had a number of these forged warehouse receipts and it has entitled more than one party to the same metal.
Kevin: It’s like a shell game, in multiple ways. You’ve got one pea and maybe 15 or 20 shells.
David: We’re talking about copper, we’re talking about aluminum. Ironically, in the U.S. futures market, you don’t have to commit fraud to have multiple claims on the same metal. That is actually ordinary business.
Kevin: That happens every day.
David: 20, 50, even 100 times the claims, per ounce, in the gold and silver market, compared to the actual metal available for delivery.
But let’s go back to China, because this isn’t gold and silver. This is more, I think, more than a tempest in a teapot. You also have CITIC, which is a state-owned company in China, and they are not able to put their hands on some of the metal that they have stored at this port. I mean, 100,000 tons of aluminum.
Kevin: 100,000 tons is missing, basically. It’s not there.
David: Yeah. Again, we’re not talking about small quantities. If you assume that there is a shoebox inside a warehouse that goes missing, you look at the vast warehouse and all the things that are stored there in something the size of a shoebox, you know, sometimes there is going to be slippage, so to say. That’s not exactly slippage. 100,000 tons of material that can’t be accounted for – something is not quite right.
Kevin: How much financing of this sort actually exists? Is this just a few million dollars? Is it billions? Where are we at?
David: Goldman-Sachs puts it in a range between 80 and 160 billion dollars.
Kevin: Wow.
David: We use this term loosely, but the collateral damage is probably minimal. Granted, to you and me, 80-160 billion dollars seems like a lot, but we’re talking about trillions of dollars changing hands each year, and out of 80-160 billion, maybe 10% is in play, missing, if you will.
Kevin: But those loans have derivatives on them, they have multipliers on them, so you may have 80-160 billion dollars’ worth of loans to start with, but you have the whole financial system that builds on that original collateral.
David: In this case, it’s not just the official banking system, it’s the shadow banking system. How many times have those good assets been used as a basis for a loan, and a new loan, and a new loan, and a new loan. We don’t have any evidence of leasing, or of loans made on official U.S. gold holdings. But we do suspect that this is a part of the ongoing conundrum of returning Germany’s gold, and it may, in fact, explain why official gold tonnage remains unaudited to this day. Because, again, this notion of taking an asset and creating an income stream off of it by creating sort of a debt attachment – does that make sense? You lease it out, somebody basically has a call on that gold, they have a title to that gold. This is essentially what has happened with the copper and aluminum in China, and I’m just wondering. I know China is a disconnected story, but it does still serve as a cautionary tale, nonetheless. We don’t think about our official gold stocks because they’ve really dug in their heels and said, “We’re not going to audit them. We will not audit them.” So there really is no way of proving one way or the other. It’s only in instances where, you know, the Germans don’t get their gold until 2020. Just scratch your head and say, “If it’s there, the logistics are pretty simple. Anybody want to call me today, I can ship you 5 billion dollars’ worth of gold within about seven days, not seven years.
Kevin: Dave, you were talking about kimonos, and peeking behind, but let’s talk lederhosen for a minute. The Germans asked for just simply one-fifth of their gold back, and of course, we’ve talked about how our U.S. government came back and said it would take seven years at about 84 tons per year. That, to me, just puts light on what you’re talking about, that maybe the gold is not there. Let’s distinguish the difference between gold that is not there, let’s say warehouse receipts, versus actually stored gold. Many of our clients, most of our clients, have gold not only in their hand, Dave, but they have gold that is stored in depository. Please explain how that is different.
David: I will, and just as a preview, next week we are having a conversation with Benn Steil. He has published a book with Princeton University Press called The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order.
Kevin: That’s a fascinating book.
David: It’s absolutely fascinating. It was written in 2013. In it, he basically summarizes, “He who owns the gold makes the rules.” And it was the U.S. in the post-war period that dominated the world monetary system because we owned the gold. Now, Harry Dexter White set us upon that, and we’ll get into this next week. There was a battle of wills between the British and John Maynard Keynes, and the United States and Harry Dexter White, who actually later was thrown under bus for having collaborated with the Soviets. A very interesting story. He worked directly with the Soviets for years as a spy. Nevertheless, at Bretton Woods, he did represent the U.S. interests very well, and it is interesting that it was possession of gold which set the stage for world monetary dominance. It had been the British – they lost their gold through two world wars – and we retained the gold in 1944 and became the world’s dominant power. So this whole question of “Do we have the gold?” becomes very relevant when you look at monetary history and say, if we don’t, we don’t have a leg to stand on in terms of stability or legitimacy in terms of the world monetary order. So more of that next week in our conversation with Benn. Benn, by the way, has done some excellent writing for foreign affairs, and his book is perhaps a little detailed for some, absolutely scintillating for others. It is a very good read.
Kevin: And it’s not just economics. You really get inside the personality, I feel dirty about it, but you get inside the personality of John Maynard Keynes, okay, and even Henry Dexter White. Whew! There are a lot of communist leanings, or something leanings. These are the people who made the policy that we are living under, to a degree, even still.
David: Yes, it was interesting. Back to your question. So often through the years, we have insisted that physical gold either be delivered directly to a client, or stored in an allocated or segregated situation. Those are very legitimate arrangements. You also have, as an alternative, warehouse receipts, which are just slips of paper that say you have a claim to ounces that can be acquired, or perhaps they have been acquired, but it’s just too squishy. There have been a number of European banks in recent years that decided to close their commodity accounts, send back the cash, and if someone had a gold exposure, if they had a commodities exposure, rather than deliver the physical product itself, they just liquidated the asset. Which suggested to us they got on the wrong side of a trade, and that it was not a physical metal account to begin with, it was paper only. Had the client wanted physical delivery, they would have found out the physical was not actually there.
The common theme that we have found among these account-holders, is that storage was free. Think about that. You feel like you are a very important person. I think this is how the financial institutions have appealed to a client’s sense of self-importance. Free storage with this exclusive relationship. And I think this is where the balderdash lies, where the B.S. lies. Why? Because you don’t get something for nothing. When you are storing a physical asset, it takes up actual space.
Kevin: A depository only makes money one way.
David: That’s exactly right. So in a lot of instances, Kevin, I think this is where common sense was overruled by pride. Let me just backtrack and say I have seen free storage legitimately offered once in a blue moon, once in a rare case where a private bank was in a position to charge exorbitant fees for asset management. We’re talking about 4%, even 6% a year, some huge fees, and the metals allocation was just kind of thrown in.
Kevin: So you pay $100,000 for a Jeep, but they’ll throw the wheels in for free.
David: Yeah, or the windshield wipers. Exactly.
Kevin: But it doesn’t happen often, is what you’re saying.
David: In that case the fees were easily absorbed by the institution. So the problems in China are obviously not gold, they’re obviously not silver, but we’re talking about industrial commodities, we’re talking about copper, we’re talking about aluminum, with as much as one-third of Chinese imports now being implicated in the current fraud.
Kevin: Wow, that’s huge.
David: Yes, it is, it is, because this is the largest consumer of these commodities in the world, so you might expect some price volatility with aluminum and copper. Again, these are not backwater issues, you’re talking about the seventh largest port in the world and it does include a number of high-profile banks. We comment on the situation for one reason. Trigger events are often peripheral events. In other words, they may be disassociated. The fact that there is not enough copper backing this particular loan – is it enough to cause insolvency and perhaps a bailout sequence in the Chinese financial picture?
Kevin: You’ve talked about this so many times. When you have the pressure already built up, the trigger is almost inconsequential. You think about World War I, Archduke Ferdinand and his wife, that assassination should not have caused the largest, worst war in world history at that time.
David: Yes. So when you are looking at the lending requirements in China, you can see this sort of asset financing as a lynchpin within the underground world of loans, unofficial, off-book. There are often reasons why these things don’t come to light for a long period of time, why audits don’t catch things like this, because sometimes audits are not wanted. They are not being done, because they are not wanted. And finally, to me, as an investor, an investor who is interested in investing anywhere in the world where risk and reward are in balance, it underscores a very important point. In a world where international investing is considered a must by some, one should always remember that you have to have good information, the best information possible, and transparency certainly helps. To date, China is not one of those places where you can get good information. Transparency is a joke.
Kevin: And the market doesn’t always offer you good information. We’ve talked in the past about efficient market hypothesis, that basically says, since the market has all the information available, it will adjust prices accordingly. We just talked earlier in the show about high inflation, and how Stockman had pointed out if you just look at the numbers, we have much higher inflation. But you know, there is an investment out there, Dave, where you can go buy treasury bills that adjust for inflation, called TIPS.
David: Treasury Inflation-Protected Securities. Yes, it would show that there is no inflation on the horizon. They are priced to reflect zero inflation, and they’re well under the 10-year rate, which brings to my mind the questions that are often asked concerning the efficient market hypothesis. Many people look at the TIPS market and they assume that a move higher in TIPS, that is, the value of TIPS, that would indicate huge demand and really, a perception that there is no inflation, they believe that will tell them when inflation is becoming a problem.
Kevin: Right, they think it is sort of a precursor.
David: And to me, this neglects how TIPS are priced, according to a popular vote. Just follow this in sequence. If you are looking at the price of the TIPS and you think that this particular asset is telling you the collective wisdom, the collective knowledge of investors in fixed income believe there is no inflation on the horizon, you basically are subscribing to the efficient market hypothesis, where price is telling you all that you need to know. There is a potential bit of quicksand, because if the market judgment is flat wrong, you may, in fact, find that the collective wisdom was no wisdom at all, it was collective ignorance. Wall Street depends on market efficiency, and price signals carrying a very clear and clean message. And TIPS are either right, they’re either correct that there is no inflation on the horizon, and this is, again, supporting evidence for many investors of a successful Fed money-printing scheme, where there are no long-term side effects. Or the alternative is that that section of the bond market has been compromised, like the rest, by the central bank bought rates of our day. And what I mean by bought rates, is, again, you have that 35 billion dollar footprint of the Fed buying treasury securities, buying mortgage-backed securities, manipulating rates lower, and what do we lose? We lose the price signal. That’s gone. The messaging is corrupted. So a judgment of future of inflation, via the TIPS market, Treasury Inflation-Protected Securities market, may, in fact, be dead wrong. And we suspect that it is.
Kevin: And I think the numbers prove that out. You know, I’m looking at this generation, Dave, the generations before, a lot of the growth in the economy came from going out, buying a home, getting a job, paying for the mortgage. Student loans were just not that much of an issue, but it seems like it is just such an overwhelming overhang at this point.
David: They are at record highs. It comes as no surprise that home ownership, on the other end of that, and that is, particularly, the 35 and younger age group, is at a record low. Wall Street Journal, we read that one, too. We like the Financial Times, but we read the Wall Street Journal, as well. They ran an article on that last week that, yes, we are seeing a disappointing participating rate between 35 and younger, and being first-time homeowners.
Kevin: It’s because they’re having to pay their student loans off, or they’re not getting jobs that could actually pay for a mortgage.
David: And the interesting thing is, that on a generational basis, the homeowner is the person who is the home repairer. You think of a house as a home. Well, in many regards, economically, a house is a money pit. It requires constant upkeep and maintenance, and now you’re paying extra bills, and utilities are up, utilities are down, and more water this year because there is a drought, just to keep the green lawn. And all of these things require money that goes into the economy that is gearing for GDP statistics. So we’re looking at a generational unhinging of commitment. You don’t see the same follow-through, 35-year-olds and younger stepping in and saying it’s time to own a home, and for the next 15-20 years we’re going to pay it off, and we’re going to repair it, and we’re going to be adding to that economic churn which takes our money and runs it through the economy each year.
Kevin: So if it’s not the below 35 age, who is buying a home today? What are the homeowners looking like at this point?
David: May numbers were interesting. We had a month-to-month growth of 5%, awkwardly, if you’re looking at the year-to-year comparison, May 2013-2014, I think it was about a 5% decline.
Kevin: So month-to-month it went up 5%, but the decline of year-on-year is 5.
David: Correct. So the big price improvements are coming in the million-plus range, which is no surprise to me because we’ve had such an asset boom in real estate, and in stocks because of the Fed’s activities there, that you are seeing something of a wealth effect.
Kevin: That made the front of the Durango Herald just the other day, that finally, we’re starting to see the million dollar-plus homes moving, so yes, indeed, that’s happening.
David: There is also the lower range, $100,000 to $500,000, essentially where they have conforming loans, that’s where the market has been most influenced by the Fed because they’re the purchaser of last resort. There, you are seeing some volume, as well. What does 2015 look like? Should the “taper” finish up, and you’ve got your 15-year mortgages, your 30-year mortgages, they are forced to go it alone, without the assistance of the Fed. The Fed balance sheet, again, has expanded to over 4 trillion dollars. They are not buying mortgage-backed securities after October of this year. How does that impact mortgage rates?
Kevin: That’s got to be interest rates rising.
David: 5% on the 30-year? 6%? 7%? Our guess is 5% to 5½%, with rates further down the line rising further. But again, you’re talking about the first step, the first major step toward bond prices going down, interest rates rising, driven by a broader rising level of rates in the bond market. Our concerns for 2014 are miniscule, miniscule, compared to what we see in the 2015 and 2016 time frames. Why? Because the major changes, the biggest bubbles in the world that have ever been blown, are in the bond market, and we’re wondering if central banks aren’t beginning to batten down the hatches, themselves, in advance of major changes, rising interest rates, greater inflationary concerns, and really, a reorientation of the asset classes that have been winners over the last 3-5 years, frankly, with benefits going to the losers of the assets of the last 3-5 years.
Kevin: And this is strangely reminiscent. Dave, last week you said that you had pre-read the July issue of the McAlvany Intelligence Advisor, the newsletter that your dad writes, and you encouraged anyone who wanted a copy to give us a call, and we got a lot of calls, and that offer is still available at this point, but I had not read it when you brought it up. I didn’t get to see the preview copy, but it’s a fabulous read right now to see where we were when this company started, back in the early 1970s. It was a turning point where many of the same signals we are talking about today were showing up, and your dad just happened to be, by divine providence, I think, at the right place at the right time. And he writes about that, and we find out a little bit of the history of why he owns gold, why we should own gold, and what, probably, is just about to happen again.
David: There is something interesting. It is wisdom that you only gain from observing things in the marketplace for over five decades, and I ended that newsletter with a greater respect, a deeper respect, for my father, and it is not because it was a story that I haven’t heard before. Maybe it’s my age, maybe it’s what I hope my kids have for me, a certain degree of respect when I’m an older man, I don’t know. But I finished the letter, and I thought, “That was well done, that was well said.” It captures where we are, it captures where we are going, and it brings an encouraging tone to a group of people that are trying to do their best, making sense of the world as it is, not as it is fabricated by the powers that be.
What are the decisions that need to be made right now? Those are some of the things that he discusses in the newsletter from a very even-keeled historically based perspective, personal anecdotes, and how he felt at the time, the last time gold was taken down in the 1970s. It’s really helpful to have someone that has gray hairs say, “It’s okay, we’ve been here. Stick around. What’s next is really fun.”
Kevin: For the person who wants to read that, who doesn’t necessarily subscribe at this point, they can give us a call and we will be happy to email them an electronic copy of it, and like I said, we had a lot of people call over the week, and it was definitely worthwhile.
