The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: Your family, David, has an interesting history with Detroit. I remember, we have gone to Detroit back through the 1990s, we have clients there, we’ve had conferences there. We went to Detroit just a few years ago – you, your dad, myself. We saw quite a change, but I remember each time we’d go to Detroit, your dad, Don, would point out that he almost had a career in that area with Dow Chemical. Back in the 1960s when that was to happen in his life, and I’m glad that didn’t happen, actually, in his life, Detroit was the place to be. I mean, as Detroit went, that was America. That was Boom Town, USA, per capita. I think Detroit had the highest per capita income in the nation at that time.
David: That’s right. In 1960 it had the highest per capita income in the country. That beat New York, that beat a lot of the other metropolitan, very cosmopolitan areas, and it was basically at the bottom of the funnel, if you will. Money flowing from across the country, and to some degree, around the world, toward the manufacturing power of this one city.
Kevin: That was the car city. That’s where that kind of power came from. But what is interesting, Dave, in the 1990s, Detroit still had some potential, but we started to see a decline as we went there, and we were giving talks, and doing conferences at the time. The people who lived there, some of them could observe a change. And then the last time we went, I think it was four years ago, it was profound. We really did see such a change. These types of issues, like the City of Detroit defaulting, Dave, it was obvious four years ago that that was going to happen. What it reminds me of is that these things that occur are not necessarily something that should surprise us – not just Detroit, but what is happening to the nation, some of the things that are happening in the world. It reminds me of when Sherlock Holmes tells Watson, “Watson, you see, but you don’t observe.”
David: And that’s a critical point, because there are evidences all around us of deterioration at the fiscal level, and we will wonder some day how shock in the treasury market occurred because it was the gold standard of the fixed income space. How did rates soar so high. Why did prices drop so low? Surely it was a surprise. And I think that’s exactly right. People see, but they don’t observe.
Kevin: Let’s just bring this into the current market. Dave, we are being told that we are in this roaring bull market in the stock market, but every signal out there is telling the person who actually is observing that this is the makings of a bear market, not a bull.
David: And it is a bet on recovery. It is a hope for recovery, and certainly the one element there that is predictable is the money printing. We are running out of buyers. We are running out of people to come in and buy the stock market, but we are not yet running out of money, because the Fed has made its commitments, and at this point, has done nothing to reduce its commitments. Meanwhile, we do see housing starts abominably low this last week. Existing home sales – ugly. Frankly, the only thing on the home building front that was positive was home builder sentiment. This is a survey of people who are out there swinging a hammer and saying, “Hey, listen, we are building. The question is, are you going to be able to sell what you are building, because you certainly feel positive about what you are doing. You are putting your own capital at risk, in many instances, and I think that there is a degree of hope that it turns out all right, and that the evidence that you have been given by the Fed, by the Bureau of Labor Statistics, etc., has been true, has been helpful, has been sort of at the leading edge of what is a recovery.
Kevin: Why don’t we then talk about what a bear market looks like versus a bull market, because we are being told bull, but the home sales, like you said, declined. They are even revising the May numbers down at this point, so what we were being told was not accurate. What we felt, was accurate.
David: Bear markets reflect a deterioration of confidence. That is really what you have, and prices can even move sideways or move down when people gradually reappraise risk, and that can happen two ways. You can either look at, on the one hand, a diminishment of opportunity, or on the other, an outright increase in risk, and when someone sees an increase in risk of loss, there is a consequent change in behavior, particularly investor behavior.
Kevin: Talk about greed and fear running the market, when there is a diminishment of opportunity, that’s that greed being softened down. But outright increase in risk, which is the second reason. That’s the fear response, and that’s the one where people panic.
David: And we have a lot of people assuming, again, this recovery narrative. Meanwhile, we have the Keith Halls of the world, and thank you Alan Newman for sharing this with us. Keith Hall, former head of the Bureau of Labor Statistics says the employment rate at 7.6% is misleadingly low.
Kevin: And he would know. He was the head of the Bureau of Labor Statistics. He feels it should be higher.
David: Suggests restating it perhaps 3 percentage points higher. The 7.6% as evidence that we are in recovery – I think he says realistically it’s closer to 10.6, and of course, we are talking about the U3. If you are looking at the U6, the official stated rate is 14.3, and arguably, that could be 3 or 4 percentage points higher, as well, if Keith is correct.
Kevin: So those are recession/depression levels of unemployment if we just counted those unemployed workers.
David: As you said, when we look at the stock market we have observations to make, and the question is, do you have eyes for them, or are you glossing over those things in hope of the recovery story? We have mutual fund cash levels which are below 4%. We have, last week, the largest influx into equity mutual funds since June of 2008.
Kevin: So what you are saying is, for every 100 dollars that goes into mutual funds right now, only 4 is kept on the sideline for cash.
David: That’s right, and that is an indication of how committed the investment public is. It is an indication of sentiment, and it is extreme on the bullish side. This is where I think, again, you make the observation, when everyone piles onto one side of the boat, bad things tend to occur. Historically, we’ve seen cash levels get to below 4%, and within a certain period of time, three years, two years, 18 months, 12 months, you have stock market values cut in half. We saw this in 1973, we saw this later in this decade at least twice, where in the year 2000 cash levels got to the 3.6, 3.8 level, about where they are now, and again in 2008, where again, mutual fund managers were fully committed. It was an all-in bet into the equity market. They didn’t leave much cash. They didn’t leave much room for error, and therefore, the boat listed. Why? Because everyone was in. You ran out of buyers. And that’s the strange scenario we are in today. We are running out of buyers. Everyone is all-in in the equity market. We are just not out of cash yet because we are still getting that steady flow, the unhealthy, sort of, smack for the junkie, flow from the Fed.
Kevin: That’s where the observation comes in versus just the seeing. We can see that cash levels are below 4%. But the observation comes from understanding that when that occurs, historically…
David: It means something.
Kevin: You are getting close to the top of the market.
David: In addition to that, you have margin debt, which is slightly off its peak set in April, we’ve talked about this before. But it is, in our view, supporting that sell-in-May thesis. And we are okay with being a day early. You may recall that that is far better than being a day late.
Kevin: Right.
David: And that is, again, the idea that when you overstay your welcome in an inflated asset class, it’s similar to thrill-seeking in a game of chicken. If you stay the course too long, it can be hazardous to your health. I think that the one factor in the market that is driving prices higher is Fed money-printing. If you have a restriction in the flow of dollars coming from the Fed, less monetization, less credit creation, you are defining the course for the Dow toward 12,500, which is about 20% lower off of current levels. On the other hand, if you increase the flow of Fed money, and I’m talking about funny money – this defines the course toward 16,500 or even 17,000.
Kevin: So you think there is some gain, still, in the Dow, if they continue to just flood this market with liquidity.
David: You’re not buying reality, you’re buying a momentum trade on the basis of Fed liquidity provisions, and that’s it. You are now in the nosebleed section. When you are looking at what is called the cyclically-adjusted price earnings multiple, what has been popularized by Robert Shiller, from Yale. It is also called the Shiller PE. It currently stands at 24.51. We’ve had three periods in the last 100 years when we did have a more extreme, shall we say, unstable, valuation, and that was 1929, 1966, and the year 2000.
Kevin: Those were all tops on the stock market.
David: They were all tops. So we are either at, or very near, a top. If you look at this valuation metric, and we’ve talked about the cake before, the cyclically-adjusted price earnings multiple. It is a ten-year rolling average of the price earnings multiple for an index. That is a very helpful way of knowing what your future projected returns would be. Over the next ten years, they would be less than 2%, closer to 1.5%, and that includes probably a 10-15% year. Maybe this is that year. Included in that are also extreme negative years, but your average is going to be between 1 and 2%, with that kind of a valuation. The challenge is this: If equity prices were to climb by a third, that would bring us back to what has been the mean value for the Shiller PE going back to 1880.
Kevin: So you’re talking about a 10,000 point Dow, from the level that we are at now, Dave.
David: Yeah. And Alan Newman asks, “Is that possible?” Could we see a one-third decline to bring us back to the average of the cyclically-adjusted price earnings multiple? And he reminds us that when prices have moved to these extreme levels, the corrections have more typically been 50%, not one-third, 10,000. But we are setting the stage for a Dow-gold ratio of 2-to-1. A 2-to-1 ratio with the Dow trading at probably 8500 points.
Kevin: Okay, so gold would need to be about $4000, $4200, something like that.
David: Yeah. And this is the course ahead. This is a 2, 3, 4-year process for this to occur. Of course, it could happen sooner than that. But realistically, the fight that is being put up to preserve the dollar, to preserve the treasury market, to preserve the financial system, and particularly, the very connected financial players, is immense. We should expect it to increase, not decrease. The intensity of the fight will increase, as time goes on, but ultimately, we see this as a losing battle, market forces being more like natural laws of gravity, etc.
Kevin: Well, unlike the laws of gravity with Detroit, the laws of gravity will also apply to the United States. One beacon of hope for a lot of money managers is China. They’ve looked at China and said, “You know, China just has nothing ahead of it but more and more growth.” We can argue the dynamic of slowdown at this point, but even China, in its communist state, its controlled economy state, seems to be doing things that actually might make it more efficient, like the interest rates.
David: Just to be clear, there is a huge weakness in the emerging markets today, and that will continue. The capital flows from the West are the primary drivers of growth in the emerging markets. But to very clear on China, we are both bullish and bearish, probably bearish in the short run, and incredibly bullish in the long run, which means that between now and a successful outcome, you can go broke ten times over.
Kevin: Right.
David: We don’t suggest buying China today, but we do suggest keeping an eye on what are some healthy dynamics. Long-term reforms continue to build a long-term bullish case for China and this week you get interest rate reform amongst the banks in a move that was toward free market determinism, as opposed to state-directed outcomes. Interest rates have been controlled, and controlled, and controlled, to the extent that you had an unfair advantage. Select sectors in China could get very cheap loans, and that, again, was the state saying, “We are going to choose winners and losers. You are a winner. Here is a way of financing below a market price, and it acted as a state subsidy for that particular industry.
Kevin: And that’s socialism, that’s communism, that’s, unfortunately, not efficient for the market. So freeing that up seems to be a very bullish type of thing.
David: Ironically, on the other side of the equation, is the U.S. controlling and manipulating rates, and choosing winners and losers in the marketplace. And so, while China is, in fact, moving toward a free market orientation in the banking system, to a degree, just even this week, we are seeing degrees of moving the opposite direction in our own markets. I see China like the U.S. in the early one-third of the 20th century. In the first part of the 20th century there was great long-term growth story dynamics.
Kevin: But a lot of hiccups in between.
David: There were a few financial catastrophes that had a way of wiping out speculators, debt-holders, and really cleansing the economy of what, in retrospect, à la the 1920s, was irrational exuberance. But steering a long-term course toward financial success and prowess, again, assuming that we have a few disturbing financial crises along the way, we see on the horizon some 1930s-style opportunities over the next few years. We’re talking about buying opportunities, where reasonable assets, and an economy that has a long-term growth trajectory that is declining, but in our view, that’s healthy. You move from double-digit rates of growth to single-digit rates of growth, and you may say, “Well, that’s negative. We’re seeing decline in growth rates.” But you’re moving toward longer-term sustainable growth rates based on less artificial inputs, like direct investment from the government, and something that is not controlled by the internal workings of the economy, dependence on foreign exchange and business. You are moving in the direction of service-oriented, and more toward a consumer-oriented economy in China. That will take time. Don’t get killed in the interim, but there will be opportunities over the next 10, 15, 20 years.
Kevin: And that’s something that, for the listener who just continues to faithfully listen, you’ll plan on interviewing and talking to people as time goes on, to clear that path for possible investment in China.
David: Today would be premature.
Kevin: Let’s talk, then, about something that doesn’t have a long-term growth dynamic right now. Let’s go back to what we started with – Detroit.
David: Well, it’s very significant, and you see this in the National Review report this last week – 40% of Detroit street lamps don’t work, two-thirds of its public parks are permanently closed. And it is equally important, particularly when the question of this stand-your-ground law, the whole Zimmerman-Trayvon case. The police response time in Detroit, if you are dialing 911, is roughly an hour.
Kevin: That’s amazing. So if you don’t know how to defend yourself, and you are in Detroit, actually anywhere right now, but Detroit especially, an hour response time.
David: And by the way, if you are sitting there bleeding on the street, one-third of local ambulances are drivable, two-thirds inoperable. So you have a partially abandoned city where houses are offered for a dollar, and are not finding bidders, even at that price. You have a population which is less, by two-thirds. You have a third-world literacy rate, with adults, 47%, functionally illiterate. All this from a city that as recently as 1960 had the highest per capita income in the country.
Kevin: That’s what we were talking about. It really was the place to move back in the 1960s.
David: What it reminds me of is a book that I am reading, The Collapse of Complex Societies. Cambridge University Press published, it was recommended by one of our guests, specifically, Jim Rickards, in his book, Currency Wars. And this is what you have. The dynamics of collapse in a complex society, and this is just a microcosm of it. It is when you have so many economic inputs that become unsustainable, unbearable, that you have this kind of collapse, literally, an abandonment. You would say, “How do you go from 1960s being top of the world, to now being bottom of the rung, barely holding on to the ladder, socioeconomically. This was a once vibrant city. Today it is decaying. The details was just shared, all they illustrate is extreme cultural and social blight.
Kevin: I know we are focusing on Detroit, but there are a lot of people who don’t live in Detroit, they’re not going to go to Detroit, but what we can see right now is going to spread to other markets, the municipal bond market, other cities, actually, our nation.
David: Back to that issue of observation. People see, but don’t necessarily observe. What elements are in play that are considered to be sacred, yet are at risk in the wake of this municipal bankruptcy, what we had last week. Of course, number one, you have pensions. They’re on the chopping block, and this has direct political ramifications. Consider the, just a play on words, social insecurity, that is stirred amongst city workers and retirees. This isn’t Detroit city workers and retirees, this is throughout the country. Think of the pressure across the land put on politicians to guarantee pension, retirement, and health benefits. If it can be called into question, if the promise of a future income can be jeopardized, or somehow diminished in the wake of bankruptcy, what is the political lobby that comes to bear on Washington, D.C., on various representatives across this land, to say, “You will make good on this promise. We worked our tails off, set aside money for this. We have contributed funds, and this is not only your money at stake, it’s our money at stake, and you will guarantee, you will deliver, exactly what was promised to us.”
Kevin: Something that was warned about early on. I had a client send me an email today, David. I forwarded it to you, and I forwarded it to your dad in the Philippines. It was a copy of a 2002 McAlvany Intelligence Advisor, warning people of the coming collapse of pension funds in cities like Detroit and other areas, and counties, and states. It is, again, seeing something coming, observing it, and then maybe doing something about it.
David: It’s as simple as math. You just have to look at the math, and in a very unemotional way say, “What does this add up to?” In the case of Detroit, you’re talking about obligations that date back to the heyday. Manufacturing in the post war environment. You had the suburbanization of America during the two decades of the 1960s and 1970s. That promoted car ownership for every family in the nation. You had Detroit, which again, was sort of the bottom of the funnel. It was the center of the automobile universe in the world at that time, and then you have the administration of that city, a growing challenge, lots of new city employees. They are accruing future benefits. Those are the unfunded liabilities that now hang as an albatross around Detroit’s neck.
Kevin: But isn’t growth always the assumption, when you have something like that occurring? Look at Silicon Valley, look at the tech stock boom in the 1990s. Look at some of the things that are occurring today. There is always this assumption of continued growth at that level.
David: It is the basic underlying assumption. Future liabilities that you are throwing on to future generations are easily justified by the growth and opportunities created by the administrative process. You could argue that there are opportunities created by an administrative process, but at least they are facilitating a way of life and an environment in which those opportunities may occur. So that’s a vulnerability, future liability, vulnerability, that society is willing to take on, on the assumption that you have future growth.
Kevin: So David, the pension issue is one concern, but this isn’t just a concern for a single city. These are underfunded around the country at this point.
David: As you recall, there is not a trust fund that is fully funded. Most of our national pensions are underfunded. In other words, they don’t have all the money they need, in large part, because actuaries and boards have assumed growth rates on the assets that are in those funds, that were common, really, in bull markets, but they have been shamefully, frankly stubbornly, kept too high over the last 13 years. In other words, you are assuming a 10% rate of return, a 15% rate of return, a 5% rate of return, whatever it is, and you deliver a 2% rate of return, or a 0% rate of return, or in 2008 and 2009 negative rates of return. And your assumptions in terms of future pension payments had a growth dynamic, on the assets that have been set aside, and you are moving the wrong direction. You’re shrinking.
Kevin: They were assuming bull market growth in the stock market. Remember the S&P. It has not really performed to the degree that they have demanded over the last 13 years.
David: No, no, no. Go back to the year 2000. We started with the S&P at 1500. Today it sits at a hair below 1700. That’s about a 13% gain over 13 years. You throw in, generously, 1% inflation rates and you are talking about negative rates of return when inflation and taxes are factored in. Again, that’s arguable.
Kevin: It’s more than a lost decade, David, it’s a backwards decade.
David: You are really talking about inflation rates closer to 4%, 6%, 8%, so deeply negative returns as opposed to what in nominal terms, the move 1500 to 1700 looks like a cumulative 13% rate in over a 13-year period.
Kevin: So your point is, it is not just a Detroit issue.
David: No, it’s pension underfunding at a national level. They’ve underestimated inflation and there are real-world consequences to that. There is this inability to pay because the pot is not adequately full. You don’t have an abundance to pay from, which means the reality is, the pension system that we have is more likely to become the pay-as-you-go type system we have with Social Security.
Kevin: David, you were on Fox earlier this week. You were asked, “What’s the magic percentage point that you should draw out of retirement savings?” When a person is thinking ahead and saying, “How much can I take out per year,” what’s a reasonable rate of return?
David: 4%. There will be years that this requires a draw on principle. There will be years where that’s of little concern, but keeping a conservative number puts the math in your favor. Aggressive pension managers have assumed growth rates of 7-9%, and that’s the only ability that they have to meet pension obligations. So this is the issue. We think you need to put the math on your side. 4% is a great number. Today, with pension fund managers assuming too high a rate of return and not getting it, what they are leaving is a widening gap between the funds required to pay pensioners, and those actually available, which brings us to the Detroit administrator. He is very apologetic, but points out, it’s just the math. There has to be an adjustment to what Detroit retirees are paid. A big haircut is required, but perhaps that’s where the White House can come in. Knight on a white horse. Socialize that risk, too. Put the American taxpayer in the gap, stepping up with a blanket guarantee of pension assets.
Kevin: What you are saying is, David, a possible prediction is that the U.S. government, as a federal whole, will come in an maybe bail Detroit pensions out, but boy, doesn’t that set a precedent when you have unfunded pension plans all across the country?
David: Yes, Pension Benefit Guarantee Corp. can’t do very much, just like the FDIC can’t do very much in the case of more than one or two major banks going under. You are talking about pennies on the dollar in terms of funding and the ability to cover those obligations. The federal government would love this only too much, because gifts of that nature – not only are they spending other people’s money, but it comes with strings attached. You can seed over more state sovereignty and oversight to Washington, D.C., in return for the national taxpayer filling the pension void. That, again, has not been announced to date, but just keep in mind, socialists do see other people’s money as a cure-all.
Kevin: And pension funds are not the only thing we should be looking at at this point, Dave. There are a lot of people listening to the program right now who have municipal bonds in their portfolios, and those municipal bonds are what, right now, are being defaulted on in Detroit.
David: Right. So the issue of Detroit. You are right, contagion, that’s of concern. But pensions we’ve considered. Social insecurity bred by nonpayment, or reduction, we should say, of pension paychecks. But number two is the contagion in the mind of investors, not pensioners but investors. Think of the municipal market – sacred. It is that second category, sacrosanct, generally assumed as immovable in the security market. For a fixed income investor who has municipal bonds. These are the things that you like. They are as safe as the day is long.
Kevin: And not all municipal bonds are created equal. There are two types. There is the type that requires revenue to come in from taxpayers, and then some that paid no matter what.
David: Yes, so just to review, the two varieties are revenue bonds and general obligation bonds. And it is understood and the ability to pay coupons on a revenue bond is tied to the source of the revenue for that particular batch of bonds, and thus, there is an extra layer of risk in the equation. If we illustrate that, let’s say the sales tax and property tax from a series of strip malls is directed toward the principle and interest payments for a revenue bond. If the strip mall is vacant, or worse, the owners are unable to keep up with property tax payments, then the revenue bond holder faces a risk on nonpayment. And everyone understands that revenue bonds are a little bit more dicey. They depend on the quality of the revenue behind them. GOs are a horse of a different color.
Kevin: And those are general obligations. Those are the ones that should pay anytime.
David: They are the general obligation of the tax authority, and they are held as a first priority for payment under any and all circumstances. That’s why risk is assessed differently with GOs and there are states that you wouldn’t want to consider GO bonds. Look at Obama’s home state – it’s a disaster. His domestic home state, that is. Currently in the dead heat for first, as the state with the fastest-growing population receiving food stamps – Illinois is not exactly a bastion of fiscal health. As we said, maybe a year ago, you could fire every state employee in the state of Illinois, take your current payment, in terms of payroll, down to nothing, and you would still have close to a five billion dollar deficit, and I think that is annual deficit. That’s on the basis of these old pension liabilities and obligations in the state of Illinois.
Kevin: So, we took someone from Illinois and put them in the White House to do that same thing. I’m sorry, that’s just an aside. Let’s go back to how the boring municipal bond market, the person who is retired, who knows that they don’t want to pay tax and they don’t want to take a risk. Municipal bond general obligations.
David: When you look at a bear market, and I’m just going to say this again, bear markets reflect a deterioration of confidence. Prices can move sideways, prices can move down, but when people reappraise risk, either because the opportunity has gone away, or they see an increase in risk, there is a consequent change in investor behavior. There is a consequent change in the price of the asset in question. You have the seemingly boring municipal bond market. It appeals to both the wealthy investor and the institution alike. Look, you don’t pay federal income tax. You’ve got a tax-free status with municipal bonds. Of course that’s appealing to a wealthy investor. Of course, the credit quality, the boring nature of the bond is interesting to an institution, because with a predictable asset you have the ability to leverage it up, and not have bad ramifications come your way.
Kevin: Let’s talk about what you are talking about as in institution, because that may sound distant from a lot of people’s portfolio, but we are talking insurance companies, Dave.
David: Yes. Simple, basic, predictable, boring, low risk, high credit quality, predictable cash flow, low volatility. These are the things that you get with muni bonds. This is a 3.7 trillion dollar market, in aggregate, if you look across the country. Municipal data as a percentage of GDP is about 21% today. Again, going back to the Detroit heydays, compare that to 1960, municipal debt was about 66 billion, GDP was 520. That’s about 12% of GDP.
Kevin: So it’s almost double right now, as far as the percentage to GDP at this point.
David: They have increased pretty aggressively. Well, so has GDP. The assumptions that a muni investor has – these are sacred. Repayment of principle with tax-free income. The reappraisal of risk – of course it affects the price, and it perhaps affects the appetite of investors in the future, maybe just at the margins of the market. There was an interesting report that came out this last week by the NAIC, the National Association of Insurance Commissioners, and they stated that from 1991 to 2012 there have been 217 Chapter 9 bankruptcies.
Kevin: Which is what Detroit just declared.
David: That’s right. That’s what a municipality goes through, the Chapter 9s. Or roughly, if you do the math, 217 off of 21 years, roughly 10 per year, unevenly distributed, but roughly 10 per year. With 2012 notching up to 20 – 20 Chapter 9s – about double the average. You have individual investors. Individual investors have had to swallow a hard pill from the White House this past year. Mr. Obama is suggesting changing the tax treatment of municipal bonds, introducing the idea of a cap on the tax-free benefit. On the other hand, you’ve got institutional investors, and this is where the NAIC comes in. They are more concerned about credit quality. They are more concerned about ability to pay, more concerned about just the predictable nature of the asset, because it is, in this case, a very significant component in their portfolio. U.S. insurance companies hold about 14% of the entire municipal market. They are substantial holders, 14% out of that 3.7 trillion number.
Kevin: Well, and you can see, that’s the type of investor you are talking about. They really cannot take short-term risk. This is a long-term investment. They want to have something that they can rely on, 10 years, 20, even 30 years down, as they roll those bonds. And they do need credit quality to remain relatively constant, because it is on the basis of a certain credit quality, that, as a fiduciary, they can actually hold it as an asset.
Kevin: So what you are saying is, with what is going on in Detroit right now, the eyes of the municipal investors are on the general obligation bonds. If you lose money in a revenue bond, it means the taxpayer can’t pay the tax. That happens sometimes. But general obligation bonds. Those stand in front of the line, in front of everybody, do they not?
David: They are supposed to. Again, Detroit data is the sliver of the total – 18½ billion dollars. And, okay, the haircut is going to be severe. But it’s small. It’s a small piece of the total municipal market. The reason the eyes of the muni investors, again, individual investors and institutional investors are watching the GO market, is because Detroit is going to be a precedent-setter. If you are at the top of the creditor food chain, you expect to come out pretty well in a restructuring or bankruptcy.
Kevin: Which is general obligation holders.
David: Yes, giving up gains for safety? That was a part of your play. You chose the boring, you chose the totally boring, because you wanted predictable. Now, on offer, for the general obligation bonds in Detroit, is 20 cents on the dollar.
Kevin: In other words, they are going to lose four-fifths of their value if they take that offer.
David: So there is come confusion amongst the broader cross-section of muni investors. What exactly does it mean to be at the top of the food chain, because 20 cents on the dollar doesn’t fit that expectation. That’s what we are talking about. The real reappraisal here is for investors that had assumed a sacred place in line in the event of bankruptcy – first in line. To have lost considerable clout and standing, this is what is at stake in these court hearings, in this bankruptcy hearing. Yes, we have pensioners who are going to take a haircut. Yes, we want to see what the political response is from D.C., but here in the municipal market it is not the 18 ½ billion dollar sliver, it’s the 3.7 trillion dollar muni market across the country where people have assumed a certain type of risk, and they may have to reappraise, if, in fact, they are not first in line, if they are more dog meat instead of top of the food chain, this is a real issue.
Kevin: So, in a way, this is a Cypress type of event. If you think about it, Cypress, over in Europe, started setting precedent. We are now familiar with the term “bail-in.” We are looking at Detroit right now. This general obligation thing actually applies to the whole of the municipal bond market.
David: You don’t have to be a Detroit bond-holder. It’s the reappraisal of risk. That’s the topic, once again, when investors lose confidence and see risks on the increase, or opportunity on the decrease, you change investor behavior, with the consequence being a repricing of the asset in question. We are just talking about muni bonds, here. Yes, Motown is redefining municipal bond insecurity. This is the crazy thing. They are proving that general obligation bond-holders are not as special as they thought themselves to be. Not as protected.
Kevin: Well, timing is everything. Mr. Obama is now talking about taxing municipal bonds. Talk about perfect timing when you are seeing the potential for loss in general obligations already. This probably is going to have an impact on the interest rate market, as well, Dave.
David: That’s exactly right. There are a couple of things that I want to mention on commodities. Kevin, I don’t know if you remember, maybe it was a high school type thing, “There’s a tear in my beer, and I’m crying for you dear.” Kind of a play on a country song because everybody is crying in their beer.
Well, there is a tear in the beer. Miller/Coors, that combined corporation, they are after J.P. Morgan and Goldman-Sachs. They are after them because J.P. Morgan and Goldman-Sachs have gone into the warehouse business, and they are delaying the delivery of aluminum to these end-users, to the point where the fees paid for storage are increased, and it is creating an artificial bottleneck and increase in price. So they are assuming, and this is what they are charging, 3 billion dollars in the past year went to Goldman-Sachs and J.P. Morgan because of an arbitrarily controlled environment.
Kevin: So it’s a form of a monopoly. You monopolize the availability of aluminum by buying contracts, and selling contracts, and controlling the inventory.
David: And frankly, this is great. We have a Senate banking, housing, and urban affairs committee panel that is going to examine whether banks should, according to Bloomberg, control commodity storage. Power plants? Refineries? Because at the end of the day, the bank is in the business of making profits for their principals, not in serving a broader, general, social good.
And we’ve already seen this, with Wall Street firms having to pay massive fines for manipulating energy prices. This goes back 10-12 years when we had the brownouts in California. It turned out Enron was involved, and there was all this big mess. Again, going back to the deterioration of trust. This is where we saw Enron manipulating and controlling to their advantage. We saw, complicit to the crime, Arthur Anderson, signing off on doctored paperwork, what ended up being essentially corporate fraud.
This is the environment we are in today. Now Goldman-Sachs, of course, they have their statements out saying, “No, we’re really not doing this, this is normal,” but executives and risk managers with Miller/Coors, LLC, are saying, “You’re costing us a lot of money by manipulating the commodities price. That may be a bad segue into gold and silver, but we have this manipulation, not just in gold and silver prices for the benefit of the house, but there are lots of ways to gain an advantage if you are a bankster, and this is now in the news, July 22nd, Miller/Coors sees metal warehouse delay costing them 3 billion dollars.
Kevin: Well, who would have thought that maybe the golden brew would be the one that actually frees up the gold market, because you’ve pointed out last week, and the charts are attached, still, to that Weekly Commentary, that the inventory of actual gold in warehouse just plummeted by almost half.
David: Well, enough on the gold and silver standard of beers. What we are really talking about next is gold and silver, themselves, and I thought we’d share a Bernanke quote from the last week, where he just says, “Listen, psychologically, lower prices mean things are improving. Clearly things are improving. This is from a man who controls the monopoly of money and he neglects to say that gold has been money for 5,000 years, and when we fail on our project, like every other controlled currency has in the past, it will be money again. That is not acknowledged at all – the role of gold as money. It’s somehow like a can of pork and beans and an AR15 just for a worst-case scenario, or an Armageddon, if you will.
Kevin: Something that is also not acknowledged is the Goldman-Sachs and the Merrill Lynch connection, April 12th and April 15th, very clearly manipulated. This is not something that he could have possibly been ignorant of. Let’s go to that clip.
Ben Bernanke: Gold is an unusual asset. It’s an asset that people hold as disaster insurance. They feel if things go really badly wrong, at least they will have some gold in their portfolio.
Questioner: Is that an accurate feeling?
Bernanke: Not all that accurate. For an example, a lot of people hold gold as an inflation hedge, but the movements of gold prices don’t predict inflation very well, actually. But anyway, the perception is that by holding gold you have a hard asset that will protect you in case of some kind of major problem, and I suppose that one reason that gold prices are lower is that people are less concerned about extreme outcomes, particularly negative outcomes, and therefore they feel less need for whatever protection gold affords.
Questioner: Do you believe it is indication of, perhaps, psychologically, the direction of the economy, for investors?
Bernanke: I think psychologically, the gold price going down is not necessarily a bad thing, from that perspective. It’s just people have somewhat more confidence and are less concerned about really bad outcomes. But let me just end by saying that nobody really understands gold prices, and I don’t pretend to really understand them, either.
David: I think that is the first note of humility I’ve ever heard struck in his voice. He doesn’t understand it. Well, that’s clear. That’s clear.
Kevin: (laughter) So our Federal Reserve Chairman does not understand gold.
David: Well, is the bottom in? Let’s watch and see. We have silver that is 10% above the lows set last month. We have gold that is 12-15% above the lows, and that’s constructive, but we’ll wait a few more weeks to really tell. This is why calling a bottom is sometimes like catching a falling knife. In real time you have no assurance that prices won’t go lower. But in retrospect, it becomes very clear. And we have good reason to believe the bottom is in. Our confidence level will grow over the next few weeks and months. We’ve already shared the reasons why, in recent weeks, this is a reasonable level to hold. Frankly, a retest at the $1250, $1225 area, in essence, going lower again, but not breaking to new lows, below $1200. $1184, I think, was the intraday low. That would scare the shorts off of the speculative shorts in the market.
Kevin: These shorts that are hitting all-time highs right now, as far as the quantity of people betting the gold market down.
David: That’s the futures market. It continues to see those numbers increase, with a stubborn belief that we have an economic recovery. It is full-fledged. A gold position is thus unnecessary given the trillions in intervention, successful restabilization of the economy, zero inflationary consequences,” again, just going back to Bernanke’s comment. We’re all geniuses now. If we’d only known this hundreds and thousands of years ago, a controlled money system always has positive outcomes with Ph.D.s managing it. Except that the historical record is different. Except that every experiment of this kind in the past has failed, and there are no periods which give evidence to that zero inflationary outcome. That is, in our opinion, a false narrative. But here’s the challenge. It is believed by so many on Wall Street.
Kevin: Oh, of course. I remember the CNBC interview a couple of weeks ago, where you were just openly mocked and laughed at for suggesting that $1200 would be a great point to buy.
David: Well, I’ll raise the issue next time I’m on Squawk Box, but just remember that when you are building a position, in any asset class, it’s not a matter of picking the perfect price and making an all-in bet at that price. You make multiple purchases at a variety of prices, given the solid average-cost basis. That is a reasonable way of taking a position. It’s the same thing when you’re unwinding, just as it is most reasonable gradually unwinding a large position at a variety of prices, as the asset increases in value.
Listen, anybody who is seeking the perfect entry price, and the perfect exit price: A, they are a novice investor. B, they don’t understand the liquidity dynamics of any market. Easing out of a position at incrementally higher prices and taking an average price on a liquidated position is the best method for long-term success in investing.
Bull markets of a secular nature, these take years, even decades. And we’re talking about secular bull markets, right? And we have cyclical moves which can be counter trend moves. That’s what we’ve witnessed in recent months and years, 4-5 times in fact, in the last 13 years, we’ve seen the same exact thing.
Kevin: David, it struck me the other day, again, that we’ve got to stop looking at annual returns. There is nothing magic about December 31st. And we have seen gains year after year after year, for the last 12-13 years, on gold. December 31, it’s higher than it was the December 31 before. But that should not matter. If you look at the overall trend, the secular trend, not these short cyclical changes. The secular trend is still up, no matter what the end of the year looks like.
David: It’s the anxious and tender-footed investor that rarely benefits from a long-term secular trend, because the counter trend price moves tend to force emotional decision-making and create a lot of self-doubt. That classic phrase of “be right and sit tight” is a classic Wall Street phrase, and it needs to be more in practice.
The bull markets of the last 50 years have all lasted 10, 15, 20 years. We had the Japanese equity market, we had the U.S. equity market, tech stocks at the tail end of that, U.S. real estate. These are trends and dynamics. A bull market in U.S. bonds. These are dynamics that last 20 and 30 years, and the volatility that we have seen in the U.S. treasury market over the last 30 years, those counter trend moves where interest rates were rising and bond prices were falling, didn’t change the course over that 30 year period, just like these counter-trend moves in gold don’t change the ultimate course and destination of gold at higher prices.
We are in a secular trend. Anyone who remains a little tender-footed because of the volatility, it’s understandable to feel what you are feeling, but it is inexcusable to take actions that take you and your family out of positions that are so helpful, not only here, but in the future. Stay the course.
