The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“The reason why gold still has merit, even in a rising interest rate environment is, if you can figure out what your positive – what your over/under is, for your positive or negative real rate of return, factoring in real inflation, now you know who is buying and who is not. In a negative to zero rate environment, guess what? Gold still is attractive. Summers-Barsky nails it.”
– David McAlvany
Kevin: David, we had a huge response to last week’s show. There were a number of people who were wondering what the heck happened to gold, and you basically told them: 2.7 billion dollars worth of gold dumped in the Shanghai market in two minutes. But there is more to the story. And I want to talk, also, about some of the people who are now very bearish on gold, and who are the people who are bullish on gold, and why we would listen to one side versus the other.
David: There has been some discussion, too, about whether or not the Chinese trade in Shanghai wasn’t, in fact, a proxy, if you will, for a New York trading house. So, maybe it is irrelevant, but what I do feel is particularly relevant is, as you mentioned, the two categories of gold traders, which are today, entirely unbullish, that is to say, very, very bearish.
On the one hand you have speculators. These are your small speculators. And on the other hand you have hedge funds, or the managed money crowd. These are the guys who are very, very bearish on gold today. Keep this in mind. These are the trend followers that tend to sing in unison, they tend to sing in key, at every market extreme. So, you have these two groups who were incredibly bullish as gold was reaching $1920 an ounce.
Kevin: Right, back in 2011.
David: There were as long as long could be. They owned more ounces, by proxy, either in the futures market or via the exchange-traded products like GLD, than in any time in history – these two groups. So contrast their vote, which is today very negative – don’t like gold, think it is going down – contrast their vote with that of the producers, otherwise known as the commercials.
Kevin: These are the guys who are producing gold, they are bringing it out of the ground, and they therefore have to hedge their bets. In other words, they have to neutralize their position. Would you explain that a little bit? Because in a way, you have to make the same decision for this company because we have inventory.
David: Sure. At market peaks, they are very short, the commercials are. And when a market is bottoming, they’re not very short at all.
Kevin: Can you explain the reasoning behind that, as a manager of a company that has gold in inventory?
David: So, let’s say the cost of production is $1,000. We’re just going to use round numbers here. The cost of production for an ounce of gold, let’s say it is $1,000, and the current price is $2,000. They don’t know that it’s not going to go back to $1,000, so they are happy to go ahead and lock in that $1,000 profit on an ounce mined, and they do that by hedging that production. They go ahead and lock in their profit margin by going short [selling] what they know they can deliver to the market. So on one hand, they are long [buying, or in this case mining – in either case, obtaining] gold in the ground, and they are short at a certain price that guarantees their margin spread. That is the mindset of a commercial. So, the higher the price gets, the more they will tend to hedge, or short, in the market. So again, the hedge funds, the managed money crowd, the speculators, these are the guys who are net short for gold in a major way, since 2006 more short than they have been in that timeframe.
I would still side with the commercials. My bet would be on the commercial guys, where they tend to hedge their bets when prices have already risen, and they don’t really want to hedge their bets when prices have already fallen. So the commercial vote signals that we have bottomed, that the hedge vote that gold is going lower.
Kevin: Absolutely. In fact, Dave, just look at your own actions. If gold is getting to $1900 or $2,000 an ounce, and you have a large inventory…
David: We will hedge 100% of our inventory.
Kevin: Exactly, because you want to be neutral if the market goes down. You don’t want the company to go out of business. A mine will do the same thing, and that’s what you’re calling a commercial.
David: Exactly, so we’re not speculating with operating capital. That is the point – you can’t speculate with operating capital. And if you weren’t hedged, you would be. That is where, again, it is the trend followers, it is the specs, it is the money managers, that tend to draw a straight line in whatever the current direction the market is going. And so, here is the problem with that. You have extrapolation on the one hand, you have indefinite continuation of a trend, which is the presumed course by these guys. And again, it is trend following. It is what I describe when I talked to Mr. Behar from Société Générale when I was in Shanghai.
Kevin: He is a trend follower.
David: I said, “Okay, in 2011, what were your projections for gold? Were they higher, or where they lower?” “Oh, much higher.” “And now that gold is in a downtrend, what are your projections for gold?” “Oh, much lower.” And I’m just thinking, what is the value of the six-figure salary that is being paid by Société Générale? The man has a ruler and a pencil and he knows how to draw a straight line.
Kevin: And he says, “More of the same.”
David: And that’s the problem with extrapolation and indefinite continuation of this presumed course for gold. The commercials do what they do. They live and they die by their understanding of the commodity in question, which in U.S. dollar terms, they know, is cyclical. It is very cyclical. So, the commercials are not jumping up and down as the price rises, they don’t let their emotional temperature get the better of them and get overly enthusiastic. In fact, when the price rises, guess what they are doing? They are battening down the hatches because they understand the cyclical nature of the markets.
Kevin: I think some of these guys who have to run a mine through the ups and they downs – let’s face it, they have payrolls, they have people who are coming to work every day, and they cannot be made or broken on price moves, so they have to neutralize when things are high. They have to also back away on that neutralization because, frankly, hedging costs money, as you know.
David: And they are not panicked. When prices fall, what are they preparing for? They are preparing for the next upswing, because again, knowing the commodity, whatever the commodity is, it could be copper, iron, or just as easily could be gold, they look at the next upswing. And the guys that are in trouble are the ones that are over-leveraged, that have borrowed too much, that have bad balance sheets, that have rocky balance sheets. And those are the ones that will fall prey to the cyclicality of the metal, itself. That is where business management has ignored balance sheet vulnerability because of the cyclical nature of their business.
So, yes, business management of the commodity space – I think this gives you a very different insight than portfolio management in the commodity space. The timeframe involved we are talking about here, for a business manager in the space, is months, it is years, it is even decades, versus the portfolio manager in the commodity space who is looking at nanoseconds. If he is a long-term thinker, maybe he is trading in a day where portfolios may see a tremendous amount of turnover in a week, but you are talking about the judgment of a short-term trade. So answer me this. Who has been around longer? Just boiling it down to brass tacks, who is likely to remain in the space after either fanfare or panic has run its course? And I would say, it’s the commercial interests.
Kevin: Well, of course, and what you are basically saying is, at this point, these guys are not concerned about gold going much lower. That is what they are showing us.
David: They are not shorting. They are actually moving toward a long position even as the hedge fund, the managed money crowd and the specs are moving toward being short, assuming that the trend is going to only and forever be down. The most reliable vote is with the commercial interests.
Kevin: You were talking about nanoseconds. We have to look at what the motivation of everyone is. If you are running a mine, or a gold company like you are, Dave, you are going to neutralize the position, and you are also going to not spend money if you don’t think it is going to go down any further. But if you are someone in the press – I’m not talking just about hedge fund managers – hedge fund managers and these nanosecond traders, their motivation is to look good that day. Period. It doesn’t matter what happens 10 or 20 years down the road. It is really the same with these guys who are journalists, talking about the markets. Let’s face it. If you were to turn on any financial TV – a lot of these channels interview you – most of the time they are telling you what is occurring right now, and what will occur over the next few minutes, hours, or days, but they are not looking at legacy investing, they are not looking at running a company long-term. I think of George Zivic. He is a portfolio manager over at Oppenheimer. When he has other buddies out there who are making money right now, he has to answer to the shorter term.
David: This is where, again, asset allocation is going to include some percentage into gold as an alternative asset class, and that is really how it is categorized anymore, as an “alternative asset class.” And in this particular time slice, more and more Wall Street guys are saying just exactly what George did in the recent Bloomberg article. He says, and I quote, “There is not a single motivating reason to own gold.” And so, he has basically said, “In our asset allocation, over here at Oppenheimer, we think it is ridiculous, useless, worthless. It has no place. I repeat, there is not a single motivating reason to own gold.” Of course, this is in contrast to investment advisor sentiment, which was setting bullish records in 2011.
Kevin: Oh, they loved it when it was at $1900.
David: Yes. Or if you look at the street-level investor, they were voting gold as the best long-term portfolio allocation, also in 2011 when gold was reaching new highs. But keep that George Zivic portfolio manager comment in mind as it, I think, echoes Jason Zweig’s comments last week in the Wall Street Journal. So, yes, gold is a pet rock, admit it, it takes faith to own it, and it is backed only by hope and imagination. Frankly, hope and imagination is all you have backing the U.S. dollar.
Kevin: I love what Jim Grant said this week when he was talking about Jason Zweig, who he says is a friend of his, but Jason Zweig probably put his foot in his mouth.
David: You’re right. Our thanks go out to Jim Grant who pointed out in his recent missive that Zweig has created the perfect bookends for the cyclical bear market gold has been in since 2011. Zweig, of course, penned Your Money and Your Brain, where he explores how an investor’s psychology can get in the way of their success.
Kevin: Which, by the way, is a very good book. That is an office read.
David: I’ve required everyone in the office to read it. But he also penned an off-the-charts bullish analysis of gold stocks two weeks before they peaked, with gold setting its records near $1900. Again, when you look at the extremes in the marketplace, understand that they are driven by fallible human beings. They are driven by emotional human beings. They are driven by people who have even analyzed the impact of psychology and investing, and yet are too close to it sometimes to see that their own psychology is committed, maybe, perhaps, overly so.
Kevin: And lest we call ourselves holier than thou, we are human as well. My wife and I were watching the news this morning as I was eating breakfast. I told her, “You know, it’s so hard to know what is going to happen next.” We’re human. There is no way. You can predict trends, you can look at the long term, but be careful with your brain, and be careful, especially, with your emotions.
David: I mentioned Zweig’s article last week, and I just thought it would be worth reflecting back to, I think it was the September 19th edition of the Wall Street Journal in 2011, where Zweig talks about why you need to own gold stocks. These are the winners. This is what you need in your portfolio.” And again, two weeks before the market peak. And now he is penning the same thing. “Well, you’ve got your pet rock.” And it sounds to me like he is just crying over spilt milk.
Kevin: I also like what Grant had to say, though. You need to understand who you are casting a vote for. If you are saying that you don’t like gold, you are basically saying that you do like everything that the central bankers are doing.
David: He says, and I quote, “Necessarily, to be bearish on gold is to be bullish on the former tenured economics faculty members who guide the world’s monetary destiny. It is to cast your financial ballot against the price mechanism – against the price mechanism – which the mandarins have been over-riding. It is to vote for the proposition that this greatest of all experiments in money-conjuring will end happily, and profitably, for the holders of financial assets.”
Clearly, we have cast our financial ballot along with Jim. We are bullish on the metals, we lick our wounds, we have for the last few years, and we look at them in perspective. Am I going to reconsider my vote? Or is my vote reinforced when I continue to look at the world as it is versus as it is being presented by the money mandarins. I have made the decision to actually double down on my bet as a consequence of looking at whether my vote is legitimate or not.
Kevin: And I understand that you have cast that vote. What I want to do, though, is go back to those formerly tenured academic faculty members who are guiding the economy, because the question right now, if you turn the news on anytime that has financial news, the question is, is the economy recovering enough for Janet Yellen to do what they have been threatening to do for years and years – what is it, six, seven years we haven’t seen an interest rate increase. So, tell me a little bit about the economy. Let’s talk about GDP, let’s talk about corporate earnings, and then let’s talk about whether we see an interest rate increase this fall.
David: Earnings, on the whole, for corporate America, are in the middle of expectations. A few disappointments, but, by and large, companies are still engineering the results on the earnings front. But year over year sales declines are surprising people, and I think that is where you are seeing some weakness in the equities markets. You have General Electric, J.P. Morgan/Chase, Microsoft, IBM, City Group, Johnson & Johnson, United Technologies, Pepsico, Intel, Coca-Cola, Oracle, Honeywell, Goldman-Sachs, American Express. Could the list go on? Yes, it could. But, that raises the issue of all these companies with year-on-year sales in decline. Can the Fed raise rates? And if look back in history, you won’t find them raising rates in the context of a declining sales trend.
Kevin: A future guest of ours, just in a few weeks, Bill King has said, that never happens when year-over-year sales are falling.
David: That’s exactly right. The Fed has never hiked rates with sales in decline year-over-year. And even stranger, sales have not declined year-on-year outside of a recession. So keep that in mind. We talked about commodities staring us in the face, as they are in decline, and you should see something of a rebound in the commodity space if we have a robust global economy, and it’s not there. So, in spite of the advertising that it’s here, it’s not there. The same thing is true of sales. We should see a pickup in activity, a pickup in sales, and yet what we have is an indication that perhaps we are already inside the pale of recession.
Kevin: What you are saying is, every single time that happens, we’re in a recession. I love those kinds of statistics, Dave, because it is a little bit like margin debt for the stock market. Every time it tops 2% we have a crash. Period. Every time year-over-year sales decline, we are in a recession. You can’t raise rates in a recession. We talked about that last week.
David: You remember the topic we covered a few weeks ago. In spite of government numbers indicating all is well, we have GDP this week with a possible upward revision for the negative quarter one results – that is what J.P. Morgan is looking for. You have the commodity market that is underscoring a very, very weak global economy, and yes, that is an indication of a decline in trade. We have the IMF, we have the BIS, we have a variety of statistics coming out of China and other parts of emerging markets indicating a significant decline in trade. So, you have the real world economic realities, and then you have what can be patched together to cover over those, because we are right in the midst of fresh category inclusions and blending in gross domestic income and gross domestic product, and revising all of our statistics dating back to the 1960s and 1970s, because again, GDP isn’t quite shining the way it needs to, so what do you do when the statistic doesn’t shine? You readjust the components.
Kevin: Change the numbers.
David: And we’ve done that with inflation, too. So, again, it is this issue of earnings. Think about it. Earnings are a financial engineering game.
Kevin: It is perception.
David: And they say all is clear, or nearly so, on the economic growth front. Government stats are saying the same thing. And yet corporate sales, across multiple sectors, which cannot be easily fabricated are indicating a recession is nigh. So the Fed would have to consider this as a context. We are talking about them moving from the discussion of raising rates to actually raising rates, and they have these real world realities to factor in. Not that they will discuss it, but I do think that they will reflect on it.
This week we also had a beat on durable goods orders. We saw that came in at 3.4% versus the expected 3%, so should have been a major boost as we come into the FOMC meeting.
Kevin: I didn’t see the stock market react to that at all.
David: Well, the market failed to acknowledge it. Rather, the market looked at the number – okay, I think this is what they were looking at. I think they were looking at taking out the transports, which, if you remove the massive commercial jet orders, the number comes in at 0.8% instead of your 3.4%.
Kevin: Wow, that’s a big difference – 0.8 versus 3.4.
David: What it says is that the broader manufacturing market is in a malaise, and clearly, the headline number is attractive, but when you dig into the numbers and realize it is really dependent on one line-item, commercial jet orders, you understand why market participants said to themselves, “The beat, 3.4 versus 3, on durable goods orders doesn’t impress. It didn’t impress because it needed to be broad-based, and it wasn’t.
Kevin: Okay, let’s pretend for a moment that Janet Yellen does come out and raise rates. The emerging market currencies have been in freefall. You brought that out again last week. Some of these currencies have fallen better than 20-25%. When you raise interest rates, you actually increase the value of the dollar more, relative to other currencies.
David: And I think you have a lot of investors who are leaning at, and dependent on, the Fed’s promise to raise rates. So, with that in mind, volatility in the emerging markets, both debt markets, currency markets, potentially equity markets, as well, I think will persist. Last week, a continuation of the trend, where we started the week, where we finished, it was the emerging market currency slaughter. You had the Brazilian currency, the Mexican peso, the Russian ruble. You had South Korea, Turkey, Columbia. They are now reaching, in a 12-month timeframe, down 30%. Again, this is because in the last 12 months there has been more aggressive dialogue about an interest rate increase. And 12 months ago we said, “Well, we don’t care what happens elsewhere. I think we need to be careful. Remember, it is a strong dollar. This predicated rate move – it’s the strong dollar and hot money flows. That is the story, which is reaching levels today which mirror the 1997 currency crisis in Asia.
Kevin: Which was a blood bath in Asia.
David: Some of the progress made from 1997 to the present has been the greater integration of world financial systems, so the idea that somehow what happens in the emerging markets or Asia, we are immune to it, is pitifully naïve.
Kevin: If we were to go back to 1997, Dave, the market integration wasn’t nearly what it is now, as far as anything that happens in Asia – if you sneeze in Asia you can have a collapse here in the United States.
David: You are right. The integration process has been great. This is one of the things that you can say is a benefit of globalization, but it also means that with an interconnection in the financial and in the banking system, in the currency systems, that yes, major hot money flows can be debilitating there, and ultimately, that debilitating effect can be here. And you combine the hot money flows out of the emerging markets and the carnage that you have in the Chinese stock market, which is a real time event right now, you have the makings of a Grimm’s Fairy Tale. And I just hope that the lessons learned will be as obvious as the grotesque nature of the events that are preceding maybe that moment of clarity, “Oh, that didn’t work out so well.” It is what you want your kids to learn if you are going to slog through some of Grimm’s Fairy Tales. I think the reality is that the financial markets tend to forget very quickly those lessons, even if they do learn them.
Kevin: Back in 1997 Asia wasn’t the power that it is now. Now we are talking a quarter of a trillion dollars moving out of those markets a year.
David: That actually, according to Doug Nolan of Credit Bubble Bulletin fame is just Chinese outflows that are at a 250 billion dollar quarterly pace.
Kevin: Wow, so a quarter of a trillion dollars, and that is quarterly, not annual.
David: But it is not just China. You have the Malaysian currency, which is now at a 16-year low. You have the developed market, if you are thinking Europe, euroland, Japan. Investors in the developed markets are clinging to the belief that the powers at the Fed, the ECB, the Bank of Japan, and to a lesser degree this month, the People’s Bank of China, just kind of failed to turn the Shanghai Stock Market around. Nevertheless, you have, again, what did Zweig call it? Hope and imagination? But it is in the central banking community rather than in pet rocks or gold.
Kevin: Look at Shanghai, again, the beginning of this week. It seems like each week something is happening in Shanghai that affects everything else. The Shanghai market just crashed again.
David: Starts with a bang, leads to a whimper. Shanghai on Monday is down 8½ percent. You get 1700 companies that day which fell the maximum 10% before they hit a circuit breaker and trading is halted. So, that is the stock market. Behind the market, and this is very critical. Again, there is a distinction between the stock market and the economy. Behind the market is the economy and it is slowing rapidly. In China, you have rail freight, which is at levels that are worse than in the 2009 crisis period.
Kevin: Dave, you have pointed this out so many times. The financial markets, which are the stock markets, are not telling the truth about the economic market.
David: (laughs)
Kevin: The economic market is much larger than any stock market out there. Now, are we starting to see an alignment? Are the financial markets starting to tell the truth about the economy?
David: That is the point, I think, that markets hither and yon are on the cusp of catching up with economic reality.
Kevin: And I think the thing that magnifies this, Dave, is that so much is done these days with debt. It is not like somebody just buying a few stocks and selling a few stocks. They are putting a little bit of money in and owning a lot of stocks, or they are selling a lot of stocks with a little bit of money, and margin is the ruler right now.
David: That is true in the debt markets, too, and the banking arena, as well. Let me just, on that point, look at how leveraged markets create their own self-reinforcing vortexes. A market that has a lot of leverage in it is, by definition, overextended. When you layer on a time-sensitive element like margin debt, then a trickle of outflow from that market can cause an initial, and maybe even an insignificant decline in price, but then you have operators in the market that have to decide whether the basis for being, in getting overextended, has been compromised. Has it changed? Are we in a new environment? Are we now going to deleverage? We were leveraging up and it was profitable. Are we now going to deleverage? If they want to stick with positions, if they don’t want to close out their positions, guess what they have to do?
Kevin: The have to hedge them, just like what we were talking about earlier in the conversation.
David: Exactly, so you hedge them. You do this by continuing to own the asset, but simultaneously selling it short. That creates a neutral position for you in the marketplace. It is like a scale that has equal weights on each side. You are in balance. If you are long one side, short the other. But the short position can, in itself, pressure the price lower. So this is again the financial market vortex with too much debt already in the picture. And when you are overextended, how can it be a self-reinforcing issue? Short position pressures the price lower. That leads to further outflows, further declines in the price, with a greater number of investors then looking for that same kind of coverage, that same sort of protection, that is, a hedge on the positions that they are still maintaining. And as they slide lower, this again adds to the negative pressure on prices and it repeats the circle of negative outflows and further hedging pressure all over again.
Kevin: Let’s use the example that we were talking about before. Let’s just say, Dave, that you had – oh, let’s pick a number – 250 million dollars worth of gold that you needed to hedge. You are fully bullish on gold, you are holding the gold because that is your inventory, but you also need to hedge 250 million dollars worth of gold.
David: So I would short 250 million dollars worth of gold, and it is going to show up as current activity…
Kevin: …and it might push the price of gold down a little bit…
David: …but it is not going to matter to me because if I shorted it at a number, I own 250 million here, I’m short 250 million there, I lose a dollar on what I own, I gain a dollar on what I shorted, and I am neutral. Do you see how that works?
Kevin: Absolutely, but let’s talk about the guy who is short 250 million dollars worth of gold and doesn’t own a single ounce.
David: (laughs) Well, that’s a fun game until your bluff is called. You have the same circle, this vortex, if you will, in China. You have one equity analyst in China who commented this last week, “If the government exits the bailout, prices could accelerate their journey back to fundamentals.” This was in Reuters from July 28th.
Kevin: What does that mean? What is a fundamental when you are this high above it?
David: Right, right, right! So, what’s the value of the stocks. He is basically saying, “We know what the intrinsic value of the stock is. It is way below current prices, and if the government steps out of the way, we are going to return to maybe what they should be priced at.” I’m thinking to myself, “Yeah, China – how about the rest of the world, too?” Will we have that in the U.S.? I suspect shortly there will be an unwind in margin debt. We popped up another 6 billion dollars. We are at 505 again. When you have an unwind in leverage, and as that Chinese equity analyst said, a journey back to fundamentals ensues (laughs), I think people get this. I think there is a vast number of people in the marketplace that know that something is about to change. You can feel it. This is not a deep market intuition as much as a very simple observation. China is going where our central bank has already gone. And I quote our Commentary guest, Victor Shih, who was in a recent Bloomberg article. He says, “This scale of intervention reinforces moral hazard that is already rampant in the credit side of the Chinese financial industry. With the moral hazard spreading to the equity side, there will be no end to the expansion of central bank balance sheet, which is necessary to keep both credit and equity afloat.” Do you remember the short seller hedging a position? In China it is now considered malicious to sell short.
Kevin: He talked about people going to jail for either talking negatively or selling short.
David: The word they use for that is malicious. You have malicious intent.
Kevin: Remember the Russians? They call them hooligans.
David: Exactly. I am surprised that they haven’t drug out that kind of language. It is like our racketeering laws here in the United States. If you can’t pin the bad guy with anything, you accuse him of racketeering. It’s kind of a catch-all (laughs). The Russians have that, they call it hooliganism. Yeah, we’re accusing you of hooliganism and sending you to the gulag for 50 years.
Kevin: But what you do is, you divert attention, though, Dave. It is really not the government right now trying to keep the market together and calling people hooligans, or malicious, or what have you. The opiate of the people is something that governments use all the time. It can be religion. It can be, actually, political pressure, hatred of another race, hatred of another nation.
David: But you are seeing that stirred in China right now. In fact, the Washington Times, July 22nd, had a great article on this. If you watch the political and geopolitical crossover, this is what they noted in that Times article. You, right now, have anticipations for, and preparations for, celebrations getting under way for the 70th anniversary, and this is what they call it – the 70th anniversary of the Chinese People’s Anti-Japanese War, and World anti-fascist War Victory Commemoration Day (laughs).
Kevin: Hmm. That’s a long sentence telling you exactly how to think about…
David: The Chinese People’s Anti-Japanese War and the World Anti-Fascist War Victory Commemoration Day. Right. What you have is anti-Japanese Nationalism, which is a partial cure for the inflamed and financially frustrated masses. And it goes along well with anyone who would be critical of current domestic policy changes afoot there in China if people don’t like what the current administration is doing, just remind them of what the Japanese did so many years ago, and like you said, it is redirection, which is an art used in magic tricks, but it is equally valuable in foreign affairs.
Kevin: Don’t you think, though, the Chinese leadership is walking a very, very narrow tightrope? On one hand they are trying to show stability in their market because they would like the RMB to be included in the SDR system with the IMF, yet they also have a stock market right now that wants to be a free market, that actually does want to return to the fundamentals. That has never been a bad thing. Returning to the fundamentals means things are priced correctly again.
David: I always think of Aristotle – virtue, in this case, the right price, is the mean point, or the mid point, between excess and deficiency. The market is constantly trying to find equilibrium or virtue, and it is doing that by bobbing up and down around the mid point. At some points in the market cycle it will be well below what it should be priced at – it will be undervalued. And in other points of the market cycle, it will be well above what it should be priced at. It is at excess. Our own lives reflect that. Virtue is the mean between excess and deficiency, and what we have is market practitioners, specifically, central bank money mandarins, stepping in and saying, “No, but we will define virtue in the new era, at a significantly higher price. Forget what it used to be. Forget the fundamentals. It is convenient for use to choose point X.”
Kevin: Well, then my question is, Dave, let’s say you are sitting from the IMF’s perspective, from Europe right now, from America, and you are looking at the RMB and you are saying, “Is China stable enough to include it in the SDR system?” And then you are looking over at the stock market, and you are looking at what they are doing with their currency, and you are looking at the stock market. What decision is made? And if you are Chinese, what decision is made?
David: Right. You are really talking about an intersection. A decision has to be made as to where the Chinese are going to focus.
Kevin: You have to choose where you are going to sacrifice.
David: Right, and the question ahead, if Victor Shih is correct about an ever-expanding central bank balance sheet, is whether the politburo will continue to prop up equities at the expense of exchange rate stability, that is RMB credibility. Now is the time for the Chinese to attempt internationalization of their currency. Now is the time that they are making the case for inclusion into the special drawing rights system through the IMF. If you have too much foreign currency volatility, it will argue against an expanded footprint for that currency, which, in turn, damages future trade relation expansion. Which do you care more about? A, a minority of the population invested in equities, or B, a greater role for China in the world economy, which could be damaged if the scale of interventions takes the RMB exchange rate literally off the rails.
Kevin: We have watched the central banks controlling things, and even my wife this morning before I came in, said, “You know, Kevin, this is the new norm. It is the new norm people have in their minds that the central banks have got this thing. But a former guest of ours, David Stockman, who was with the Reagan administration, he says they have spent their ammo.
David: When I think of him, I think of a man with fire in his belly. So, fire in the belly Dave Stockman articulates, this week, that the central bank spending spree over the last 15 years is at its limits. They have used their ammo. They had aggregate balance sheets – we are talking about all the world’s major central banks, developed world central banks, 3 trillion dollars in aggregate – they have boosted that to 22 trillion dollars, leading him to conclude this, and I quote, “There is a deep falsification of financial crisis on a planet-wide scale.” Yes, there are other indicators, and you don’t have to look at central bank balance sheets. If you want to look for stress in the financial markets, there is the ever-so-subtle space, the spread between junk bonds and U.S. treasuries that has been rising since April, and that indicates both a tightening of liquidity and a reassessment of risk. Again, that is April to the present timeframe.
Kevin: So, what David Stockman is saying is – he didn’t say if, he says that have spent their ammo. But if they have – if they have, Dave – talk about a return to fundamentals. The fall is greater than any bridge collapse in the history of mankind. We are not talking about a return slightly to fundamentals where it just dips down maybe a foot or two, we are talking about a bridge collapse of thousands of feet. There is a long way to go, if you take out central bank intervention, to fall.
Now, speaking of that, because the way the central banks control everything is with two methods – simply two things. They print money or they maneuver with interest rates. There is a mentality out there that gold goes down every time interest rates rise.
David: But actually, that is not the case. That is not the case at all. Interest rates are one component. Write this down. You have interest rates and you have inflation, and if you go back to Larry Summers’ paper – I don’t know how many times we have mentioned this on the program, but Larry Summers, in the Summers-Barsky thesis, looked at Gibson’s paradox and dissected the math of how gold could either go up or down depending on whether you had a positive or negative real rate of interest. So is it positive or is it a negative real rate of interest? How do you decide if you have a positive or negative real rate of interest?
Kevin: So, for the person who has not heard of Gibson’s paradox, what is the simplicity of it?
David: Very easy to figure this out. You take your current interest rate. For simple illustration purposes, let’s say the interest rate is 10%. But if your inflation rate is 10%, guess what you end up with? Ten minus ten equals zero. Do you have a positive or negative real rate of return? And in fact, if inflation is twelve, and your interest rate is ten, you have a negative by two, a negative real rate of return. What Gibson’s paradox and the Summers-Barsky thesis explores is the role of positive and negative real rates of return and their impact on the gold price. It is not just interest rates. So, if you think that a rise in interest rates is crippling to the gold price, keep in mind that you had a rise in interest rates from December 31, 1976 through September 25, 1981, and actually, you could step even further back, if you wanted to look at interest rates from the early 1970s, starting at, say, the 2% range and going to 12-14%, and gold continued to rise during that entire timeframe, just between 1976 and 1981, you had ten-year yields going up 130% and gold going up 235%. And if you wanted to look back at other periods in history, 1986-1987, 1993-1994, 2003-2004, 2005-2006, 2008-2010, you have interest rates increases in that period 2008-2010, 85% increase in the ten-year yield and gold is up 33%. It is not axiomatic that rates go up and gold goes down. What is axiomatic is, according to the Summers-Barsky thesis and Gibson’s paradox, if you end up with a very, very positive real rate of return, the shine is off the metal. You are better off in a positive-yielding asset than a no-yielding asset. The reason why gold still have merit, even in a rising interest rate environment, is if you can figure out what your positive, what your over/under is, for your positive or negative real rate of return, factoring in real inflation, now you know who is buying and who is not.
Kevin: Sure.
David: In a negative to zero rate environment, guess what? Gold still is attractive. Summers-Barsky nails it.
Kevin: So, let’s talk about that for a second, because 1976 to 1979 was a period of great crisis. We had the Iranian hostage crisis, we had the Russian invasion of Afghanistan. What interest rate rises actually show is, there is a crisis. Interest rate rises are not a sign of health, Dave, even though we have been trained that by the central bankers. Interest is a measure of risk, and when interest rates rise, risk has increased.
David: The only argument against that would be that we have to normalize to some level.
Kevin: Right.
David: And so we have held things so artificially low that an initial interest rate rise would be normalization, not an indication of excess risk, but anything beyond that normalized level would certainly be an indication of risk.
Kevin: And they may throw the dog a treat, rather than the steak, by putting a quarter of a percent rise at some point, just to say they did.
David: Sure, and the advertising will be, that’s negative for gold. You will be wise enough to know there is a difference between a rise in rates and a significant rise in real rates which factors in inflation, as well. You have to be dealing with a net number. That is where the math lies. That is where the powerful math lies.
As we conclude, on a nonfinancial note, I just want to mention what happened over the weekend, which I think is very significant, sort of a Middle East powder keg, if you will. In 1996 I visited the Al Aqsa mosque while living in Jerusalem.
Kevin: That is on the Temple Mount.
David: And at that time I was able to go inside the Dome of the Rock. And that was very near the last time a non-Muslim could do so. Fast forward to this weekend. Some events, in retrospect, have a certain critical explanatory power as other things unfold, and this weekend’s events may have been just that. You had the Israeli police defending against Palestinian attackers near the Western Wall. That led to Israeli police moving well into the Temple Mount.
Kevin: And they are not supposed to be there, are they?
David: In and around Al Aqsa.
Kevin: Yes.
David: And it just so happens that this incursion, if you will, occurred on the day commemorating the loss of the first and second Jewish Temples on that site.
Kevin: They call it the 9th day of Av, that is a commemoration every year.
David: So, if you look at the response in the Arab news and Al Jazeera, this did not go over well. There is sure to be not only acrimony, but payback, for the “violation of sacred space.” Again, if you are looking for an event, almost like the assassination attempt of Ferdinand, right? What is the connection? How did things get riled up? I would say you need to watch the Middle East. Watch that region closely. Because powder kegs occasionally and unexpectedly blow up.
Kevin: Right. Well, Dave, there is so much tension in so many different places. We have built this huge – it is not really a house of cards, it reminds me of the game of Jinga. I don’t know if you have every played it before, but these are rectangular little blocks made of wood and you build this large tower, and each player has to quietly and slowly pull one of those little pieces out. You never which one is going to cause the whole thing to kerplunk, but when it does, it is not just one thing that falls, it’s everything.
David: No, I like the analogy better than the powder keg, because it is that thing where there are many factors involved, and instability grows and you can point to one thing as a trigger and it actually may be coincidental, and not causal. We will have to see. So, just like the game you mentioned, Jinga, you have all of these factors. And it is not unlike what we have looked at – financial crisis, economic crisis, political crisis, geopolitical crisis, something of a crisis domino effect. Which causes which? Do they intermix? Do they interconnect? Yes, they absolutely do. Which is the next piece? What is the most critical piece before it falls apart?
