The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: David, we are coming off of a trip to Southern California and then up to Seattle to see our clients. It was fascinating talking to the clients, listening to where their heads were at, and we are watching the markets right now. We are seeing the S&P500 and the stock market going on and hitting new highs. We are seeing gold a couple of weeks ago coming down substantially, yet all the indicators are saying that the markets are doing opposite what they should be doing. I’m referencing insider trading right now on the S&P500.
David: Well, that’s true, it’s not all the indicators in the sense that the price is moving higher, which is one heck of an indicator, which is saying, “You’re missing the boat. You should be buying stocks right now.”
Kevin: Makes you nervous, doesn’t it?
David: But when you look at some of the concerns we have right now regarding copper – Dr. Copper continues to not follow that track higher. On a one-day, two-day basis, it will move higher, but if you look at the last 3-6 months, it has moved considerably lower, even as the S&P has moved higher. Durable goods orders – they are fading. They continue to move lower, even as the stock market moves higher.
Kevin: Well, and how about utilities? A lot of people watch utilities, not industrials.
David: Yeah, so if you are looking at a chart of the Dow-Jones utilities average, it, too, is heading lower and the question is, will that lead the industrials lower at some point? Is it the leading indicator, if you will?
Kevin: Okay, but back to my insider comment, okay? Insiders are the guys who run companies. David, you run a company. If you were selling shares of ICA, I’d be paying attention.
David: Well, of course, and if we were selling 1500 times what we were buying, that should get your attention. That was the insider selling number from January, and you know January was quite a few months ago.
Kevin: What is it now, right now? As we are hitting new highs, what’s the insider selling versus buying?
David: 31,000-to-1. That’s 31,000 shares sold for 1 share purchased. You can look at this several different ways. “You’re missing the boat. We are at 15,000 on the Dow, the S&P has pressed past 1600, and we’ve got blue skies. Blue skies looking at me, blue skies, that’s all we see.”
That should be our mindset, correct? How can you ignore? – Well, I’ll tell you what we can’t ignore. We can’t ignore the fact the CFOs, CEOs, CIOs are saying, “Bird in the hand is better than two in the bush. We like the price today. We don’t know what the price is tomorrow.” And for those of you who listen to earnings calls – we do, we spend the time, and what do we hear? We hear, “We met earnings expectations on lower revenues,” over and over, and over, and over again, we have heard that, this quarter.
And of course last quarter as we mentioned earlier, mentioned a few months ago – 78% of companies in the first quarter had given lower second quarter guidance. What does that mean? It means they’ve basically lowered the bar. They’ve said, “We’re not going to make as money next quarter as we did this quarter. Just so you know, that’s our expectation.” And guess what? The news media comes in the next time they report, and what do they say? “We made our expectations. We hit our number.” But again, declining sales, declining revenue. This is what’s troubling.
Kevin: Well, and see, that’s the thing, Dave. Contrarians don’t watch the price of something to see if they are going to buy it or not. And we are being trained, with financial TV, with instant gratification as far as information goes, people are watching the price and they are thinking, “Wow, the stock market’s going up, I’d better buy something. Gold is going down, I’d better sell some.”
But price is one of the last indicators you actually want to watch. You want to watch earnings when you are talking about stocks. You want to understand the fundamentals that are underlying it. We’ll talk later about gold, the actual accumulation of physical gold stocks right now is hitting records, yet the paper markets are being manipulated down.
David: (laughter) I read a great quote the other day on the efficient market hypothesis and it went something like this: “Yes, I believe in the efficient market hypothesis. It’s as efficient as the people who are operating in the market.” And to me, that says everything. You don’t have all the information and you’re assuming that someone else does and somehow collectively we pool our ignorance and come up with the proper solution, the right price to pay, what we consider value in this particular moment, but again, pooled ignorance is the best you have with the efficient market hypothesis.
Kevin: Well, and prices can make mistakes, is what you are saying. The efficient market says, “No, the price never makes a mistake,” but the price is almost always mistaken to the fundamentals in the long run.
David: And so the difference to the contrarian who judges, sort of comfortably, the crowd, as they are making decisions and the contrarian is comfortable making his own judgment separate from the crowd. Crowds tend to, just as we’ve described, follow momentum, and thus they are overly optimistic when prices are rising, and unfortunately, they are overly pessimistic when prices are falling. That is, in large part, because following the crowd does not often engage the mind. It’s an emotional exercise.
Kevin: Speaking of the emotion, I think of Cramer. When I get back from lunch in the afternoon, you have the TV on here in the waiting room, and Cramer’s got his pink shirt on, and his tie, and he’s yelling, “Buy!” or he’s yelling, “Sell!” But he’s really just the shepherd leading the crowd if you think about it. He’s a Goldman-Sachs background kind of guy and people love the entertainment of the price.
David: I think separating emotion from a decision-making process when you are talking about investments, is vital. If you want to be a successful long-term investor you have to look at the facts, and I think we want to do that a little bit today, shed light on where we are, where we are going, what the last 12 years of an ongoing bull market in gold has been, and where we are going from here.
Kevin: And let’s talk about the breaks in that bull market. We didn’t actually have a long-term break, but we had some scary times. I think back to 2008.
David: But that was the worst of the corrections. We had multiple corrections before that, which were anywhere from 20-24% declines, in a very short and sharp period, and that is very characteristic of a bull market. It takes a long time to make any forward progress, and then you can give it back in, literally, a New York second. That’s what we saw in the early part of the decade, 20-24% declines. What was shocking – what was shocking – was the decline that we saw in 2008, where we declined more than 30%.
Kevin: It reminds me of the talks that we would have with Don, your dad. This family firm has been around since 1972, so this is not our first bull market, and it wasn’t our first bear market after that, and so you go back to the mid-’70s, those times were harrowing, as well, on the way to $850.
David: Well sure. The Wall Street Journal, in 2008, was talking about the drop in gold and the fact that it was attributable to selling by speculative funds. And that is precisely what occurred in mid April, and again, in previous shows, that’s what we have made mention of – 400 tons being dumped on the market in a few short hours. This is remarkable. The combined total of sold contracts over a two-day period, Friday and the following Monday, was 1 million futures contracts.
Kevin: That’s amazing. That gold doesn’t exist, Dave.
David: No. So John Hathaway puts these numbers together. That was equal to 3,000 tons of gold sold, that is, 12% more than the global annual gold production, in a two-day period. That was not physical gold being sold, that was futures contracts.
Kevin: Repeat that again; it’s important.
David: That was not physical gold being sold, that was futures contracts. So essentially the weakness was in that space which you might describe as a leveraged speculator’s gamble.
Kevin: It doesn’t take much money to play there either.
David: That’s right. A little money down buys you a significant footprint in the market. And frankly, when you want to manipulate any market, go where your firepower is magnified. So again, we reflect on the 2008 time frame, and it is identically, the pressure coming from selling by speculative funds.
Kevin: Well, and you know, we were being coached by the most benevolent firm out there, Goldman-Sachs. They were coming out in the press and trying to let people know ahead of time what they needed to do.
David: Interesting. They said, I quote, “Aggregate speculative net long positions across COMEX futures and gold ETFs remain near record highs.”
Kevin: But that wasn’t true, Dave.
David: But that was part of their justification for saying, “We would like to short the market now, because there are more people who are long the gold market now than we’ve seen in a long, long time,” when in fact, net long futures positions had plummeted 76% since the previous October. And gold ETFs had already seen a reduction of physical stocks by 200 tons. That was from the beginning of the year up to that point.
Goldman-Sachs was misrepresenting the state of the market even as they were, frankly, in an unprecedented manner, sharing their top trade recommendations with the general public via the Wall Street Journal.
Kevin: Wasn’t that nice of them? And of course, what is really needed, when you take a position like that and you are trying to manipulate a market, you do need the public to sort of believe the lie. You tell a lie often enough…
David: And people will believe it.
Kevin: And hopefully people will believe it, yeah.
David: But 2008, 2013, I think we will remember these time frames as critical junctures in an ongoing bull market in precious metals – $700 then, $1321 now – these price ranges have both witnessed a tsunami of physical purchasing. What is unique is that this physical purchasing has put a floor under the market.
Kevin: Strangely, the Chinese didn’t pay any attention to the drop, except that they liked the better price.
David: (laughter) No, in fact, there were a number of articles about Auntie so-and-so, and this is sort of the classic thing where your Chinese auntie has a little bit of savings in a coffee jar, or a tea tin somewhere in the apartment. She emptied it all and went gold shopping on those particular days.
Kevin: Well, and wasn’t their demand this past month twice what it was the year before?
David: 223 tons in the month of March set records. It was nearly double any other previous single month in Chinese history. Fairly interesting that you’ve got major demand, and of course that was March. I would argue that March demand was a part of what precipitated the need for COMEX, the LME, Scotia Mocatta, J.P. Morgan, to step into the market and say, “Hey, wait a minute. We’re dealing with major constraints in terms of delivery. Because demand is high, we need to scare the daylights out of these folks. Let’s sink our teeth into the short side of the market and see if we can’t scare the longs and get them liquidating, not purchasing. We can’t handle this kind of demand.”
Kevin: You know, strangely, the people who are buying gold seem not to be able to read, because if you were able to read any newspaper in the country, they’d be telling you to sell right now.
David: And that’s what we continue to see. But it’s not unlike 2008 – this was in the Wall Street Journal – Deutsche Bank, Michael Lewis, printing in 2008 that gold was moving to $600, $620 and that was what he considered fair value in the price target for gold. And again, we are now looking at targets of $800 to $1000. That’s what Wall Street firms are bandying around now, because again, they moved their price projections higher when the price was moving higher, as momentum players, as trend players, and now they’re moving their price projections lower. Again, momentum playing, trend playing, on a technical basis, this is what they see. But the same City Group research team, which as of May 1st said that $770 is the new destination for gold? That’s the same team that was calling for $2500 gold in a feverpitch when gold was at $1900. Again, you assume that analysts are somehow more rational, or put together, or analytical. That’s balderdash.
Kevin: They’re watching the same TV.
David: They’re watching the same TV, and they are working off a model which is now utterly dependent on momentum – trending. Looking at fundamentals is something that is very passé on Wall Street. And I think that’s where we are going to find most of Wall Street misses the major moves in gold.
Kevin: Dave, I just think back to all the past bull markets we’ve seen, not just in gold, but you’ve got detractors in each market when they are looking at momentum. But let’s go back. We talked about the 1970s. Let’s go back and look at a quote from the 1970s.
David: In 1976, we saw the price of gold move lower, and lower, and lower, and on a technical basis, the back had been broken. I remember my dad went hiking out near Aspen, Colorado, and climbed up to the top of a 14’er and he sat there, just thinking, “Is it possible, is it really possible, with all the money printing, from an Arthur Burns and from the guns and butter era…
Kevin: Is it really over?
David: “Is it really over?” And he sat there and he thought, “You know what? The fact that I’m even considering this, they’ve just broken the back of the strongest gold bull on the planet. It’s over. This is the bottom, this is the low. We have seen it.”
And in fact, he came off that mountain and two days later, the price of gold began moving higher, and this is a quote from Time Magazine, 1976. “To hoarders and speculators, gold lately has had about as much luster as a rusty tin can. In 19 months, since gold purchases became legal for U.S. citizens, the price has fallen more than 40% from its peak of $198 dollars an ounce. In three chaotic days of trading last week, gold fell $14 on the London market, reaching a 31-month low. That’s $105.50 an ounce. Though the price recovered to $111 by week’s end, this is still a dismal figure for gold bugs, who not long ago were forecasting prices of $300.”
Kevin: That’s Time Magazine 1976 and, of course, the rest is history, Dave. 1976 to 1979 or 1980, gold went on to over $800 an ounce.
David: Well, and we also recently witnessed a two-day 13% decline, and this is almost an exact duplicate of the capitulation low in 1976 following a three-day 12% decline. You read the New York Times from that same year, 1976, and you would have found this: “In 1976, there is simply nothing in the economic picture today to cause a rush into gold. The technical damage caused by the decline is enormous, and it cannot be erased quickly.” Again, as you referenced, Kevin, from 1976 to the end of the bull market, there was a 750% gain – a 750% gain in four years – and yet the New York Times would tell you there is simply nothing in the economic picture today to cause a rush into gold. You assume that when you are reading newsprint that you are dealing with intelligent, well-informed, well-educated, thoughtful folk. It doesn’t mean that they know what is actually happening. It doesn’t mean that their opinions are formed on the basis of fact.
Kevin: Well, and they are pretty consistent. There is another article that said, “Meanwhile, the economic conditions…” This is back from 1976 as well.
David: Also Time Magazine.
Kevin: Yeah, Time Magazine. Were they there to hammer it down? I think of Maxwell’s Silver Hammer – bang. It says, “Meanwhile, the economic conditions that triggered the gold boom of ’73 and ’74 have largely disappeared. The dollar is steady…”
David: Steady? We’re talking about a steady dollar in the middle of the 1970s dollar correction, and it had found stasis for just a few weeks and then all of a sudden they were printing this garbage.
Kevin: Well, and it goes on, Dave, even worse. So the dollar was steady, “but world inflation rates have come down,” they said, “and the general panic set off by the oil crisis is abated. All those trends reduce the distrust of paper money that moves speculators to put funds into gold.” So again, they were pooh-poohing it.
David: Fred Hickey would reference the 2013 Wall Street Journal article, a very recent Wall Street Journal article, basically saying the same thing. It said, “Meanwhile, the traditional catalysts for gold prices, inflation worries and financial market turmoil, have ebbed somewhat, further dimming gold’s appeal.” Again, this is the kind of press that we have, to come full circle, the decline in the gold price in 1976 was brutal, and the media helped in the washout, reflecting the darkly bearish sentiment of the day. Again, the New York Times article. These were published within weeks of the turn in the gold price, a turn which, as we mentioned, took gold, over a four-year period, up over 750%.
Kevin: Well, the parallels are amazing because the Federal Reserve has stimulated a stock market rally right now. That’s where the money seems to be going under Bernanke, but we had Burns back in the 1970s and he was doing the same thing.
David: Exactly, you had confidence in the equities market. You had the Fed chief in 1976, in that year, he would have been called a genius. Stocks were rallying. They had started rallying in late 1974, they rallied all the way through 1977. Again, if you were concerned about the market, if you had a reason to be buying gold, or not be buying gold, because look, equities are doing their job, Arthur Burns’ easy money policies seemed like the perfect recipe. You had asset appreciation, you had economic recovery. You had no inflationary consequences. This is the perfect recipe, right? And Arthur Burns is the genius.
Kevin: But any time you reference inflation to anyone who was alive in that generation…
David: “Oh, that ’70s show.”
Kevin: That was it.
David: “Oh, that ’70s show.”
Kevin: Yeah.
David: What every investor should recall from that period is that inflation lags – inflation lags – and is only evident some time after the policies are implemented. We have Ben Barnanke, the Arthur Burns of our day. He has put more inflation into the pipeline than you can imagine, and very different from the 1970s.
Kevin: Well, more inflation than any Fed chief in history.
David: True, but he’s not alone. We’re talking about the Bank of Japan, the ECB, the Swiss National Bank, the Bank of England, and we haven’t even begun to see the fireworks from the Bank of England. You’ve got Carney, who has almost a similar reputation as Kuroda, being a man who is not afraid of getting creative when it comes to monetary policy, who is just taking the helm at the Bank of England.
Bernanke is the Arthur Burns of our day, he may be fixing things, and yes, today he is receiving high praise for his work, but honestly, I think he will retire this year before the inflationary lag takes place, so that he can be remembered as a genius, and so that he can blame the mess that, yes, he created, but the blame will fall on the Fed chief that inherits the mess he has left behind.
Kevin: Okay, so when we see this next leg, if we are seeing a parallel with the 1970s, then there is going to be a leg up on gold that takes away everybody’s breath.
David: Yeah, the next leg higher, I think it’s maybe the dramatic, maybe that final leg higher in a bull market, it’s going to be marked by a change in inflation expectations. That’s the critical driver. Look at the way bonds are trading. Look at the prices that you have in the bond market. They are pricing in, basically, zero inflation for 30 years.
Think of what a banker does when he signs up a mortgage and charges something like 3-4% for 30 years. This says two things: Number one, I’m not going to hold the paper, I’m passing it on to Fannie Mae and Freddie Mac, because there is a subsidy in the market. They’re buying everything, at least if it is confirming. But the rate structure implies that there is no concern about inflation, and I think this is where the market is getting it dead wrong.
When you have consensus, and again this goes back to that basic theme that we started with – the contrarian versus the crowd mentality investor. Everyone today is concerned about deflation, and you can see that evidenced in the bond market. You can see that evidenced in even people stepping in to noncontrolled areas of the bond market. We’re not talking about just the Treasury and mortgage-backed space, but junk bonds. People are not concerned about future inflation. If they were, they would realize the risk that they have, the interest rate risk, the volatility that they have, both in terms of long-dated maturities and credit quality, which is questionable.
Kevin: And you know, it is interesting, that may be what the crowd is looking for, but the person who probably knows interest rates better than anyone in the world, Bill Gross, said after 30 years of a bond bull market, which means falling interest rates, that’s over. This is the same year that he said gold would be his investment of choice. He hasn’t changed that.
David: I think it’s a mere coincidence that he is calling for the end of the bond bull market and ownership of gold is now necessary for investors, and yeah, I think it’s just a coincidence. (laughter)
Kevin: (laughter). Yeah, okay, so let me ask you a question, though Dave. We did talk about some of the lows in the ’70s, and we talked about 2008. As far as this particular low right now, what is your feel for the gold market?
David: We’re putting in a cyclical low. I think $1321 was the low. If we retest it, we may, but the deflationary concerns and the notions that monetary policy has somehow succeeded, without any real-world consequences, those are conclusions that are going to be very stale, and in retrospect, even by the end of the year, will seem really childish, even naïve.
Kevin: Like Billy Crystal said in Princess Bride, “It would take a miracle for that to happen,” because we’ve added a trillion dollars a year in Japan, we’re adding a trillion dollars a year in the United States.
David: And we’ll have to see if we see further growth in China. Of course, they do toggle back and forth. Their last major input of credit was the equivalent of 4 trillion dollars if it was an economy our size – theirs is still smaller than ours. Again, juice on a massive scale. We mentioned England. Carney is known for his nonconventional approaches, and of course Europe, their accommodation by the ECB, and we still have the depositor concerns.
Kevin: Right.
David: And take away the inflationary consequences and concerns about inflation, and now you have a whole new group of gold buyers just here in the last 30-60 days and it is looking at Cypress and saying, if they can do it there, why can’t they do it here?
Kevin: I think that’s a great point. Not one of those buyers who is trying to get money out of Cypress, or even some of the other countries, like Portugal and Spain, and the Chinese were doing the same thing – not one of those persons was looking at a chart trying to time the market. They just wanted some other money than the stuff that was stuck in Cypress, and this is what we were seeing. Cypress seems to be, like we’ve said before, the shot heard round the world. When the inventories of these COMEX warehouses started dropping dramatically, it really coincided with the fear in Cypress.
David: There was the rumor-mongering the same week that gold took its hit. That was April 15th. It was Monday and Tuesday of that week that there were rumors that Cypress may have to give up their gold and if that was the case, that might have a domino effect with Portugal, Italy, Ireland following suit, although Italy is the big one in the mix in terms of a major gold holding. The notion was, “Uh-oh, if it’s Cypress, then it’s all these other countries next.” Well, listen, it was rumor to begin with, but that still set the market on edge enough to react to Société Générale’s notes, to Goldman-Sachs’ short recommendation, and the rest is history, as they say.
Kevin: Even the U.S. mint sold ten times more American Eagles in April than they did the year before, so, yeah, that was goin’ on.
David: Here’s the thing. In the EU, they continue to deal with this issue of bank stability. The discussions are taking place this week, and include a consideration of what they consider the success story in Cypress. Think about this. This is EC finance ministers who are basically saying, “It worked. We bail out the banks, and that bail-in system, it worked there, it could work elsewhere, and if we have further banking issues, regardless of the country in question throughout Europe, this would work.”
Kevin: So your deposit is my deposit, is what they’re saying.
David: Yeah, I mean, they’re not kidding. The discussion is to codify this 100,000 euros as the threshold for bank deposits. Above that, you’re going to be the bail-in, below that, you know, it’s okay. Depositors beware. You may have had little to do with the problems up to this point, but you definitely are part of the solution, a significant part of the solution, particularly, if you are a large depositor.
This is the absolutely asinine feature of the EC finance ministers. The European community finance ministers are not realizing that if they go through and make this a reality for all of Europe, a contingency plan, if you will, in a banking crisis, what they will see is the equivalent of a great deflation in Europe. Why? Because everyone will want to take their money out of the banking system and stuff it in a mattress.
Kevin: Sure.
David: And so what happens is, you end up with a very cash-constrained market. And the only solution that the ECB would have to counter-balance a major drain in cash is erecting capital controls, not allowing cash to quietly move across borders or outside of the EU. In addition to that, they can just print. They can print and create more liquidity for the system, as liquidity is drained from the system to sort of counteract that.
Kevin: You brought up a great point when we were at the conference this last week that I had not thought of, Dave. You talk about the bail-in in Cypress and yeah, that was painful. 10%. Ouch. 10% of my deposit is gone if I’m a Cypriot Bank deposit-holder. But…
David: It’s a one-time deal!
Kevin: It’s a one-time deal, and yes, it’s bad, but look at where our inflation rate is, Dave, if it’s measured the way they actually should measure it, back when Volcker was measuring it. What is it, 9%, 10% right now? But it’s annual.
David: And you know, academically, there may be reasons for counting it differently, and they’ve just made sure that we have a new way of counting it, because, as you know, I’m sure, inflation, as it is stated in the CPI, is overstated. It’s not 2%, it should be closer to 1.6%. That’s what they’re arguing for right now.
But we’ve done this a number of different times where we have changed the model, we’ve changed the way we counted inflation, and that’s what you’re talking about, because when Volcker was in office, the way he counted inflation, if he looked at our numbers today, used that same model, we’re talking about 10% rates of inflation.
Kevin: That’s the equivalent of what the bail-in was once in Cypress, but that’s every year. That’s the loss in buying power, Dave.
David: 10% bail-in every year, and you don’t mind, because you don’t see it coming. It’s on an unannounced basis. This is why Keynes loved the notion of inflation. He loved the notion of inflation. Nobody understands it, it’s a great way for governments to finance operations. It is a way of increasing taxes very quietly. You see?
Kevin: David, speaking of inflation, they understate inflation already, but they also try to manipulate perception to try to keep inflation down. I think of Greenspan, going back to the 1970s. They came up with these buttons that said, “Whip Inflation Now.” WIN buttons that everybody was supposed to wear so that people wouldn’t raise prices. Even though Burns was printing money like mad, everybody was supposed to wear a button and be patriotic and not raise their prices. But even with Hilsenrath, and the article from this weekend’s Wall Street Journal, it was interesting, they’re trying to let people know, “Well, the Fed may have been printing, but they’re going to tighten up.”
David: It’s interesting, you have to watch what the Fed does, more than what they say, because at this point they are printing full-out. In the last couple of months, we actually had them increase beyond the 85 stated, to closer to 110…
Kevin: Billion a month.
David: Yes, and again, we’re back to 85, but that is the suggestion, that they are going to be reducing this money-printing and bond-buying, 45-billion a month in Treasuries and 40 billion a month in mortgage-backed securities. Our view is that the reason they are talking about this, the reason they are suggesting a reduction is that the Fed is trying to inspire private-sector borrowing and spending. Again, what they are suggesting is a change in course.
Kevin: You’d better buy a house, because interest rates are going up.
David: Exactly.
Kevin: Right.
David: And if they did that, it would imply an increase in mortgage rates, and so the suggestion of a change, I think, is the Fed’s verbal leverage to push people off the fence, in terms of making a real estate purchase, taking care of a refinance, doing something that would stimulate growth in the economy. The suggestion should be sufficient, without actions needed. Again, watch what the Fed does, not what it says. We’re seeing the Fed balance sheet expand again, after about a 16-month hiatus. That was very, very significant.
Kevin: Okay, but I have a question, because with low interest rates, we do have some home buying and we do have a lot of stock buying. I say a lot, but actually, the volumes are down, but the prices are up. But what impact would this have? If interest rates actually did go up, would the stock market crash?
David: A change in Fed money-printing could cause stocks to give back 10-20% very quickly.
Kevin: You’re talking 1500 to 3000 points, Dave.
David: That’s correct. The reality is, we’ve talked about momentum players, we’ve talked about trend traders, and basically, high-frequency models which have gotten us this far. Wall Street is largely a ghost town, trading on one-third of normal volume, and half of that volume is high-frequency traders on a good day. On a bad day, it’s 70-80% of total volume.
Kevin: And let’s just take a break real quick and talk about high-frequency trading, because we saw a graphic about what half of a second of high-frequency trading looks like on a single stock – Johnson and Johnson.
David: One-half of a second – 1200 transactions.
Kevin: 1200 transactions. You can look it up on YouTube. You get to see on the graphic, all these exchanges talking to each other. It’s only a half a second that they slow it down to where you can watch, for about four minutes, the trading on Johnson and Johnson. There is no possible way a human being can compete when computers have already, per second, transacted thousands of transactions.
David: Yeah, it’s in the area of volumes that we see some room for a move lower, and momentum carrying prices lower along with that.
Kevin: So what would happen to bonds?
David: Bond yields would also rise, and it’s something the government can’t afford. The first 1% we could afford, but thereafter, that’s when, as a percentage of revenue, your debt service is just too much, because on the fiscal front, you have Medicare, Social Security and defense. These are your three big ones, which are pretty well understood and predictable.
The nonpredictable one is the interest component on the national debt, and that’s where I think you can have some reasonable concerns. Again, bump it 1% and it’s no big deal, the interest component moves higher by 165 billion with every 1 percentage point increase in interest rates. So if you are looking at our current level of interest-only component, you are talking about 227 billion a year.
Kevin: So you add 165 and you are close to 400 – it’s 389.
David: Right, and that’s still less than what we were paying in 2008 and 2011. But numbers at that point, close to 400 – they’re at the outer bounds of what is fiscally manageable.
Kevin: Right. When you have 16 trillion dollars in debt.
David: 16.7. 16.7 – trillion. Yeah, you’re talking about a massive subsidy to that debt. A manipulated rate acts as a massive subsidy. With the current record-low rates, the question is, how far can the Fed allow rates to rise? The notion that they can somehow step away from the market, step away from the bond-buying and a manipulated, fabricated environment for fixed income, all well and good, but it does come at a high price.
Kevin: Well, it forces interest rates higher. If they’re not monetizing their own debt, which is what we’ve been doing, basically. We print it, and then we buy it from ourselves. If you’re not doing that, you have to raise rates, you have to tickle ’em with a carrot.
David: You’re exactly right. Without monetization by the Fed, the Treasury is under the gun to find new buyers, and that is a task that grows more difficult if inflation concerns are increasing and if there is a trend change in the bond market. You mentioned last week the Bill Gross comment that the 32-year-old bond bull market is over. Yes, with an expected rise in interest rates. Yes, with investors wanting to shrink maturities. Yes, with the increased Treasury market rollover risk. So you have Hilsenrath suggesting that the Fed is going to step way from monetization to some degree, but that does create problems for the Treasury.
And so, can they exit? Our view? No. We don’t think that that is possible. May they reduce it? May they do the same thing, but under a different guise? Let’s say, for instance, that the Fed sets up a special purpose vehicle, and that special purpose vehicle was doing the purchasing of Treasuries and mortgage-backed securities…
Kevin: But it was off the books?
David: It was off the books, essentially, and it didn’t show up as a part of the Fed balance sheet. That may go a long way, but still, it’s pocket to pocket. Just because you don’t know what’s happening in the left pocket, and it doesn’t appear that anything is happening in the right pocket. You see, it’s an obfuscation of the truth. That’s the best that they can do at this point.
Kevin: Right. Well, David, let’s face it. Whether they talk about tightening or raising interest rates, or slowing down printing, the Federal Reserve really is stuck between a rock and a hard place right now. The only buyers for Treasury debt, really, are ourselves, down at these rates, and we can’t afford higher rates. So the bottom line is, they’re going to continue to print. Gold will continue to rise.
We had a lot of meetings last week with some clients that have been in gold now 15, 20, 25 years. If you remember the triangle, from what we’ve talked about, the base of the triangle is your gold, the left side of the triangle is your growth income mandate, the right side of the triangle is your cash liquidity mandate. Over time, we have talked to people about reducing their gold exposure at some point, and there is an exit strategy that we are looking toward the horizon on.
David: Part of the necessity here is because of the growth we’ve seen. You could say, well gold is off several hundred dollars from its peak, yes, but most of our clients own gold in the $300, $400, $500, $600, $700, $800, $900, $1000-dollar range. What they have basically done is that they had a third in physical metals, and a third in liquidity, and a third in growth and income, those three mandates you described. They started with an equilateral triangle – now an isosceles.
Kevin: (laughter).
David: The bottom has stretched out, and because of the growth in the portfolio, they have more gold than they need relative to their other assets. A rebalancing at some point is absolutely necessary. So that critical point – when? When do we do that? It’s still, in my opinion, 2-3 years out, although, depending on how we finish this year and head into 2014, we may find ourselves again in that sort of parabolic stage where gold is increasing, with an annual rate of change well over 100% a year, even 150% a year, and a strategy, at that point, has to be implemented on a disciplined basis.
Kevin: And it’s not selling all your gold. We’re just bringing it back down to a third over time, and taking those free profits, talk about legacy investments, and turning that stuff into something you couldn’t have purchased before.
David: Exactly. And I think it’s really critical to see and think – think about what it means to not capture a peak price in gold, but to instead adopt a disciplined approach to liquidations. I’m just picking these numbers off the top of my head, but a part of the portfolio goes at $3000 an ounce. A part of the portfolio goes at $4000 an ounce. A part of the portfolio goes at $5000 an ounce. The greedy would say, “No, I’m not going to sell at $3000 when I could sell it all at $5000.” The problem is, you don’t know what the future holds. Only in retrospect will you know what the peak price was. With the benefit of hindsight, you will be able to say, “That was the ideal time and place to sell.”
You can become very greedy. Even as someone who bought an insurance mandate, you can see your internal motivations morph and become just like that trend-trader, just like that momentum-trader, who sees it now at $3000 to $4000, going to $25,000, or from $25,000 to $50,000, and the imagination plays its tricks, and convinces you to operate on an emotional basis, not on a disciplined basis, not on a rational basis, and that is what we would encourage folks to do.
Certainly, as time progresses, we will know very clearly, where, when, how, what’s next, and again, we’re not there yet. We are still 2-3 years, maybe even 4-5 years away from that event. Perhaps the one difference between this bull market and that of the 1970s – we talked a little bit about 1976. Of course, that bear market started in 1980, 1982, gold and silver, both, and when the bull market ended in the late 1970s, early 1980s, we went into a 25-year bear.
What could be different this time is that we are dealing with a world monetary system which is seeking for a better basis, and we’re in the process of exploring what we need. I think what we will conclude over the next 3-5 years is that the monetary system has to have discipline. What we have adopted, what we have lived with, what we have tolerated since 1971, and the stepping away from the Bretton Woods era, is a free-floating fiat currency system, with only the trust we have in central bankers, and I think we are going to find that’s not enough.
Kevin: And it’s a temporary fiat experiment. We’re seeing it fail at this point, and like you said, this may be different. The last time gold came down, the U.S. government was the largest creditor in the world. We are now the largest debtor in the world.
David: What I’m suggesting is a major devaluation of the U.S. dollar, and to some degree, a remonetization, and I mean to some degree. So what that implies is greater price stability in the future, but that devaluation represents a much higher gold price. If you devalue the U.S. dollar, that’s going to show up in terms of corn, the price of a gallon of gasoline, and certainly an ounce of gold.
Only with gold and silver, probably gold, more likely being remonetized, this is where I think you begin to see, perhaps price stability, not a boom and bust, but a boom to a higher plateau. I like prices today. I think $1321 was the floor, and if we retest $1321 that would be normal from a technical standpoint.
But what we are looking at is the combination of technicals and fundamentals, and frankly, Kevin, fundamentals have not been stronger than they are today, in the last 12 years.
