The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: David, today we continue our conversation with Ian McAvity. One of the things that amazes me is that when you see the world get into crisis, you still have people trusting paper. They still seem to find whatever the most trustworthy form of safety is, in their mind. It could be Treasury bills, it could be dollars. At one point is was euros. We have seen that back when the euro was trusted more.
When is it that we actually see the paper no longer look like a safe haven?
David: This really speaks to old habits being very difficult to break, and the fact that the investment community, globally, looks at the dollar as a great place to go during times of crisis. We agree with Mr. McAvity that it really is an indication of a need for liquidity, more than even a judgment of what is safe, and they need the liquidity, therefore they go there. What they may not know, what they may not recognize, is that what some consider to be safety has actually been degraded through time, and it still is a liquid vehicle. You want to move to the dollar, you want to move to Treasuries? Clearly, that is a good choice for liquidity purposes, but what that does neglect is that there is a safety issue in play, which they may not fully appreciate.
Kevin: It reminds me of a video game that came out 20-25 years ago that we would play called Frogger. It had little items going across the stream, and you had to jump across the stream to get to the other side. There was no one item that you could jump on that you could stay on long, because otherwise you would fall in the water, or it would go off the screen, so there was continual movement. Our paper currency is a little bit like Frogger where you jump on one for a little while, you jump on another for a little while. When, however, do you get to the other side of the shore? And would that be gold?
David: This is, I think, where, when we look at the international banking community, in particular, what you see is that the success of developing foreign currency reserves, and this massive stock of foreign currency reserves that has been built in the context of this most recent modern era version of globalization, success was forged together. But as they look down the pike, they see that their survival is not managed together, it is managed apart.
We are beginning to see that the difference between emerging markets and the developed world is that the developed world owns the gold that they want, and is happy to do something more “creative” with it, but the developing world, as Mr. McAvity said, “7 trillion dollars in liquidity,” is trying to figure out how exactly they manage this liquidity pool in an environment where safety is more and more an issue.
Kevin: David, what you are saying is that some of these developing countries with all these reserves are starting to realize that they need gold. I am wondering at what point the general populace understands the same thing.
David: We are at an interesting phase. Gold and silver are moving back into the limelight. This is certainly where an investor today, looking at what the Fed is doing, has to make a decision. Who do you want to manage your cash balances? The Fed is fixing prices in the bond market. Reflecting on the artificial nature of bond yields today, there is a real cost to maintaining these policies, socially, collectively.
But for the individual investor, is it clear enough yet that a gold and silver exposure is necessary, or do you think that many investors are still going to say, “Yes, but I prefer the euro, I prefer the yen, I prefer the British pound, I prefer the Swiss franc, even a U.S. Treasury holding?” At what point does it become clear that central bankers have it out for the saver?
Ian: I keep wondering about the intelligence level of the world in recent years because to me it is blatantly obvious that gold and silver have always had a role in portfolio structure, but people have fallen for every hoop that Wall Street and the government have thrown at them in recent years, to the extent that people now think that somehow or other, a government guarantee means something. Any of them that went through the MF Global experience suddenly discovered that a government guarantee is there, except if it is going to penalize a major bank, then we will look after the major bank, not the failing firm’s clients.
In my view, the long-term attraction of gold still is that it is the only monetary asset that is universally recognized, that has no counter-party risk. If you have a handful of gold coins in your hands, nobody owes it to you, and it is instantly negotiable or fungible anywhere on the planet. When I watch the games that are going on now between the major central banks trying to prop up the credit bubble system, or trying to re-inflate another credit bubble, I have used the comment a couple of times in my newsletters that when I see this kind of stuff going on, the way I describe it is that when the elephants are on the dance floor having a rumble, the intelligent mouse takes his gold coins and hides in the corner to avoid getting trampled.
And on the other side of the valley, let’s see what paper they are offering to try to entice you to separate yourself from your gold. It may conceivably even be a new currency at some point. I am just very troubled with the direction that they are heading in because layering debt on top of debt is essentially shortening the fuse on a stick of dynamite. They are trying to buy time to try to kick the can down the road, and they are kicking it down the road, but at the same time, one of these times, the field goal kicker is going to suddenly realize he is trying to kick a cast iron block and will break his foot. And you don’t know when that foot breaking incident is going to happen, but I think it is getting a lot closer.
David: One of the interesting things, comparing our last conversation to this one, the bond market was, at that point, yielding 4.6%. It had moved from 3.5 to 4.6. Now we are back below 3% on the 30-year. There is a question of what direction yields will go. You mentioned a Barron’s article talking about the uselessness of gold at about $1000 an ounce, and how lackluster it was as a performer.
I was reminded of that kind of thing, and I don’t remember if it was a Barron’s or a Bloomberg article, in the last few weeks, arguing, “Look, the bond bears are all wet. Rates are down. There is no risk in the bond market, and we see that very clearly. What used to be 4.6%, implying more credit risk, is now less than 3%, and aren’t we all happy? Clearly, there is a bull market in bonds and it is here to stay.”
From a historical perspective, maybe we could talk a little bit about bonds, because looking back at past centuries, and various bond crises, rates were not typically indicative of imminent crisis. Quite the contrary, they reached exceptionally low periods just prior to spiking higher. That was via a combination of PR chicanery and manipulation of the investing public, Treasury intervention, or other forms of manipulation.
Now we have the global bond market putting in new lows. Is it any different this time, or could we begin to say that we are marching toward the Rubicon, if we are not past the Rubicon? What does the bond market tell us, of any value, today?
Ian: The one thing it does tell you is that if you look at the chart, and I tend to track the 10-year rather than 30-year yield, but they are about the same. In essence, when you see the spike down in rates, that is typically the flight to liquidity. They always call it a flight to safety, but it is really a flight to liquidity. In essence, there is still a risk of a deflationary asset value collapse as part of a stock market decline, and in a sense, the deflationist camp would be more focused on that collapse rather than looking at all of the subsequent inflationary measures that they are going to resort to, to try to print their way out of it. In a sense, we are doing that right now, as we have the deflationary and the de-leveraging process under way on the one hand, and they are trying to flood the system with liquidity on the other.
As an example, the QE-3 is allegedly putting 40 billion per month of fresh liquidity into the system, and they are going to commit it all to mortgage-backed securities, as if that is somehow going to do something for housing. It is not going to do anything for housing. All they are doing is arranging a subtle transfer of bad mortgage paper from the existing banks to the Fed’s balance sheet so that they don’t have to mark it to market. Virtually none of that money is actually going to get out into the real world, and that is what we have done with QE-1 and QE-2, as well.
In essence, the Fed is re-liquefying the banking system by racking up national debt. None of that money is flowing down to the street. I think that there is a very real risk that we haven’t necessarily seen the lowest low yields on the long U.S. government paper, because in the event of a very sharp stock market sell-off, people will still revert to buying Treasury paper, in part, for people who are exposed on margin. When they get a margin call, the first thing they do is go to Treasury paper because it has a very positive impact on their margin requirements. So it is not just a flight to liquidity at that point, it also enhances their margin borrowing power to cover a margin shortfall. The low interest rate today just reflects a moment of fear in the other financial markets, in my book.
David: And so, 1¼ is not off the table, breaking through that 10-year, 1.4, on a flight to liquidity.
Ian: Exactly, but it would be a spiky kind of move. It has nothing to do with markets trying to appraise future inflation prospects. Traditionally, we always thought that the bond market was making a long-term forecast of growth and inflation. At this point, it’s not a real market. When we get the imbalances, it’s basically that Geithner offers bonds, the Chinese don’t buy them, so the Fed buys them from J.P. Morgan the following week, so J.P. Morgan gets paid twice.
David: Very convenient.
Ian: It’s a wonderful deal to be the funnel between the U.S. Treasury and the Fed. They get a break by placing Treasury bonds, and what they can’t sell to the rest of the world they sell to the Fed the next week.
David: Has QE-3 and the focus on mortgage-backed securities tipped the hand as to where deflationary pockets still exist? Commercial, residential real estate? Maybe it’s junk bonds and structured financial products, but aren’t they really hitting it where they are most fearful?
Ian: I think it’s mostly the mortgage paper. The national home price index has been bouncing along the bottom for about a year at this point, but it is still back at levels that were reached at the end of 2002. When you look at the total mortgage debt outstanding today versus 2002 when home prices were at the same level, there is 3.8 trillion dollars of mortgage debt outstanding. There is 3.8 trillion more mortgage debt today than there was in 2002.
If that official mortgage debt is still outstanding, it is on somebody’s books, and there is no way that stuff is worth 3.8 trillion. How it is being marked to market, we don’t know, but if that is the aggregate number that is being reported, that is what they are saying it is worth, and there is 3.8 trillion more mortgage debt outstanding on today’s home price level than there was when we first got to it.
To me, that mortgage-backed paper is the devil that is buried in the back of the balance sheets, and I think it is coming to the fore, because that is one of the biggest problems that they have in the European banks. They ate an awful lot of that U.S. issued mortgage-backed paper. I think the Chinese probably did own a fair bit of it. I think they have switched a great deal of it over from agency paper to direct Treasury paper.
David: At shorter and shorter maturities.
Ian: Yes, we are still dealing with the same mess that we had in 2007. They haven’t really fixed much, other than the fact that they have artificially pumped up the bank balance sheets, but I wouldn’t trust those balance sheets too much.
David: We are looking at an additional 9 trillion, or thereabouts, in mortgage debt that exists, or 3.8+, about 9 trillion extra. If there were de-leveraging to occur in that contemporary 2002 and forward vintage paper, we are really talking about something that could impact a far greater stock of paper. As they mark-to-market 3.8, there is a knock-on affect on the additional 9.
Ian: It would be an additional 6. I think the level was around 6 back in 2002. It is now above 9.8, down from about 10.8. There is a huge amount of paper that, quite clearly, when you hear reports that about 25-30% of mortgages are under water, or an even higher percentage, how do you value a mortgage that is under water and in the foreclosure process?
David: Speaking of foreclosures, short sales, loan modifications, one of the things that goes away at the end of the year, in 2013 – there are many challenges coming – but the tax cuts go away, we have the fiscal cliff just prior to that, and we also have the short sale and loan modification issues, where there has been an exemption made on the debt which is forgiven. It has not been counted as income, but that, too, goes away at year-end, just a little bit more sand in the gears. Now, if you are going to short-sale your home, you are under water and you just have to walk away, then all of a sudden you are going to get a tax bill April 15th, I wouldn’t say adding insult to injury, but it is certainly more pressure to the system, and perhaps more pressure than the system can bear.
Ian: Oh, absolutely. They have no idea what they have swept under the rug that is going to come back and bite them. There is all kinds of stuff. And then, just watching the Republican side of the arguments right now, on the one hand we have Romney saying stuff, and then the next day, Ryan is denying it by getting even less specific. So we don’t know what to expect. They talk about how they are going to eliminate all the loopholes, except they are not going to take away this one, that one, or the other one. (laughter)
I’m a Canadian, watching this, absolutely aghast that an economy the size of the U.S. could be cast into a window of such total uncertainty as to what lies ahead. And then I listen to U.S. market commentators talking about what a wonderful bull market it is because Apple is up or something. I just shake my head. I’ve been in business going back to 1961, originally, and I just shake my head and say, “I don’t know what these people are smoking. It can’t possibly be legal.” It’s just mind-boggling.
David: When we come back to your comments earlier about this being reminiscent of a 1968 to 1971 period, we had, through the early 1970s, Jacques Rouffe advising the French that we were playing games and that they would be wise to pay attention to the games that we were playing. They ultimately started taking massive amounts of gold out of our official gold hoard, and then you mentioned the closing of the gold window in 1971. The French and Swiss both figured it out ahead of time.
It appears that central bankers around the world, to some degree, are figuring it out, but 1968 to 1971 was actually very early on in terms of a sentiment change in terms of the gold and silver markets. I am just trying to figure out, if we can: Where are we in the context of this bull market? We tend to think that the first stage is long behind us where the contrarian investor took a position perhaps under $700 an ounce. Wall Street has certainly been interested, and has created a number of products to meet retail demand from $700 to $1500, let’s say. Are we moving into a final stage, or are we more in that mid stage still? Where are we in terms of a historical overlay?
Ian: We are still in the mid stage. I’ve been involved with gold since $35 an ounce. I still, to this day, say that the single most important bull market that I ever saw in gold was in 1968 when the gold pool finally was dissembled and the free trading in gold resumed outside the United States. We had a bull market that ran from $35 to $45, then it came back to $35 a year-and-a-half later. That $10 move was the one that broke the mantle that was put on it by the banking community at that time.
In my view, one way of looking at it would be to go to the Dow-gold ratio. In 1999 you could exchange 1 unit of the Dow to get 42 ounces of gold for it, but when you look back historically, there have been three periods since the 1890s where, at the extreme of the crisis, the Dow-gold ratio traded at 1-to-1, or 1.9-to-1. We are currently at around 8-to-1, which essentially says that the trend that started back in 2000 is heading toward a 1-to-1 ratio on the Dow-gold ratio.
What that says is that sometime in the next, who knows whether it is 2 years or 6 years, but sometime in this decade, gold is probably going to outperform the Dow by a factor of 8. I don’t know whether that occurs at a 5-digit gold price, or if the Dow comes down to meet the gold price somewhere in the 3s or the 4s, I don’t know. But I’m just looking at the historical relationship that when the Dow-gold ratio has spiked, it has been the culmination of the crisis period, and from my studies of history, I am not sure that I have ever seen any prices that have reached quite the magnitude of the one that we are trying to get out of now. I don’t think that this thing has blown its top yet, by any means.
Again, I come back to what percentage of a portfolio is allocated to gold? For a great many people it is still miniscule. Think back to 1999. What percentage of mutual funds portfolios were invested in high-tech internet stocks because everybody in China was going to have an email account? Intel and Cisco were the darlings at the top of that bubble. I think before this gold cycle is done we are going to see the same kind of lunacy for gold on this go-round. We haven’t even started to see that kind of thing yet.
David: 8-to-1. You wouldn’t be discouraged if you had never owned an ounce of gold before, looking at, not the price at $1700 and change, but looking at the relationship to paper stocks? An 8-to-1 ratio, you still think is a reasonable purchase?
Ian: Oh, absolutely. Again, you have to think, it’s a ratio, so think in terms of a semi-log scale. You are basically about halfway there. You have gone from 40-odd-to-1, now to 8-to-1. That is a multiple of 5. To go from 8-to-1 to 1-to-1, you are talking about a multiple of 8. You are not even quite halfway there, relative to the extremes that we saw in 1896, 1932, and 1980.
David: That’s a challenge to wrap the mind around terms of the math, but greater performance ahead, as opposed to what we have seen in the 2001-2002 to the present period. The ratio tells you everything, doesn’t it?
Ian: I’ve always referred to it as the ratio between old-fashioned hard money, as opposed to financial assets, and what we are dealing with right now is that the financial asset bubble of the last couple of decades is coming unraveled. We don’t quite know how it’s going to act in its final unraveling. What history says is that the history of gold as money is that, at the end of the day, it will return purchasing power to people who will protect purchasing power better than anything else.
The idea that somehow we are going to have a 1-to-1 ratio on the Dow could imply a Zimbabwe-type hyperinflation on the one hand, although I doubt that we will get to that any time soon. The potential for that exists, or it could be just some sort of a wholesale collapse of the stock market. I wouldn’t bet on either of those extremes, I’m just looking at the trend and saying, “Okay, I will stick with the trend that is in motion. I am not going to hold out waiting for 1.0-to-1, I can assure you of that, but it’s a question of just watching it. I would say, with some long-term moving averages, there’s a discipline coming in behind it.
David: This is a compelling story and I think it is one that should be followed up on. I look forward to seeing you down in New Orleans in the next couple of weeks, and, as always, I look forward to your newsletter, Deliberations on World Markets. Thanks for joining us again today, sharing your insights and historical perspective. Your activity in the market has taught you many, many things, and informed your instincts in ways that certainly a young buck would do well to learn from, so I appreciate you sharing with us.
Ian: It has been my pleasure.
Kevin: David, as always, Ian is a very interesting guest. I think it is interesting that in the last two weeks that we have listened to Ian, he has covered a lot of different subjects, and the Dow-gold ratio is one, and I would like to talk about that in a few minutes. But something that was fascinating to me, because you have had me study this, and you have had the office study this, was that period of time while we were on a gold standard, from 1968 to 1971, when certain countries around the world started to see it breaking down. Jacques Rouffe had instructed Charles de Gaulle to get as many dollars converted to gold as he could, because it wasn’t going to last.
David: The idea of being paid IOUs with greenbacks instead of gold coins or gold bars was a very scary prospect for Rouffe, and it wasn’t only de Gaulle, but it was also the Swiss, who started saying, “Something is afoot, here. There is a major change, and we could be on the side of this where we get short-changed.” So they were very active, very pro-active, in taking gold and having it distributed to them in Europe.
Kevin: Strangely enough, that was a period of time when Johnson had said, “We’re going to be printing money to pay for these things.” And Ben Bernanke is saying the same thing right now with QE to infinity.
David: What Ian is suggesting is a unique perspective, because what he is really implying is that the international community is in the midst of recognizing something that is going to change, something in the monetary structure which is going to change, because that is, in fact, what was happening during that 1968 to 1971 period, and it wasn’t something that you necessarily discussed at cocktail parties, it was something that you discussed behind closed doors, because there was a strategy that had to be put in place, and orchestrated, without tipping your hand as to what it was, exactly, you were doing, or why you were doing it.
Kevin: Is this similar to what we see the Chinese doing right now? They have an official amount of gold that they say they own, yet you were just in Hong Kong, David. You saw the flows of gold that are not being reported. There is a whole lot that is not going onto the balance sheet right now.
David: And beyond China, it is the developing world which has massive amounts. Again, they have benefited from trade surplus dollars all these years.
Kevin: So they have trillions.
David: Exactly. It is this shift, and I think it is important to remember that a shift in sentiment is something that is almost imperceptible. You can go from being a skeptic one day to being a believer the next, and a skeptic would say, “We don’t understand, necessarily, the source of our bias, but we don’t think that we want any gold, and we don’t think that it is necessary,” and you can, over a 6, 12, or 24-month period, find yourself in a camp that sees it as absolutely necessary, not necessarily understanding how you went from being a skeptic to a believer.
I think that change is afoot. We are watching the international community, again, participate imperceptibly, with a shift in sentiment. What was negative sentiment toward the “barbaric relic,” is shifting to positive sentiment, but it is not in the developed world, it is in the developing world, and it is central bankers there who actually have the money to divert from other fiat currencies, be it the euro, the Japanese yen, the U.S. dollar, to a hard asset, in part.
Kevin: For the person who wants to read the book, The Monetary Sin of the West, by Jacques Rouffe, it is about that period of time in the 1960s when the international community started to get a hint that the gold standard wasn’t going to last much longer, and they started loading up quietly on gold. That book is fascinating. We have it in our resource section at mcalvany.com. For a person who would like to read it for free, it’s a lot cheaper than the very nice used version you bought me, which was close to $200, but well worth reading. If this is a situation that is repeating at this point, where there are people quietly accumulating gold, in the past, Jacques Rouffe was vindicated in the end.
David: There are two more things that we should comment on from this ongoing conversation with Ian. One is that the central bank motive for having a part of their resources in precious metals is actually very similar to the sophisticated investor, in the sense that they are looking for a monetary asset, something that provides both liquidity and safety, not just one, but both, and does it without having counter-party risk.
As Ian said, that is where gold is a standout in terms of a reserve asset, and as a monetary asset, in the modern era. This point is critical, and I think it is one that can easily be lost on the man on the street, because “What even is counter-party risk, counter-party exposure? That doesn’t even compute? I’ve done banking business with the local bank down the street for 50 years.”
Kevin: Never lost money.
David: “Never lost money. Never considered who my counter-party risk was – the idea that that bank could go under, or that one of their lending partners could go under, and that would have a ripple effect into my world.” And yet we do have real world, real time, experiences over the last 36 months, of institutions which were bullet-proof, now left as bullet-riddled, in debt.
Kevin: What is amazing about a person who does finally experience that counter-party risk in a bad way is that it is a profound change in their life. They never trust anything that is paper again. I think about the people who lost money on MF Global here recently. They were stunned. For most of them, it has never happened before, but from this point forward, it will never happen to most of those people again.
David: The second part, I think, is interesting. One aspect is, who is buying gold? It is the sophisticated investor concerned with counter-party risk, and a central banker who is also looking at credit risk in a very different light, and certainly that will accelerate over the next several years, but, and this is point number two, it is this Dow-gold ratio that is compelling from a growth standpoint.
We often look at gold from the vantage point of insurance, and I think that is the healthiest position to take. But as an insurance policy, something that is insuring your purchasing power on an ongoing basis, you can look at your purchasing power in currency terms, which really limits your ability to see what it has done for you, because all you are doing is looking at it in terms of nominal appreciation or depreciation.
Kevin: But that currency is going down in value, whereas if you measure it in something else…
David: Stuff. The stuff of a company. The stuff of acres. The stuff of single-family homes. And look at your increased purchasing power in those terms, and it is compelling. It is difficult for me, I think, to see the 1968 to 1971 period as an exact replication here in this period, except that I am reminded by Ian that the international community is behaving very similarly.
As skeptics moving to the position of believers: “Maybe we do need gold.” But having said that, from an investor standpoint, we have gone from a 43-to-1 ratio, Dow-to-gold, a cross-section of the Dow buying 43 ounces of gold, and now buying 8 ounces of gold. That 5-fold increase in purchasing power, as compelling as it may seem, pales in comparison to the 7-8 fold increase in purchasing power.
Kevin: You go from 8-to-1 down to 1-to-1.
David: Immediately in front of us. I think this is where, for someone looking at $1775 in the gold price, anything short of $2000 and saying, “It seems rich.” Well, rich relative to what? Rich relative to its nominal value in dollars terms, yes, but in terms of its ability as an asset to preserve your purchasing power. The journey from 8-to-1 to 1-to-1 is far more powerful – the benefits derived are far greater – than anything you have seen in the last ten years. That is worth pondering.
Kevin: David, it is interesting, there is somebody that I know who has been in the precious metals business now 26-27 years. He says it is just simply like this: There are two types of people. There are those who buy because they fear the system is broke, and then there are other people who are buying to try to make money. What you are saying is that there are two audiences right now, and there is nothing wrong with being a little bit of both.
David: Exactly. We have the central bank community, which is beginning to change their sentiment toward gold. We have the investor community which has looked at gold and said, “Why would we own it when we can own things that are far more sophisticated and fancy? We don’t need the barbaric relic, and they are in the process of changing their tune, on the basis of a 10-year track record.
But then you also have the concerned party who says, “There are issues which the system is not addressing and we fear that there is a comeuppance, someway, somehow, somewhere, and we don’t want all of our assets exposed to the vagaries of the market.
Kevin: David, this is why you have preached over and over, rehearsing an exit strategy, because at some point that insurance position grows to excess as you get toward the top of the market. Let’s say that we are nearing that 1-to-1 ratio on the Dow. The person who owns gold is going to love it at that point because it has done so much for them that they, at that point, also have to start making decisions elsewhere.
David: And as Ian has said, you don’t wait for the perfect number. You don’t rehearse for perfection. We are talking about a very messy world. We are talking about a world that is full of concerns, and even stresses and strains, in an environment where gold and the Dow are trading at a 2-to-1, or even a 1-to-1 ratio. This is not a world where you are making very clear-cut decisions. It is a world that is very, very concerning, and very, very disturbing.
And you need to have already rehearsed those decisions, as you say, but this is classic. We have seen this three or four times in this century where the advantage of owning physical assets and making the transfer to paper assets, has been profound.
We have talked before about the Bass Brothers making that transition, where the Hunt Brothers did not, and they recognized a change in the market which was going to put an end to the rise in precious metals. That was Fed policy in the past. That was different leadership in Washington in the past. We don’t have that today. We don’t have anything in the next 3-4 years, which is any semblance of a Volcker/Reagan combination to restart the system.
Kevin: But maybe there is light at the end of the tunnel.
David: And there is, but I think we are talking about 2015-2016, and a long journey from here to there. Do you have the plan in place? Have you rehearsed your strategy, here in the present tense, and into the future? This is something that needs to be done today, not tomorrow.
