The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: I was looking at the number, Dave, and over the last several days, the U.S. mint has sold more silver American Eagles than in the entire month of July. We are talking several million coins. Somebody must know something, even though prices have been going down.
David: Here is the contrast between the way futures traders feel about the market, and actual demand for the metal, itself. You have sentiment for gold, for instance, which is at a 27-year low.
Kevin: It’s incredible. 5% isn’t it?
David: Yes, exactly, 5%. That’s daily sentiment index for gold. It registers a 27-year low, and yet, we are seeing physical demand for the metals. But in the futures pits, what’s the sentiment? The price is going down, and it is going down further. There is a different kind of investor that looks at it and says, “I like ounces. I’ll be adding to ounces. If you are going to give them to me cheaper, that means I have to spend less money for the same ounces; this is beautiful. Or, alternatively, more ounces for the same money.”
Kevin: We talked about silver. That is not excluding the gold side. They are also hitting record numbers of sales on the gold side, as well. The beauty of being able to see both markets – you can see the futures market and you can see that they have driven the price down, and maybe they will drive it down a little bit lower. We get to see the physical market. We see that we have demand. We see the demand going over to China. We see the demand also going over to India and Russia. We get to talk to our clients. Probably the best questions that are asked are, really, not what you find on financial TV.
David: That happens every day, just in the course of our daily operations we have great questions that are asked, and I would just mention that over the last 6-7 years of doing this weekly commentary we have had a special time of the year, toward the third or fourth quarter, where we have a segment called, “Your Questions Answered.” We at least take a stab, or an attempt at, addressing either your questions or inquiries about everything from politics to geopolitics. In some instances, clearly, it would be out of our depth, and we can refer that to one of the guests that we have, subsequently, on the program, and try that and make sure that those are answered. But we look forward to that, and what I would encourage you to do as the listening audience, is go ahead and write down your questions over the next few weeks. We are going to take the next 2-3 weeks, and we will remind you next week and the week after that, to be sending in your questions, and then as we head into the month of November, we will address those in the weekly commentary.
Kevin: And those questions can be sent to mc******@mc******.com.
David: It doesn’t matter if you think it is a big question or a little question, any question is a good question as far as we are concerned. And if your question ends up being very similar to another one, we may not read it off, precisely, but we will have them grouped together in that way. We look forward to getting them. It proves to us each year just how remarkable our audience is, how engaged our audience is, in almost every field of endeavor. We appreciate you, we appreciate your curiosity and questions, and we will do our very best to get you an answer to those here in the next few weeks.
Kevin: I’m going to jump right in. A question that we often have coming in is, “How far can gold go down before it goes up?” Or, “How far can the equity market go up?” Let’s talk about the equity market, the stock market, right now, because it seems that is where everybody is.
David: We may be near peak levels in the equity markets that represent the high water marks that hold for years to come. You may recall that the long-term peaks that we have seen over the last hundred years have held for a decade or more, which would come at a very inconvenient time for retirees, for baby boomers, if we were to see a severe market selloff.
Kevin: Until this year, this was called the lost decade. From the stock market point of view, we lost ten years of growth in the stock market.
David: That is exactly right. If you are looking at the performance numbers from the year 2000 forward, gold is up 230% even with a severe correction. The S&P and Dow, call it 25-30%, and that includes, of course, the benefits of last year’s growth, and this year’s growth, which have kind of put it to those positive numbers. Otherwise, you are, as you describe, looking at a lost decade. The reality is, we have seen a deterioration in the economy. We have seen a deterioration in credit flows, an expansion in money and credit. We have seen dead incomes for better than 15 years where we have not seen income growth, so we are not getting the kind of economic energy that would drive or propel stock prices higher, although we have had monetary energy.
Kevin: That’s the printing of money, Dave. There is no productivity there, that is just pure printing of money.
David: Back to that issue of it being an inconvenient timing for retirees and baby boomers. The recovery in equities thus far has put back and changed some of the extreme pension funds which were underfunded, and you could say, pitiful, a bit of a joke. But on average, if you are looking at state pension funds, they are still about 40% underfunded at present, and that is with the benefit of a major asset price increase. So valuations on stocks, theoretically, can move to extreme levels that would parallel the year 2000, and yes, that would imply higher stock market values from here. But we anticipate weakness over the next several months, which should extend into several years of consolidation, so if we were to just take a guess, our first stop is 14,500 on the Dow, somewhere between 14,500 and 15,000.
Kevin: So, we are talking, from around 17,000 where we have been at, down to about 14,500?
David: Yes, and that actually, although it sounds like it is a big decline, is a modest decline. A more thorough decline would take us toward 12,500, and that is only a 25% decline, whereas significant declines over the last 10-15 years have been closer to 50%, not 25%, and that is what makes this last five years such a remarkable period of time. It is five years with nary a 10% correction, and again, compliments of the Fed, you have had artificial inputs which have smoothed out the downside, as and when we do have a correction, and the tendency to see a decline in equities has come at the end of QE-1 and QE-2. Here we are on the cusp of QE-3 being wrapped up, and it doesn’t guarantee that the stock prices of S&P, Dow, and NASDAQ go down, but should we see that margin debt number, for instance, begin to accelerate liquidations and we could have a cycle of reinforced selling, a 50% decline that rivaled 2001 or 2008-2009, what we have seen two of already in the last 10-15 years, would have the Dow breaching 10,000.
Kevin: You bring up the Dow. Let’s say that we are with the Federal Reserve, and we are looking at indexes and we are saying, what are people watching? Because we can’t control everything, so let’s go ahead and make sure the Dow is looking good, or some of the smaller indexes. But Dave, when you broaden your scope and stop looking at the small dials on the dashboard, you start seeing that some of these stock indexes have been falling now for a while.
David: What is interesting is that there is less participation, and I am not just talking about volumes, which we did cover a few weeks ago. We are talking about new highs that are being set. If you look at the number of stocks that participate in an index, and you see the index rising, you assume that everybody in the mix is doing pretty well. Quite to the contrary, what we have seen is fewer and fewer of those companies pushing to new highs. In other words, you have this divergence between a few large companies that continue to press the index higher, but with a larger number actually beginning to fade.
Look at the dominos that have already fallen, and maybe we could look at this in order of quality, from the lowest to highest, or market cap, from smallest to biggest. You have the Russell 2000, which is a small cap index, just small companies, small capitalization, very small market value, and they hit a peak in early March of this year, and they have been in decline ever since. Now we have right around 50% of the companies in the Russell 2000 which have already declined by more than 20% from their peaks, and according to the mandarins of our day, they would say, “Okay, well, there you have it. A 20% decline from peak? That defines that you are in a bear market.” So you have half of the small cap companies already in bear market territory. You have utilities, which had a closing high at the end of June and are no better since then. You have the S&P mid-caps, the S&P 400, not the S&P 500, which are your biggest, biggest companies. Guess what? They peaked in early July.
Kevin: Even the Dow seems to have maybe put in a peak.
David: It peaked September 19th and we will see if that holds or we take that out. In addition, when we were talking about small caps, we could have also talked about high-yield bonds in terms of the quality categorization. High yields have been in decline for two months, and this is what is really interesting. Just as in 2008, gold and silver have sold off up front, potentially leading the entire financial universe to lower levels, and if you recall, it was only gold which recovered in 2008 to finish positive for the year, but as a leading indicator, as something that said, “Hey, wait a minute guys. Everybody is getting liquid and it doesn’t matter what it is, if it is not nailed down it is getting sold.” Everything started to sell off in the early fall of 2008, again, with a healthy recovery by the year-end for gold.
What does this say to us? What are the markets telling us? If we had to boil this down, could you boil it down to two words? Everybody remembers the shortest verse in the Bible, right? Jesus wept. Two words today: Be cautious.
Kevin: Dave, if this was just a game and it was just for Wall Street people, it wouldn’t be so important, but we are talking about a large percentage of household income right now is in the stock market. It gets huge right before we usually have a crash.
David: So be cautious. Have cash on hand. Offset your Yellen management of the cash position that you have. If it sounds like I am talking out of both sides of my mouth, well, maybe I am. I am suggesting you increase your cash position, I am also suggesting that you have sufficient insurance on that cash position. Because listen, we have the usual central bank foibles which require a precious metals hedge.
Kevin: Yes, it is important to be cautious. I remember 2008. We talked about questions that our clients had, and some of the questions that were coming in in 2008 because the stock market was peaking and falling, gold was falling, and the question was, “Wait a second. I thought gold goes up contrary to the stock market. Sure enough, it did. We saw the same thing in 1987. We saw gold come down a little bit, and then end much higher in the October crash of 1987. We saw the same thing in 2008. So, what you are saying right now is that the stock market seems to have been putting in some peaks. It could go higher, but gold being down is not a reason not to own gold. It is a form of owning cash so that when the crash comes, even if gold does go down slightly, or at the same time, it recovers, typically, much quicker.
David: And it recovers for the right reasons, because people are thinking first in terms of liquidity, and second, in terms of quality. Liquidity is, in any sort of a deflationary scare, at least, your first priority, because you haven’t really sorted through what debt obligations you are going to keep or not keep. There are times when investors just say, “I’m going to have to let that go,” whether it is the second car, or the boat, or you say to yourself, “Do we really, really, really need the second home?” There are hard financial decisions that are made, but you begin to prioritize. On first blush, people look at all the debt obligations they have, and they try to keep all of the debt obligations in motion because they assume, with a very positive attitude, that this, too, shall pass, that this is a short correction, not a big deal.
Kevin: So they will burn cash. They may even sell gold because it is so liquid.
David: In order to raise cash. And that is the point, that an initial hit is not something to be scared of, because what you have is a reappraisal shortly thereafter. That reappraisal is critical. This was sort of dinner table conversation growing up because we talked about the merits of owning gold, we talked about how it performs in an inflation versus a deflation. My dad’s argument was that gold is a metal for all seasons. In a deflation, even if it has an initial selloff, people come back to it, flocking to it, when they begin to see systemic risk, when they begin to prioritize the debt payments that they are, or are not, going to make, and realize they need something that acts as an anchor to windward in the context of financial chaos and a financial storm.
Kevin: Dave, you were talking about how a stock market selloff could be substantial. But if you look in any year that the stock market had a crash, usually the percentage of stocks to household assets was about a third or more of the household assets. Aren’t we there right now?
David: Yes, that is consistent with high valuation, so if you are talking about cyclically adjusted price earnings ratios, which are high, but not extreme, these are all numbers which could go higher, but again, what you just mentioned, a percentage of household assets which were made up of stocks and mutual funds, these come from Federal Reserve reported numbers, and right now that is 34.4% of household financial assets. That is, stocks and mutual funds make up just over a third of household financial assets. There is only one number which ever has registered higher and that is the year 2000, when it was 39% of household assets.
Kevin: And that was right before a crash.
David: Precisely, which was in mutual funds and stocks. So, we are close to all-time records. Of course, they could go higher, but we are awfully close already, both in nominal terms, and as a percentage of GDP, we have talked about margin debt, which has exceeded all past records. So, what are you looking for, as a bargain-hunter? What did we discuss a few weeks ago as exceptional values? The reality is, they are few and far between. Look at sentiment. Very high sentiment in the stock market. Contrast that with what we mentioned about gold in our first remarks, very, very low. And so, you look at high sentiment in the stock market, you look at high valuations, you look at the absence of bargains, and as an investor, what am I looking for? When people hate stocks, companies have suffered through a bear market, you usually see that household number between 10% and 15%.
Kevin: And that is when Buffet is buying. We talked about how Buffet, for the last two years, has been sitting out this market.
David: That’s right. So, fear dominates the market. In that environment, the vast majority have lost money. They are, in a demoralized fashion, throwing in the towel, and that is what Buffet described as irresistible value. What do we intend to do at that point? Swapping ounces for shares, I think, in that environment, would provide an exceptional increase in purchasing power, and an exceptional expansion in terms of a family’s or individual’s financial footprint. Currently, we have the pendulum at the wrong end to consider that kind of a move. Again, you have low sentiment in the gold market, very high sentiment in the stock market, high valuations in the stock market, percentage participation, percentage ownership in terms of household assets, again, 34.4 versus a peak of 39.4. Maybe we get there in the next reported number. Maybe we are actually marching there as we speak, because of course, these numbers are reporting a past state of affairs. We may be at 39 now, but history will tell us better if that is the case.
Kevin: I think it is important sometimes to not look at the last peak on gold, and measure everything from the last peak, because if we were just measuring the Dow, in gold, like we have discussed in the past, back in the year 2000, Dave, it was 43 ounces of gold. That is what the Dow was worth. Today, the Dow is only worth about 13 or 14 ounces of gold, but the greater move, actually, mathematically, is ahead of us, because you go from 13 or 14 ounces-to-one, to maybe 3-to-1, or 2-to-1, that is larger than the move from 43-to-1 down to 14.
David: That is right. In terms of a multiple expansion, in terms of that increased financial footprint, as I like to describe it, that is a trend we expect to reassert itself with the Dow-gold ratio shrinking considerably into 2017, and yes, gold improves one’s purchasing power in that environment. By the way, that is entirely consistent with every period of past deflation in the last 600 years, where gold increased your financial footprint considerably, and many are concerned that that is something to be worried about.
Kevin: Dave, before the crash that we had in 1987 and then 2000, and even in 2008, there seemed to be a strong hopefulness. You had people watching CNBC and all the financial TV, saying buy this tech stock or that tech stock. I remember back in the late 1990s there was just such a fervor for watching financial TV. CNBC is searching for anything to talk about right now, aren’t they?
David: They’re searching for anything to talk about because their ratings are at 21-year lows. Basically, viewership has dropped off a cliff.
Kevin: And not a reflection on you, Dave. I know that you are a guest on CNBC every once in a while, and I am sure their ratings go up.
David: Thank you, I appreciate that. But what is interesting is, you have this contrast with past peaks where the public was, as you describe, exuberant, hopeful, and the environment today is not one of exuberant hopefulness and expectation, it is one of desperate hopefulness. Because again, you have baby boomers who are starting to jump ship from the work force in earnest this year, and they need to capture the growth of the last several years to fund their retirement income, and supplement their income with this sort of nest egg of savings in retirement accounts. CNBC ratings tell you that people are already nonplussed with, uninterested in, the markets, and if they are participating, they are doing so with a lot less time spent day trading and playing volatility than they were in the late 1990s.
It is a participation that is somewhat of a forced participation in the sense that they don’t have many other options. Frankly, they would rather be in bonds today, they would rather be in CDs, because they are getting ready to retire and they would like to toggle back that risk metric, but guess what? There is no income to be had. There is nothing that is happening in the world of CDs and fixed income, so, reluctantly, they are there. The CNBC ratings, I think, are very telling, because for their ratings to be at 21-year lows, and viewership to be abysmal, it just says that there is a different kind of backdrop, and should we see a market decline in equities, it is going to become not just a little flood, but a deluge of Noahic proportions.
Kevin: If the stock market, even though it has been hitting new highs this last year, is a snoozer, lest people are watching on CNBC, I have to admit, Dave, this unseen hand on top of the gold market, talk about a snoozer, as far as prices go. We had a little bit of gains; now we are coming back down to where we may end the year just about where we started the year.
David: Right. We are playing with the cyclical lows of 2013/2014. We have basically not lost any ground from the beginning of the year, but we have given up the gains from the first quarter or two of the year. Again, this goes back to what we were describing earlier, the sentiment indicators. If you go to tradefutures.com you have your trader sentiment on these items, and it is worth noting, the market extremes, because on the one hand, you had, in August in 2011, with gold setting new all-time highs right around 1900, listen to this: 98% of traders were bullish. These were traders in the futures bids.
Kevin: All but 2% were saying it was going to continue up?
David: That’s right. 98% of traders were bullish, and guess what happens? At 98%, quite simply, we ran out of buyers shortly thereafter. And what happens to any market when you run out of buyers? We see, as of the September 19th date, gold near $1200, 5% of traders are bullish. This is one of the lowest readings ever, and I think it is reasonable to ask, just as we ran out of buyers at the top, are we running out of sellers? And I think we are very close to that. Obviously, there is speculation which abounds about the idea of lower gold prices, and I think that is worthy of comment.
Kevin: There are a handful of commentators right now that continually point out deflation, and somehow tie the price of gold to a deflation. I think, errantly, they will say, “Look at copper prices,” or, “Look at lumber prices. Look at the prices of other commodities.” They treat gold like a commodity, but you have pointed out in the past, many times, that deflation is actually the environment for gold.
David: Well, this is wonderfully complex, and the ideal scenario for a gold owner, although it is a multi-step sequence in terms of the rationale. Deflation improves your purchasing power. Think about that just in cash terms. If you have $100 in your bank account and the price of assets is going down, guess what? Your $100 goes further. In past periods of deflation, the 1930s, and stretching back into the 19th century, the 18th century, the 17th century, going back 600 years, what you find is that your reference point for cash was not actually greenbacks, with nothing but the central bank promise backing it.
Kevin: They were a receipt for gold.
David: We were talking about cash and gold being one and the same thing. So, your purchasing power did improve in the context of past deflations, but in every instance of past deflation, gold was money, money was gold. The move toward money was a move toward gold.
Kevin: We have not had a deflation when we have been off the gold standard; am I right?
David: That is right. So, there is a misunderstanding in terms of the history of money, and perhaps the nomenclature. You are moving gold into a commodity category, which is to separate it out from the role that it has played for 5000 years, and say, “Oh, no, something is very different since 1971. It has to be treated as a commodity, not a currency, because in 1971, didn’t you know that Richard Nixon disconnected gold from the currency world?” Well, I’m sorry, an arbitrary decision to disconnect gold from the currency world does not eradicate, or make it irrelevant, in terms of its long-term role, past, present and future, in terms of the world money system.
Kevin: So, it is good to measure things, anything, whether you are buying a house, stocks, or whatever, in ounces of gold, and see if you are gaining buying power or losing buying power. Whether gold is rising or falling in dollars, that is irrelevant.
David: We had Sir Charles Vollum on the program a few years ago, and we have had some great private conversations, a couple of different places around the world where we have met up. His website, priced in gold, gives you a real insight into the fact that we have already been through one of the worst deflations in recorded history. If you treat gold as money, as I think you should, you will see that the cost of things has come down considerably for the saver in gold ounces.
Kevin: Relative to ounces of gold.
David: Right. You may be concerned about deflation and concerned about the nominal value of the gold price. Go to Priced in Gold and study every one of his charts, and what you will see is that, actually, the gold owner has done quite well, and I think, will continue to do quite well in terms of an improvement in purchasing power. Vollum would echo our sentiment that at a certain point, you spend your cash on assets that are dirt cheap. When does that transition occur? When you are selling ounces for other assets?
Kevin: Right. And you are calling cash ounces of gold.
David: Precisely. And I think that is still in the 2017 to 2018 timeframe, maybe it is 2016. But, listen, we don’t know how this history will be written in specific details. We do know that once currencies were unhinged from gold in 1914, since then we have experienced all the episodes of hyperinflation in world history.
Kevin: Wait a second. There have been high inflation episodes with Rome, and with Greece. Are you talking high inflation, or hyperinflation?
David: Hyperinflationary scenarios.
Kevin: What is hyperinflation, then?
David: We will discuss this in detail in the coming weeks with, frankly, the expert on hyperinflations. He is from the University of Basel in Switzerland, Peter Bernholz. Simply put, you have monthly inflation rates of 50% or greater; that is how he would define hyperinflation – monthly inflation rates of 50% or more. And he would say we have had about 30 of those in world history, and they all fall from 1914 to the present day. All hyperinflations in world history fall within the context of fiat money and the failure of faith, again, all within the last 100 years. So, yes, you have the preconditions of a massive budget deficit, you have loose monetary policies, those are common elements. But we will explore some of that in greater depth with Peter here in the next couple of weeks.
Kevin: We have to define the difference between high inflation, inflation, and hyperinflation. A 50% or greater rise per month, that is hyperinflation, but that is never caused by growth in an economy, that is a loss of faith in the currency, isn’t it?
David: Right. And most of your Wall Street guys and gals, analysts on the street, some of my best friends, would say, “Hey, listen, we don’t see any wage inflation, therefore we will not have inflation.” And that is all well and good, that is one way to get to higher rates of inflation, to see wage increases first. But that is not always what you see at the front edge. As we will explore with Dr. Bernholz, that is, actually, not where your hyperinflations come from. Your hyperinflations are sourced very, very differently. So, the monetary mandarins of our day, the central bankers, would like to keep the masses mesmerized, and what are they doing that with? They are doing that with theatrics, they are doing that with euphemisms, they are doing that with sleight of hand, in terms of changing the definitions of words or referencing old concepts as new things. Let’s face it, we know that debt monetization has been a cause of super-inflation and hyper-inflation consistently through time.
Kevin: But we don’t do that. We quantitatively ease.
David: We quantitatively ease. We don’t monetize debt. Literally, that’s what we are talking about, theatrics and euphemisms, verbal sleight of hand, and the general public says, “And that’s right, we have no, nor will we have, inflation into the future.” Listen, just a little side note or diversion. What I have tried to do is, over the next couple of weeks I want to set up a discussion between Peter Bernholz, on the one hand, and one of my favorite interviews that we have each year, once a year, a friend of ours, Russell Napier. He will join us to discuss deflation and the structural changes in the current account deficit and the highly probable collapse of emerging market economies, in what he feels is sort of the sealing of the fate of the early 21st century. This part of our economic history will be one of the most extreme deflations on record. Now, if any of you are hyperventilating, he has an interesting conclusion here, and that is that central bankers are no longer prudes when it comes to money printing, and this remains the long-term outlook. Deflationary collapse, triggering central bank activism on a scale never witnessed globally, and in concert, because now we are not talking about just the Fed, we are talking about a variety of central banks all operating in the same vein.
Let me ask you this. When the globe is experiencing a money-printing mania, all at once, where will the smart money already be?
Kevin: Right. Well, we are seeing it, Dave. It is not the small stock trader who is buying gold right now. These are the large governments that are preparing for this very event.
David: I have a family member, one of the smarter gentleman I know, if you could just measure a subset of IQ for business acumen, this is a guy who has been successful over and over, and over, and over again. He loves operating businesses, and he is very good at operating businesses, and he is very good at seeing potential growth, and getting in early, and getting out before it is too late. It is interesting, because I had a conversation with this family member, a distant relative, and he said to me the other day, “Dave, you know, I am thinking about making a major acquisition of gold.” And I said, “Well, you are not alone. The number of large purchases of 400-ounce good delivery bars is on the increase, considerably.” What is that an indication of? Big money interests, very wealthy individuals, basically saying, “I need X percent in gold, and I don’t care what the price is. Frankly, I don’t care if the price goes up or down, I just want ounces because it is a real asset.” And I think, frankly, it has probably gotten too cheap. Suffice it to say, I lose more sleep over not owning enough ounces than over the short-term volatility in the metals market, and that short-term volatility is driven by good men and women of the world, at central banks, with wingnut theories about what drives long-term sustainable economic growth.
Kevin: In our conversation last week with Joseph Tainter, he was talking about how a system can become so complex that nobody, actually, can exit the system. When you are talking about these central bankers, and we have talked to them here on the show, I think a lot of times they are doing the very best they can in a system that they know is not going to sustain itself forever.
David: Right. So, you are basically doing the best you can with what you’ve got.
Kevin: Well, how about Mario Draghi, then? Is he doing the best he can with what he’s got, or is he just insane?
David: Last week he offered up 1.3 trillion dollars in assets to be purchased, and the market was not particularly impressed. Anymore, what it takes to impress the market, it is like going to a downtown urban venue where crack addicts need more and more to get the same job done. If you are offering the same old trillions, it just doesn’t do it anymore. You are not going to excite me.
Kevin: He’s like, “Hey, let’s buy some Greek debt, let’s buy some Cypriot debt, let’s buy from Cypress.”
David: And that actually stirred some concern, of course, amongst German voters, because what is he really talking about? To buy Greek and Cypriot debt you are talking about buying stuff that does not have the credit standards, the credit credentials, to act as quality collateral for additional loans from the ECB. Let’s back up here. We are talking about the ECB saying to banks that are sitting on garbage paper, but need fresh liquidity, “What you can do is, you can take your garbage paper, give it to us, and we will give you fresh loans. And we will just use that garbage paper as collateral for the loan. We don’t care that it is garbage, because we are going to make up the rules on our own terms, and for your benefit.”
This is what some have described as the equivalent of a bad bank proposal. They are attempting to take the debt that could never be accepted as collateral, for even more loans to free up liquidity for those financial institutions. This is what I would describe as the clothespin proposal. (laughs) Just hold your nose and spend the money, other people’s money, of course, and fresh off the printing presses. This is why you have a lot of German voters, and German politicians, frankly, who say, “Hey, wait a minute. Is that the role of the ECB? Wait a minute. We are the largest contributor to the ECB, and we are the legitimizer of the ECB.” As you recall, the German mark was the most stable currency and was the necessary lynchpin to make the European Monetary Union work in the first place.
And they are concerned. They are very concerned because they are dealing with all kinds of issues. Not only do the Germans not want to subsidize Cypress, and subsidize Greece, but they have their own issues. Inflation is sliding again. 0.3% is the most recent number. That’s in the euro area for September, 0.3%, that is the lowest in five years, and that is with a lot of efforts to try to boost inflation. And yet, we are seeing this sort of deflationary trend in Europe, regardless. We have industrial production in Germany; industrial production numbers dropped in the most recent report, the most since 2009. It was a greater than 4% decline. So, there are reasons for Europeans to worry. The answer does not lie in debt monetization.
Kevin: Yes, it seems like liquidity, liquidity, liquidity. It is the helicopter answer, every single time. The only way they are getting away with it right now, Dave, is that people still have faith in the currency, to some degree.
David: You have a lot of investors and asset managers who have surmised that the ECB is going to back the asset markets, particularly Mario Draghi, with his background at Goldman-Sachs, who knows how to butter everyone’s bread, and he is going to back the asset markets and create a wealth effect by boosting liquidity, backstopping the credit markets, and they have assumed that the markets in Europe are a one-way bet.
Kevin: There is that certainty, again, that we have talked about.
David: Right, and a certainty based on a faith in the ability of the central banker at the helm to deliver, and there is so much money today, tens of trillions of dollars, bet on the success of a few frail men.
Kevin: Let’s say that you are in that position, Dave, and you don’t have to satisfy voters, you just come in and say, “I’ve got a solution.” What would your solution be?
David: Allow unhealthy loans to go the direction the dodo bird, allow them to fail. You have to stop increasing moral hazard. Allow those debts to be liquidated. Setting up a bad bank, all that encourages investors to do is speculate further in riskier asset classes, because they know there really is no consequence to taking greater risk. The whole concept in investing is that the greater risk that you take, in theory, there is a greater reward. But what has happened with central bank intervention – the Fed, the ECB, the Bank of England, the Bank of Japan – is that the central banks have basically eliminated half of the mathematical equation. You no longer have risk, you just have the reward, so why not maximize your reward, since risk has been accommodated, taken care of? Again, this is that notion of moral hazard. Who cares about the consequences of bad choices or bad investments when those consequences have been muted or have been taken away altogether?
Kevin: Okay, but I am going to play the other side, here. Everyone is going to say, “All right, that is just going to create deflation, Dave. If you allow all those debts to go away, that would be a debt implosion that would create severe deflation. They have kept us afraid of deflation all the years that they have been printing money.
David: Deflation is bad for very wealthy investors who have assets.
Kevin: And governments who want to tax those assets.
David: Particularly if the government has been financing itself using debt, because debt becomes much more of a burden in the context of a deflation. But for the poor and the middle class, do you know what this represents? It represents an increase in purchasing power. Again, whether your cash is actual greenback dollars or ounces, what you are really looking at is the world getting cheaper, and the last time I checked, if the world gets cheaper, and your income doesn’t increase, it really is like getting a pay raise. What’s not to like about a pay raise? You are talking about people who have extended credit without regard for credit quality being at risk, so you are talking about a significant loss in the banking sector, you are talking about a significant loss on Wall Street, you are talking about many wealthy investors losing their speculative dollars. But here is what I would say to them: “Losing money on a speculation, big boys and big girls out there, you knew it was a possibility.”
Kevin: That’s why it is called a speculation, Dave.
David: That is exactly right.
Kevin: Okay, so this is the imaginary world of deflation. My wife comes home and says, “Hey Kev, I don’t really need that $300 this week for groceries, I only need $200. Things are getting cheaper.” Now, how is that bad for me? That’s like what you are saying. I am not speculating on groceries, I am actually gaining more groceries.
David: Well, it is the exact opposite of what has been happening in an inflationary environment, and you realize the absurdity of central bank policies which are targeting an increase in inflation. They are basically saying, I don’t care if your income is going up or not. What I do care about is economic growth, which somewhere down the line may increase your income, but frankly, the last 15 years it hasn’t proven to. Nonetheless, they have targeted 2% rates of inflation per year, and that means that everything you buy in the store is more expensive.
The last five years I spoke with a gentleman who works with us on our Wealth Management Platform and our Precious Metals as a client in both companies, and he said, “Dave, you know, it is interesting. I take some funds out each month to supplement my retirement income, and the last five years have been very frustrating because I am not living any more extravagantly, but I am going to have to start drawing out more because the cost of everything is going up.” And you know what? This is what is interesting. Government, and the Fed, all of our global central banks have said that is acceptable. That is what we want, is the cost of things going up. Frankly, the deflationary scenario is not a bad one for a consumer. When things get cheaper, that is not all bad.
Kevin: And you know, with low official inflation rates, no one really considers the future anyway, only the present matters. What you bring up about this gentleman who is retired and is getting nervous, things are still costing more, yet he is being told that we are in a deflation.
David: But on the flip side you have central banks who continue to promise the power of the printing press. And yes, we have low official rates of inflation in Europe. Yes, we have low official inflation rates here in the United States, and no one is really considering the future. What are the implications of the printing press policies that are already in place? Again, only the present matters. Which really, is how you sow, not only inflationary trends in the future, but potentially, hyperinflationary trends. The vast quantities of bad debt today, yes, overwhelm the trillions in liquidity that the world central banks have created. But a sharp transition in velocity of money turns an inadequate supply of liquidity into an excessive liquidity, as supplies on hand move up exponentially in terms of their total scale in the marketplace.
Kevin: You can’t separate deflation and inflation completely because a lot of times you will see these hyperinflations occur right after a short deflationary period, and the deflation is actually caused from a lack of cash and then when there is a response to that, people lose faith in the cash because the central bankers just come up with too much of it.
David: When we discuss the structural long-term changes with Russell Napier next week, one thing we will explore is the demise of the existing world monetary system. Central bankers are working today in an environment where they have the benefit of public confidence. That is the benefit that they have today. There are, even as we speak, certain structural shifts, now actually five years old, five years of maturity behind us, and those structural shifts are growing in their impact, and I think will ultimately undermine the work of our modern-day central banker, undermining their reputation. And this is critical to appreciate, because as we have described before, confidence and faith in the money men and women of our day has been a critical element in alleviating volatility in the markets, and creating a real sense of calm.
Kevin: You can imagine, Dave, if something happened today where people said, “Oh, my goodness. I can’t trust the Fed. I have no idea what is going to happen tomorrow. I don’t know whether they are going to be able to react to this next problem.” You wonder how many times they are going to run out of ammunition and come up with some new rabbit out of the hat.
David: We could only hope they run out of ammunition, because frankly, what happens internationally is, often, that that is when they start making more and more of it. When confidence in the class of central bankers collapses, and I think we are going to see that in the next few years, what will it be triggered by? Listen, every central bank has been fighting deflation, fighting it with every tool they have in the box, and when they lose grip, in spite of the massive efforts made to control it, you are going to see the general public reevaluate all of their investment and economic assumptions. And I think, at that point, you are going to be faced with a series of currency devaluations, globally, trade wars, individuals scrambling to cope with the impact of a deteriorating global monetary system, and listen, the dollar may be the least worst currency, in that case, in a currency reset environment.
But we ask you to consider the difference, the change of central bank monetary policy being implemented with the confidence of the general public, and then in an environment where confidence is already gone. If that backdrop, confidence in the Fed, is gone, now re-evaluate the least worst currency in the currency market, and I think that is where you begin to see a significant move, where wealthy and sophisticated investors, concerned with systemic stability, concerned with the undermining, not only of the domestic currency, but the entire global monetary system, look at a deflationary environment and see gold as a critical asset to own, outside of the banking system, outside of the world monetary system now in flux, and outside of the reach of financial obligations which they also may have. So, again, you are talking about a financial asset that does not have financial ties. You tell me how important that is going to be in the future. I will tell you, it will be the most important thing you have on your balance sheet.
Kevin: You and I may be able to survive a deflation owning gold, and then a hyperinflation owning gold. Gold seems to do well on both occasions. But the emerging markets right now are completely dependent on the liquidity continuing to flow, are they not?
David: From us. Specifically, from us. It is interesting, we have had this conversation in the management committee for the foundation for the college here in town that I help advise on. The argument has been made, “Emerging market equities are cheaper than U.S. equities.” Let’s look at them from a fundamental valuation perspective, and they are cheaper by half, cheaper by two-thirds, in some instances. Well, they may have a lot further to fall, and there are several reasons for that. You have the end of QE here in the U.S., which will tighten liquidity globally unless other central bankers fill the gap, for as long as QE is off the table, or some other extreme monetary measure is off the table, you will have a strengthening U.S. dollar, which acts as a restrictive monetary policy, a tightening monetary policy, in any of your emerging markets which have a tie, currency-wise, to the U.S. dollar.
What we will explore at length, in our conversation with Russell next week, is a shrinking trade deficit, which means that we are exporting less dollar liquidity globally, which appears to be a long-term, not a short-term trend. If you want to diversify out of U.S. equities because you think they are expensive, as we do, don’t get cute and go buy emerging market equities just because they are cheaper. They are cheaper, and they may be cheaper for a reason. And last, but not least, you have to remember that should the U.S. equity markets roll over here in the next few weeks to months, global equity markets have proved to have a positive correlation. In other words, they move in the same direction at the same time, just to varying degrees. In fact, that correlation to U.S. equities increases depending on the intensity of the selling pressure.
Kevin: You may sound like a broken record, Dave, but you are repeating two words in this timeframe that we are in right now. Those two words are: Be cautious.
David: Be cautious. Raise cash. All these sort of two-word sentences. Buy gold. They are very simple. And yes, we are going to cautious. This next week you and I are heading down to Argentina. We will share some of our observations when we get back. We will be cautious on our journeys, of course, but I look forward to covering more of these details, particularly on the current account deficit, with Russell Napier next week. If that sounds like a dry and uninteresting topic, just understand that it is probably the most critical thing to impact the global equity markets, the global debt markets, in the last 30 years. Much more on that next week. And then we will explore our observations on Argentina, currency trends, the difference between the blue market, that is, the street rate for the Argentine peso and the official rates, and the ways in which Cristina Kirchner has absolutely decimated that country. That, and more, on next week’s Weekly Commentary.
