The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: Value is such an important word, in life, in investing. We were just talking about your vacation, being away, value with family, how you value the time that you had with your father, as well. But I think it is important, if we are measuring value, we have to measure it in the right increments, don’t we?
David: Yes, and I think the value of assets has always been key. If you go back through time, it was about the 1930s that the intelligent investor was hatched by Graham and Dodd.
Kevin: That’s the book, The Intelligent Investor.
David: That’s right, and he popularized something that became the backbone, the success of Warren Buffet and Berkshire Hathaway, which is, you buy assets when they are cheap, and you wait a long time, and those two things, in combination, are compelling, but it takes a very unique outlook and perspective to do that. You need to know that you’ve bought them right in the first place in order to sit with the conviction and through long periods of time, where day-to-day events may dissuade you from an original decision unless you have solid data and fact to base that information on.
Kevin: I think it is important to understand, too, very few young investors understand this concept, because part of it just takes experience. You have to see cycle after cycle. Dave, I was just shaking my head, I couldn’t believe the man who was there at Columbia with Ben Graham back in the 1930s is still investing, a 108-year-old Irving Kahn. (laughs) Marc Faber recently quoted this man, Irving Kahn, a great money manager. He was the teaching assistant for Ben Graham while Ben Graham was lecturing at Columbia University.
Kevin: In the 1930s.
David: Right. And his career on Wall Street began in the 1920s. He said this recently: “If the market is over-priced, an investor must be willing to wait.” That is reminding us that a value investor is really looking for a dollar selling for 50 cents. It’s not one dollar selling for two dollars with the hope of it selling for four. It may be simple, it may be just unimportant facts, but his perspective, I think, from a 108-year-old man, is worth considering. He says that private investors should tune out the prevailing views they hear on the radio, television, and internet. They are not helpful. You must have the discipline and temperament to resist your impulses. “Human beings, he says, “have precisely the wrong instincts when it comes to markets.” “If you recognize this,” he goes on to say, “you can resist the urge to buy into a rally, that is, buy when prices are going up, and sell into a decline when prices are going down.” 108, and he is still going to the office three times a week. Hats off to you, Mr. Kahn.
Kevin: Let’s just put this in perspective for a second. We had a program a couple of weeks ago where we said we are marking the 100th anniversary of the beginning of World War I. Irving was 8 years old. He can remember the beginning of World War I. He can remember when we were on a gold standard, when we moved off of the gold standard. He can remember the wars, World War I and II. He can remember the market crashes and the market booms. He is managing 600-700 million dollars right now.
David: Waiting is something that doesn’t come easy to investors, but I think when you have been around a little while it’s really not that big of a deal. I think of the gold market the last three years. It has been an interesting and even grueling wait. But it is still a compelling value and it is still a compelling offer in terms of real money and an insurance in a financial system that has its fleas. At the risk of sounding like a broken record, stocks are expensive. Gold and silver are cheap. If you watch the nominal values of things this is a very simple observation.
Kevin: Let me go ahead and differentiate, then. Nominal value, which is valued in dollars, fiat currency, relative to what you like to talk about Dave. You like to talk about the real Dow. You like to talk about real real estate prices. You like to talk about real money. Now, if you are valuing something and something that the Federal Reserve can just print in unlimited quantities, you are really not getting a good idea.
David: It is not going to come as a surprise to see prices increase. That was obvious in our conversation last week with Adam Ferguson, where again, if you print more money and the things that you are buying on a day-to-day basis are going up in price, the price is not particularly relevant. You deal with this issue of nominal values all of the time, but not thoughtfully enough, I think. If you look at the real Dow, that is, the Dow priced in gold, your year 1999 to present returns are negative 70%, down 70%.
Kevin: Even though nominally you have, actually, an extra…
David: An extra 5000 points added. That’s all well and good. I’m not arguing or contesting the fact that there has been growth in the stock market.
Kevin: But relative to ounces of gold that would have purchased the Dow back during that time versus now, you are still down 70% if you own shares.
David: And I think that trend will continue regardless of nominal pricing. In other words, I think you could see the stock market go up and still, in terms of being priced in ounces, go down, and you could continue to actually lose ground as an investor with that real money position still being of greater value. I think we will see the Dow trade, in real money terms, at an 85-90% discount from those 2000 peak values. Obviously, peak values; what am I talking about? We are at new peak values if you are talking just nominal figures, but again, when you are pricing things in gold terms, the Dow costs 43 ounces of gold, the cost to buy a share, a cross-section of the 30 greatest companies in the country, 43 ounces would buy it for you. Today, it only costs you 13 ½ ounces.
Kevin: In 2000, it would have taken 43 ounces of gold to buy a share of the Dow, and at this point what you are saying is that it is 13½, actually closer to 14 right now, isn’t it?
David: Right. And the cycle that we are in is reminiscent of the cycles we have seen over the last several decades and even several centuries where you oscillate back and forth in terms of the values between paper assets and tangibles. At the end of a cycle, your target is a 3-to-1 ratio, not the 13½-to-1 ratio that we have today, but a 3-to-1, even a 2-to-1 or 1-to-1 ratio, implying that from this point, right now, your increase in purchasing power, at a minimum, would be 4½ times to as much as 12 times, depending on where the ratio settles in. I would just say this. If gold and silver are cheap, then you have these paper proxies for gold, gold shares, that are even cheaper. Actually priced today, just gold versus gold shares, at a level we haven’t seen since the year 2000, at the very end of a 20-25 year bear market in gold, they are at those same kinds of levels relative to gold as we speak.
Kevin: So, if you are Irving Kahn, and you are looking at this, and you say, “I have 108 years of experience in determining value,” you would probably say that gold and gold shares right now really make sense.
David: Well, and I don’t know that he is interested in gold or gold shares, but I think Kahn’s grid of value would say this: It is worth asking the question: Are you buying a dollar for 50 cents? And if you are paying premiums for the purchase, instead of two dollars for a dollar’s worth of assets, then you are on the wrong side of the equation. Ultimately, you will be an economic or financial loser in the game of life. Why? Because, in money and investing, value is so very, very important. And so, the cost of your original investment is absolutely critical, and I would look and say that coming into the stock market today you are paying premiums.
And what you are seeing is, really, the premiums that are most comfortably paid when you have a group of investors surrounding you. They are all exercising the same thinking pattern, what some have described as the phenomenon known as group think. You look around you and there is no one contesting the idea that you should be in the stock market. Again, you would have to set aside Kahn’s earlier advice of, “Don’t listen to the news media. Tune out the prevailing views that you hear on radio, television, and internet. Why? Because they are not particularly relevant. It’s kind of white noise. It is interesting to me, it is not very often, if ever, that I have come across a 108-year-old man who is still actively investing on Wall Street, a 108-year-old man, period, but one who cut his teeth on Wall Street in the 1920s and 1930s, suggesting that if you can’t find value, you just have to be willing to wait.
Kevin: It has been interesting, this last 14-15 years, just how much money has been printed, especially since 2008. We are talking about the pricing of something in real money, which – real money is gold – or borrowed money, and how much has debt increased just in the last few years?
David: You mentioned government debt. Just looking at the government debt, it is up three times. We started in the year 2000 with 5 trillion dollars in government debt and that is now close to or above 17 trillion dollars.
Kevin: So three times. A tripling of debt.
David: Yes. Meanwhile, you have GDP growth that has not expanded over three times. Economic activity has not kept pace with the growth that we have seen in debt. And those two things, if they are moving in lockstep, kind of balance each other out, the economy growing in a parallel track with debt, the economy and its productivity, the income, the resources that are being generated, basically give you the allowance for staying, and the extra revenue to stay, on top of that debt, the new debt that you are accruing. But if you don’t have enough sufficient growth in the economy, then how is it that you are going to keep up with interest payments?
Kevin: You have to print money.
David: And one of the ways that we have kept up with interest payments is that we have seen governments step in and manipulate rates to such a low level that we can afford it, and yet we don’t see the economic mismatch between growth in debt and non-growth in the economy because of the sort of gerrymandering in the interest rate market. That is a very critical factor. What has happened in the interest rate market is not natural. It is not natural, nor is it long-term sustainable. So, we are leveraging ourselves up on the assumption that the old normal economic variables will appear at any moment, and we aren’t bankrupt yet. We are not bankrupt yet, because rates have been forced lower, and that has allowed us to shoulder the debt, the new debt accrued, going from 5 to 17 trillion.
Kevin: Russell Napier says that that could go on for a while, because politically, it is suicide if they allow those rates to rise and they get themselves into a situation where they can’t pay the interest on that expanded, tripled debt.
David: So we could expect for many months, if not years, the government to attempt to control market price dynamics, and if that is with us for a long time to come it is because, as Napier has very realistically put into the equation, there are high political costs for real market dynamics being allowed to impact investor balance sheets and for real market dynamics being allowed to impact consumer spending habits. If those things were to occur, what would happen? What would the knock-on effect be? Very unhappy constituency groups, and then all of a sudden you go back to the old adage that we have heard from other politicians. “It’s the economy, stupid.” They are able to push that off, and politicians are able to, given the monetary policies that we have in place today, skirt those issues.
Kevin: So, as long as they can maintain the faith in the central banks, they can probably maintain this façade.
David: Faith is in interesting thing because you are really talking about the general public trusting in the magisterial powers of central banks. This is, I think, very important, because you could at this point say to yourself, “Well, right, so they’ve manipulated the markets, the whole thing is rigged, and shouldn’t we just play the game? Everyone else is.” Never forget – never forget the Taper Tantrum last summer.
Kevin: That was when Ben Bernanke came out last fall and just mentioned that he might start tapering the quantitative easing.
David: And if you allow that experience, what happened in those few months, to be seared into your memory, it serves as a reminder of how fast and how powerful real market forces are in aggregate. Men, and women, think presumptively, that they have power, until they encounter a greater force. I spent some time on a paddle board here just recently. I usually went out very early in the morning because there is no wind. The beauty of being out when there is no wind is that I am more powerful until there is something more powerful than I, and what is it that gets lost when the wind picks up? All control. There is this sense in which, here I am just paddling along, out into an open bay, and everything is fine, and then all of a sudden the wind picks up in the slightest and here I go from setting a stiff pace to being stopped in my tracks. Why? Because again, we live with the presumption of power until we encounter a greater force.
Kevin: It’s very humbling, Dave, I grew up flying radio control airplanes with my father, and so my son and I were out back, it was nice the other night and I had a radio control plane. It was very still near the ground, and I got a little cocky. This is a very lightweight RC plane. I went on up at altitude and my son said, “Dad, there’s quite a bit more wind up there. You’d better be careful, that plane is not that powerful.” Well, needless to say, I lost about a $200 airplane. There was just no way to cut back through the wind, and I just watched it fade into the sunset. It is humbling, but it’s more than humbling if you’re the Federal Reserve. It’s devastating.
David: And I think this is where we are not applying common sense as investors. The investment community as a whole is forgetting some very basic things. An outdoorsman is always aware that control is only for a moment, and it is not something that you are capable of governing. We go out into the mountains here, and we’re at a turning point seasonally. We could get an afternoon rain shower up in the mountains in the high country, and that rain shower, even though it was 85-90 degrees in the afternoon, you can have the temperature drop 50 degrees in 20 minutes and be in a snowstorm – in a snowstorm – in that short period of time. You have this sense of, it’s happy-go-lucky, I’ve prepared.
We talked about this the other day when we climbed the 14er with the boys. There is this sense in which an outdoorsman needs to be circumspect. Investors, too, need to be circumspect about what they are actually in control of and who they trust, or believe, has complete control in the marketplace. And I think this is where, again, there is a presumption of power until a greater power or a greater force is discovered, and that, to me, is the market expressing itself in so many terms. In terms of confidence today, the Fed has earned the faith and trust of the marketplace, and that faith and trust, because it is not based on fact, can be shaken, I think, very easily, and just as we saw that taper tantrum last summer, there is power and force in the marketplace which the Fed cannot stand up against.
Kevin: And you know, there is a perception, and I have the same perception. If I’m looking at the stock market rising, the perception is that there are more people buying stock. But strangely enough, we’ve seen the stock prices rising. If, however, you look at what a professional looks at, which is also volume, the volume has been decreasing as the price has been increasing. Explain that.
David: A good friend of ours commented recently that late summer rallies on very poor volume that push major stock indices toward or above record levels have a tendency to end poorly in the autumn.
Kevin: Like 1987, like the year 2000?
David: Yes. You basically hit your peak in late July, back in 1987, and you could look at these period-specific time frames and the facts that were occurring, the drive of the marketplace, who was involved, who was interested in purchasing equities, and Wall Street’s a ghost town. Right now Wall Street is a ghost town and yet we’ve hit new record highs as we end the summer. Keep that in mind. Late summer rallies on poor volume, which is exactly what we have had, very poor volume, that do push major stock indices toward or above record levels, have a tendency to end poorly in the autumn.
Kevin: And we’re seeing the doctoring of numbers in other areas. We’ve talked a million times about employment and CPI. But these Fed surveys that come out, supposedly the Fed survey tells you whether you are increasing or decreasing. They’re having some very negative numbers, but they come out with the overall figure and say that it is positive. How does that work? That seems like it is doctoring.
David: I think you are seeing a trend intensify, which is the usefulness of statistics in marketing to the hoi polloi. If you can convince the vast majority of people that something is true, and back it with a number, we live in the age of science, where numbers are everything. We could care less about anything unless it can be substantiated with numbers. What people don’t understand is that you can substantiate anything with numbers. You can substantiate absolutely anything.
You have the BLS, you have the Fed’s inflation statistics, you have GDP, and now you have the Philly Fed survey. From ten days ago, they had 7 out of 9 measured categories in decline from one month to the next, and yet, they still managed to post an overall positive figure for this composite. Liars? Yes. Figuring? Yes, no doubt. This is the reality. It illustrates a conclusion governing the gathering and synthesis of data. And yes, that is putting the cart before the horse, but that is what we are talking about. We are talking about politics reigning supreme, an agenda reigning supreme, and the hoi polloi just having to go along with it, assuming that the numbers are accurate because frankly, you don’t have Ph.D., and so are you to challenge the veracity of a given number if you don’t have as much, or better, in terms of your educational background than those at the Fed?
Kevin: Dave, just that use of authority, we’ve seen back in the old days with cigarette commercials. Do you remember the cigarette, I don’t remember the brand, that said, “Doctors prefer…” and then it gave the brand of that cigarette. For the person who was looking at a doctor as an authority, they were thinking, “Doctors prefer, well I guess that must be good for me.” And yet, you have the Philadelphia Fed survey, 7 out of 9 measured categories declining, yet they still post an overall positive figure. To me, that’s like saying doctors prefer this particular cigarette.
David: And it leans heavily on the weighting of those composites, the weighting of those contributing figures, but that is the same thing that they have done with inflation. You can flexibly change the weighting for each of those inflation components. When you are measuring inflation and you are trying to get an idea of: What is our total inflation problem? Well, let’s go measure ten different items to see if inflation is on the increase. If you end up with an inconvenient number, and that would be an increase of inflation, in one particular category, then you just lower the weighting of that particular component part to where it doesn’t impact the total statistic, that is, CPI, the Consumer Price Index, or in the case of the Fed, the PCE [personal consumption expenditure], in a way that exaggerates the inflation number. So, inflation will always be tame as long as the statisticians are playing with the numbers in a way that is favorable to whoever is calling the policy decisions.
The idea of Fed independence, we’re going to end up with more and more positive GDP figures, inflation figures, employment figures. Why? As we march toward the election, and this is November, of course, it is only natural. People in a position of subservience, where they are answering to a boss, who answers to a boss, who answers to a boss, who answers to a boss, who ultimately answers to the oval office – guess what? Pressure is applied at the top, it trickles down, and you don’t know why. The results that you put in were handed back to you. The math that you did needs to be recalculated, but you are going to do your job because you don’t want to lose your job. That’s the world we live in. And then there is the investment community. The investment community has to live with this balderdash, as if it was true. This is, again, where faith and belief – it’s really an interesting phenomenon, and you’re right. There is an appeal to authority that we live with and live under in this country, more and more so all the time. There are other issues in play which I think go back to core fundamentals: We talked about government debt accelerating.
Kevin: You said three times. It has tripled in the last 15 years. Corporations are also going into debt, are they not?
David: It looks like we will add to that debt figure at least half a trillion dollars this year, so it’s not as bad as years that we have had in past, but it will still pass the 500 billion mark in new debt for 2014. Corporate bond issuance – what’s a half a billion here or there? Well, half a billion here and half a billion there makes a trillion, and a trillion dollars is this year’s issuance for corporate America. Of course, they are doing it at very low rates. Some could argue that this is smart if you are financing a growth plan on very inexpensive long-term rates. But here is the problem, and we certainly have highlighted this in the past. A lot of, not all of it, but a lot of this debt is going to buy stock with the proceeds of the debt issue.
Kevin: Yes, you have talked about that before, where the companies are actually borrowing, turning right around and buying their stocks. That increases the profitability per share of every share, because you are taking some off the market, but then you are also seeing the debt increase at extremely low interest rates. I do understand. Let’s say you are running a corporation that has to run on debt and you are looking at the Federal Reserve and they are talking about raising interest rates. Maybe these guys are looking at it and saying, “Hey, let’s go ahead and get these rates while we can.”
David: Sure. That makes sense. Listen, do you know what closed this week in Spain? A 50-year bond offering at 4%. If I was the Spanish government and people were foolish enough to give me 4% money for 50 years, looking at my track record of defaults, of inflation, of busting promises from a fiscal level – listen, there’s always a patsy, and in this case it is the general public willing to pay hard-earned money up front for a 4% rate of return on a Spanish government bond locking you into 50 years of interest rate exposure. I’m sorry, that’s insane. Now, if you are the Spanish government it’s brilliant. Why? Because you know there are enough patsies out there to get away with it.
Kevin: And you know you’ll never pay it back!
David: Of course not. That’s not an issue. This is the beauty of the financial world that we live in, much of which is constructed on a confidence game. I don’t fault corporate managers for adding a trillion dollars in debt. I do fault them for misusing those funds. If you want to grow the business, if you want to grow the franchise, by all means, increase the revenue of the business. But if all you’re doing is targeting a better compensation package for yourself, getting a bonus because you increase earnings per share, and you increase earnings per share by reducing the total of shares outstanding, by taking that trillion dollars and buying back company shares, I think it’s disingenuous. I think it is fraudulent. I think it’s prosecutable. I think that time and the tide of events will allow some of these things to come out and permanently change Wall Street and the way that companies are managed.
But that is the kind of legislation that you can only expect after a major market collapse. Remember Glass Steagall. It came about after the collapse in 1929, not before. Things got out of hand. Banks on Wall Street were buttering their own bread, and it was determined that legislation had to be put in place to protect the consumer. And thus, Glass-Steagall came into place. Of course, we had Glass-Steagall thrown out in 1999 because the consumer didn’t need protecting. Of course, maybe people were just angling for a larger, more comprehensive piece of legislation. Glass-Steagall wasn’t comprehensive enough so now we have Dodd-Frank.
I guess what I am concerned about is a trillion dollars in new debt this year for corporations. It’s all well and good if the economy recovers. You have plenty of growth in your company to pay the debt requirements that you just obligated yourself to. But what happens when your cash flows diminish? What happens when you have increased your debt payments? This is where leverage is difficult to deal with in the context of recession. Recessions are deadly for the over-leveraged company.
Kevin: Dave, on Saturday mornings sometimes we will turn the radio on and listen to the Car Guys. They come on from 11:00 to noon.
Dave: Click and Clack.
Kevin: Click and Clack, the Tappit Brothers. They’re hilarious. But they always have a puzzler of the week, and I’m going to tell you this. I am puzzled, and I’m going to throw this out for you, and I want to throw it out for the listeners, too. I am puzzled at why you can get interest rates that are so darned low in France and in Spain and in Portugal. These are rates that are lower than a U.S. treasury bond. Let me just explain my question for the person who doesn’t understand interest rates. The lower the interest rate that is paid on a bond means it is the safer, or the more likely bet that it will be completely paid off. Now, let me mention the countries again: Portugal, Spain, France. The spreads between European Nations and the U.S. are widening and the Europeans are going down, as if they are the safer bet. This will be the answer to the puzzle: Tell me why.
David: There are a couple of things in the mix here, and Mohamed El-Erian, who used to be at PIMCO, still advises Alliance, and I think is one of the new economic advisors for the White House. He is reflecting on how low the volatility has been in the foreign exchange markets, and he thinks that is coming to an end, in large part because of this distortion in bond spreads. And again, a bond spread is just the difference between one particular interest income stream and another, so let’s illustrate that. Your Portuguese bonds today are at about 3%. Compare that to U.S. treasury, which is about 2.4%, so there is a 60 basis point spread between the two [a basis point is one one-hundredth of one percent], the Portuguese having more, if you will. They are at 3%. This is why he is concerned. Spanish bonds at 2.38% are lower than U.S. treasuries.
Kevin: That is like saying the Spain has more likelihood of paying back their bond than the U.S.
David: Right. Again, this goes back to a very, very simple observation we made earlier, which is that we have 17 trillion dollars in debt and an economy which is grinding down, not gearing up. It is harder and harder to make money in the economy. We’re not seeing a ratcheting up in GDP growth, we’re seeing decay, if you will. A flatline, if you will. Meanwhile, growth continues in the debt sector. This is what is concerning. You have Spain with no prospects of paying back their debts, and yet their interest rate is lower than ours in the U.S. We’re supposed to be the benchmark for risk-free rates. The U.S. treasury is “the benchmark” for risk-free rates, and yet French 10-year treasuries are selling with a yield of 1.25, so have the French displaced the U.S. as the benchmark for risk-free rates? How about the Germans? Arguably, the Germans, to some degree, given their monetary conservatism, are at 90 basis points for 10 years, so 0.9 of 1%. And the Swiss are at 0.42, less than half a percent on a 10-year government bond from the Swiss. Again, Portugal 3, Spain 2.38, the U.S. 10-year treasury 2.4, even greater than Spain, locked between Spain and Portugal? Are we really amongst our peers when we are talking about what just a few months ago were the PIIGS? Does this, in any way, strike you as odd, and El-Erian’s comment is, “It’s not natural, it’s not sustainable. This will reverse, and you are going to see massive increase in volatility in the FOREX markets,” that is, your foreign currency markets.
Kevin: And you cannot have those rates without having someone there to purchase those bonds. Even commercial purchasers right now are increasing their euro exposure over the United States. What is that saying?
David: It’s curious. If you think about the more attractive yield on offer in the U.S., 2.4 is better than 1.25 in France, so why are people clamoring for French bonds at a pace that is forcing the price higher and the bond yield lower in France compared to the U.S.? What this suggests to me is that people see a sure bet from the ECB.
Kevin: They are just going to print it and buy it.
David: This is the interesting thing. There is always a work-around. Listen, if you have raised children, you know there is always a work-around. You can tell them what the rules are, and they have nothing better to do with their time. You’re trying to make a living, you’re trying to bring all the details together of managing a household, and guess what? Your children have nothing better to do than figure out how to game the system, figure out what the boundaries are, figure out how to press them or work around them, or redefine terms toward their favor. Think of this. The ECB cannot buy bonds directly from the government. But the ECB can provide any amount of money they want to banks, and those banks can go buy the bonds, and those banks can register those government bonds as a risk-less asset. So now you have European banks loading up on European government debt and they can now use this as an asset. They will show it on their balance sheet, and it gets counted as a riskless asset. So, in essence, the European Central Bank has created a near infinite purchaser of assets without announcing an asset purchase scheme.
Kevin: So they don’t have to call it quantitative easing.
David: It’s QE without the QE. You see what I mean? We just worked around the problem. As any individual or child would do. Show me the rules and I will tell you within about ten minutes how you work around them. That is exactly what they have done to remain constitutionally viable or on the right side of the law. There is this issue of commercial interest in euro paper, over and above U.S., and I’m not convinced that there isn’t some big money, big money, expecting to see an increase in the euro and a decline in the dollar, where your euro purchases, even though you are accepting a lower cash flow, you have another way of making money in bonds, and that is: What are your bonds denominated in? If the euro goes up, you may have made very little in terms of the income stream, but you have capital gains on the basis of your currency exposure, so when you go to liquidate it, if the currency has increased in value vis-à-vis the U.S. dollar, you are in a much better position. That is one particular issue in play.
That certainly leaves me with concerns about the direction of the euro and the U.S. dollar because here is where it is particularly relevant for a gold owner. If you expect euro outperformance, then the dollar would be going down. On the other hand, take the other side of that. Draghi has promised greater accommodation and Draghi is very close to not only the back door work-around for an asset purchase plan, but an outright QE. As and when he announces that, you could certainly see the dollar pull ahead, that is, the dollar go up relative to the euro. We saw that every time we announced a QE here in the United States, the dollar took it on the chin, because the world markets understand what it means to print money, even if we at home don’t know what it means, the world markets fully appreciate the fact that you are diluting the purchasing power of your currency the more you print of it, and that is exactly what QE is.
So as and when, or if, the ECB announces their asset purchase plan and outright QE, explicit QE, you could very well see the euro drop, the U.S. dollar go higher, and gold go lower. While that’s unfortunate in the short run for the gold owner, it’s of great benefit to the U.S. dollar owner and treasury owner, but these, again, are things that we have to deal with in light of what the ECB and other central bankers are telling us. Draghi suggested that at Jackson Hole more intervention was on the horizon, and as Europe is losing speed and moves toward a complete economic stall we could expect short-term euro weakness on that basis.
Kevin: David, you know, when you talk about the dollar rising or the dollar falling, I think it is important to restate over, and over, and over, that we’re not talking about the dollar buying more assets, or real things. The euro falling or the euro rising or the dollar falling or rising, what we are talking about is relative to each other, and yet both are registering inflation, which means that things, real items, are costing more and more. Adam Ferguson, last week, brought out so importantly that all governments indulge in inflation. That’s what he said, all governments will, and do, indulge in inflation. So, no matter what the central bank talks about, they can make us worry about deflation. None of that really matters. They will indulge in inflation. So we know that the dollar does not buy what it did last year or the year before. Our side of the street – let’s come to this side of the Atlantic for a moment. Rates are looking like they are probably going to be going up here in the United States. How much can we take of that?
David: Well, you have two central bankers who are taking the other side of the coin. Draghi is suggesting greater intervention, perhaps euro weakness on that basis in U.S. dollar terms, and as you mentioned, Adam Ferguson last week, I think, would have suggested the dollar and the euro are both circling the drain, returning to their intrinsic values, because you do have governments exercising the right to print, and they are printing a lot. Mark Carney at the Bank of England, and Janet Yellen, of course, at the Fed. They’re hinting at raising rates, taking the financial community in the opposite direction. The issue is, these two banks, the Bank of England and the Fed, have already expanded their balance sheets to unprecedented levels, and may be nearing their balance sheet limits. That is not to say that they can’t acquire more assets and expand their balance sheets further, but it will be with greater and greater consequence in terms of credit ratings, concerns about the currency, etc.
Here is the question: On balance, will the liquidity created by the European Central Bank, when you net out the taper here in the United States, and the end of the current QE programs, will it be enough to support equity markets here, there, frankly everywhere. We look at the emerging markets and the developed markets, and we are all rising on a sea of liquidity. That sea of liquidity has been enhanced by the Bank of Japan, by the Bank of England, and by the U.S. Federal Reserve, and now the Bank of Japan is saying, “Frankly, it’s not working for us. We’re not changing course, but it’s not working. The Bank of England and the Fed are saying, we’ve done our part and the economy is recovering. Of course, they are relying heavily on their own statistics which have, and do, serve a political purpose.
But this is, I think, the critical issue. On balance, this is the key. On balance, is there more liquidity going to be created by the ECB with an asset purchase plan? That is going to define asset markets for the next year to 18 months. If the ECB brings out the big guns and is willing to print what looks like an infinite number of dollars, then you can expect the FTSE [a British stock market index], the DAX [a German index], the CAC [French], the New York Stock Exchange, the world stock markets, to rise in response to more liquidity than they know what to do with. This is what some have called the liquidity theory of asset pricing. There has to be an over-abundance of liquidity to drive asset prices higher, and so on balance, if there is an overabundance, you are going to see asset prices move higher, and I think gold will move in lockstep. When you look at the other side of liquidity theory of asset pricing, what you end up with is not enough liquidity, you are going to see a decline in asset prices.
Let me look at that slightly differently. Gold could actually remain under pressure in a period of rising equity prices on the basis of central bank activism. The next trigger for the gold market is going to be a change in inflation expectations. Not a measured rate of inflation, that’s irrelevant. CPI, everyone knows that a bogus number. PCE, there’s a growing number of people who’d say, well, it’s good enough for the Fed Ph.D.s, but it’s not good enough for the general public because it’s not common sense enough, and I would tend to agree with that.
So you have the inflation numbers which are more irrelevant than ever, and the inflation expectations, that is, your expectation of inflation, my inflation of inflation, that expectation which is going to define asset prices and would define, also, the next leg up for gold. But I do see a significant baton being passed from the Fed to the ECB and that, again, plays out into how the dollar, the euro, and gold will play off of each other in the next 6-12 months. So, do we need to listen to what Draghi is saying? Not only listen to what he is saying, but also look for fingerprints in the marketplace to see what he is actually doing.
It is interesting, the financial markets have been rising just based on pure perfect knowledge that the central bankers are going to be successful, so we do have a bubble right now. It’s a bubble that is being blown up. I would call it a confidence bubble, and people have an enormous amount of confidence in the fact that even if Yellen does pass the baton over to Draghi, everything is just going to be fine.
David: On the weekend there was an interesting article in the Financial Times. The title was “Central Bankers Face a Confidence Bubble.” This strikes at the heart of not only what we have discussed, but even the over-confidence that we discussed with William White from the Bank of International Settlements when he said, “You know, people expect more of us than they should.” The Bank of International Settlements is sort of the central bank for central bankers, and he is basically saying, “We’re not wizards. We get things wrong more than we do right.” And yet, the financial markets today are assuming that the financial wizards only get it right, never get it wrong, and have these sort of infinite powers.
Again, Mohamed El-Erian, in a different article, this one in the Financial Times over the weekend, he says, “Financial markets have been consistently rewarded for believing central banks are their best friends. At some point those rewards have to be validated by fundamentals. And so it’s basically the issue of the market getting ahead of itself. Pricing is to perfection, and we’re assuming that the fundamentals will be there to back up this perfect world that we hope for and we’re just looking for evidence to see if it is as we hope.” That’s right. This is the issue, this is the issue, just to look at El-Erian’s comment. Market operators are operating on the basis of faith, and belief, not on the basis of fact, and they are believing in central banks and central bankers, that belief structure has been a key assumption undergirding the growth in the 2014 equity markets.
Kevin: Dave, that same article talked about how the plaster cast around the market is this central bank intervention. In other words, what we’ve all seen when we’ve built something, let’s say it’s plaster of Paris.
David: When you break a leg and you have to put a cast on it. You’re hoping that there is a healing process going on inside, but you don’t know what has actually happened inside until you take the cast away. And that’s exactly where we are with the markets, and this was reiterated in the Financial Times article, the question of: Have we healed sufficiently? Because we haven’t taken the cast off yet, but we are operating like an Owens, who could run a 100-yard dash in next to nothing, on the basis that strength has returned to your leg and everything else. Is that the case? Let’s remove the cast and see.
Kevin: David, maybe this whole confidence bubble answers the question of how we are in another market bubble, even though we haven’t really seen a recovery yet. Let’s face it, wages have not come up. Strangely enough, when we have seen bubbles in the past, a lot of times you can say, “Well, we see where the money came from.” The tech stock bubble had come from earlier growth during the Reagan years, and when the tech stock bubble broke we saw that bubble transferred to the real estate bubble, but we could say “Well, I see where that money came from,” and it went through that real estate bubble. Then we had that break, and then we see the government come in and intervene. But at this point the bubble is being grown mainly by debt, isn’t it? I mean, there is really nothing productive that is growing this bubble.
David: It was interesting, we have had Allen Newman on the program a number of times, and he is asking this question: How are we in another stock market bubble, when you have the average American net worth down considerably, that is, over the past decade, down over a third, and wage growth by far the weakest of any post-war recovery? This is where he highlights the concern, saying, “Yeah, it has everything to do with central bank activism, it has to do with financial games that are played through share buy-backs, and of course, the two things that he has harped on, both in our interviews with him and when he is off air but we still keep up with his thoughts, the two alarm bells that are ringing for him in terms of markets, the stock market valuations today, cash levels in mutual funds are near record lows, and you still have the record-high margin debt levels. Those two things stand out as two clear signals that the market is stretched and currently too speculative.
Kevin: Well, let’s look at cash values in mutual funds, because that is something a lot of people don’t necessarily watch, but a mutual fund has a certain amount of money that they can invest, and a lot of time, for redemptions, that type of thing, they will keep a few percent, maybe 5, 7, 8, 10 percent available in cash for redemptions. But at this point, the mutual fund industry, it’s almost all invested, isn’t it?
David: Another way of looking at cash for an asset manager, for a mutual fund, or what have you, is that it represents buying power, and to be fully invested is to be an all-in bet on one direction, assuming that nothing can go wrong, and that it is only growth from here. When you begin to see an increase in cash positions inside a mutual fund, there is growing concern that maybe you need some cash. Very interesting. We begin to see institutional investors come out of the high-yield bond market, probably 4-5 months ago. The general public was still piling in, but smart money was already pulling the plug and saying, “I think we’re going to want a little cash on the side.” And when we saw the break in the high-yield bond market here in the last few months, six weeks even, what occurred was those folks who had moved money to the sideline had buying power. They had dry powder, if you will, and they stepped into the fray and bought the asset class at a cheaper level. This is where, again, you are highlighting a mutual fund dynamic. If there is little cash there, it means that you have the all-in bet already in play.
Kevin: And if you have margin debt at records you have the same thing going on.
David: Yes, it goes beyond an all-in bet because you are saying, “I don’t have enough money for the position, but I want even more, and so I’m going to borrow from the house, pay them 6, 7, 8 percent a year, because I am so sure that I am going to see growth in excess of that 6-8% interest rate on the loan that it is just a no-brainer. I want to borrow money from the house.
Kevin: So this takes us back to the mid-1970s, doesn’t it? 1973, 1974, the Standard and Poor’s Index fell almost by half.
David: Well, 45%, and then it spent a good period of the decade thereafter unable to recover, and a part of the reason it was having a hard time recovering goes back to that expected inflation. It went from low levels of expected inflation to a psychological shift. Forget the statistics. Forget the lies and the liars that tell them. We are talking about a perception in the marketplace which determined people’s concerns and buying habits and consumer habits in the 1970s, and as and when the expectation changes, then inflation becomes a self-fulfilling prophecy. And as you saw expected inflation move from low to high levels, stock performance in real terms went from mediocre to catastrophic, and it was because inflation was cutting into the bottom line performance, even if you had a 5% return for the year in your stock portfolio, what if you have 10% inflation. Do the math. +5, -10, gives you -5 for the year. Even with a positive nominal return, inflation is eating your lunch.
Kevin: We referred back to the 1920s as a time to learn from. We brought up Irving Kahn. He remembers the 1920s, he remembers the 1930s. But in the 1920s, total margin debt as a percentage of GDP was extremely high, but I don’t think it was as high as it is even now.
David: That’s right. The roaring ’20s, with the blow-off phase in equities, 1929 being what everyone remembers as the last and the peak before the crash, we saw margin debt, as a percentage of GDP, right around 2%, and today, we are at about 3%. We are at levels, actually, that have never been seen in the history of U.S. markets, in terms of people borrowing money, leveraging their balance sheets to go buy stocks, and you have to scratch your head and ask yourself the question, is this an indication of value? Is this a period of time when you should be increasing risk because things are so sure? I look around the world and I say, I don’t know that anything is sure. I don’t know what the euro looks like. I don’t know that the Scots and the Brits even stay together. There are so many things that are up in the air. The relationship between Germany and Russia, Russia and Ukraine, the United States and Ukraine, Azerbaijan. There are so many facets that, frankly, are unstable, that you wonder how it is that people are willing to, with such a cock-sure attitude, go and borrow so many hundreds of billions of dollars to buy into the stock market.
Kevin: Did you ever see the movie The Sting, with Robert Redford and Paul Newman? What was interesting about that movie was, these guys walked into a confidence game and the main character, who placed the large bet, who was being conned, he basically placed a bet on a false bit of information, and he ended up losing everything, and that was how the movie worked. It was a confidence game that went terribly wrong for the guy who had too much confidence. You brought up these share buy-backs. Volume is low in the stock market, yet we have margin debt at a high. You have these companies taking out debt, they are going in and they are margining, buying back their stocks. It is an amazing con game, but it’s a sure bet by the way it’s being played.
David: That’s right, by the way it’s being projected and advertised. Yet Alan Newman also points out that for 2014 the share buy-backs are running and annualized rate of 637 billion dollars, which is a dead-on match for the buy-backs that we saw in the last peak year, 2007. And he goes on to point out, just for frame of reference, that if you look at all of the inflows of new investor capital in equity mutual funds in a five-year period, 2002 to 2007, in aggregate, you are talking about 548 billion dollars of buying into the stock market via equity mutual funds. This is where the general public is stepping up to the plate. Who is stepping up to the plate now? You are talking about companies, in 2014, far more interested in buying back or retiring shares than investors have been in buying them. Retail investors are very active, or were very active up until 2007, but they are not very active in the present period.
My fear is that they are just beginning to be suckered back into the stock market as people say, “Look, 2013 was a 30% up year, this is going to be a no-brainer, 15-20% this year, next year another 20%. This is what happens when you bet on America with a comeback king.” That kind of jargon, that kind of message, is going to bring in the general public at exactly the wrong time. This returns us to Irving Kahn. If it is not a good value, just sit out and wait. And if you can’t sit out and wait (he didn’t say this, but I would) you probably are not made of the stuff that will make for a successful investor. Sometimes you have to exercise patience.
Kevin: Dave, you have brought out here with us in the office that we’re not in the gold business, we’re not in the financial business, we’re in the real money business. That’s the first priority. When you are talking about waiting, I know there are a lot of listeners right now that are frustrated with the price in gold. They just want to see the price go up, but they don’t understand, necessarily, that maybe that’s exactly where you wait. You wait in real money. You brought out that Dow-gold ratio a little bit before. Right now, with the Dow still overpriced relative to gold, waiting in cash isn’t necessarily the answer because inflation you said would be the trigger probably, when this thing comes apart.
David: Well, of course, there is an alternative, Kevin. You don’t have to wait. You can join into the scheme of financial engineering wherein share buybacks, as we mentioned, this year running close to a 650 billion dollar annual pace, and if you look at what has been bought back by corporations since 2009, 1.9 trillion dollars in share buy-backs have occurred. If you want to join in to the fray, by all means, move off the sidelines, buy into the financial engineering concept, look what happens when you have central bank liquidity and the faith that goes with this great success story. But just keep in mind that every experiment in the past that has relied on central bank genius has worked up to a point, and then genius has failed. And we have the honest admission of a William White saying, “We get it more wrong than right. And I’m just trying to tell you, I just want the record to be set straight, you’re putting too much faith and confidence in central bankers. It usually doesn’t work the way we think it is going to work.
And yet, the general public would say, “No, no, no, no, we want to join in with the high-frequency traders, we want to join in with those who are leveraging up, we want to join in with the financial engineering and couple our interests with theirs in this unstoppable machine of growth in the equity markets. I would suggest that just like Irving Kahn there is time to step back, there is a time to do something else. There is a time to wait for values, and there is a time to sit in real money, and do nothing but wait for a dollar’s asset to be bought at 50 cents. That is a position that we take, perhaps because we don’t have the same faith or level of confidence in central banking prowess, and that issue of the public’s perception of today’s masters of the universe, we remain the skeptics, in large part because we look at the evidence which our central bankers are providing for their success story, and realize that most of the evidence that they are providing to us is fabricated for the express purpose of maintaining the charade.
Kevin: David, I’ve often wondered, and I’ve even talked to clients about what our life would be like if we knew we were going to live 500 years, or 1,000 years. How would we look at things differently? How would we value things? What would I measure value in? Of course, I’m not talking about the things like family, that type of thing. Obviously, you are going to learn an awful lot if you live a longer lifetime than you do here on earth right now, but Irving Kahn is a good example of someone who has lived a lot longer than just about anybody else. It is strange, at 108, that he is a man of patience. Isn’t that amazing that he is still willing to wait?
David: Multiple cycles in the business context, multiple wars, world wars and conflicts, multiple ideas coming into the fray in terms of monetary policy, a bias in terms of fiscal organization back in Washington. You could say in terms of modern history, he has seen it all. And with that in mind, you can look at price and be motivated by price, and I think this is where distinguishing between price and value, price may be what you pay, value is what you get. We would organize finances according to a strategic plan, and developing a strategic plan for your assets sometimes has you on the sidelines, sometimes has you off the sidelines completely, and this is an era where, certainly, prices over the last 12-24 months have been impressive in the equity markets.
How we got there? Tougher to have faith. Perhaps that is a fault of ours, being skeptics in terms of what was driving those prices higher, but at the end of the day, working a plan is taking time, to some degree, out of the equation and looking at values, allowing values to be more important in that context. A Dow-gold ratio of 43-to-1 is where we began 13-14 years ago. We have made great progress as gold, as real money, has increased purchasing power in that context, very significantly. Up until 2011 you could certainly say we’ve given back some of our purchasing power gains from 2011 to the present. These long-term cycles are absolutely critical, and if you allow time to become like a cheese grater on your knuckles, if you allow it to irritate you, if you allow it to dig under the skin, you will begin to make decisions that diverge from a strategic plan.
Time is one of those dangerous elements where if you simply cannot take the pain any longer, patience is not something that you can practice, your priorities, your retirement schedule, your daughter, you may have to write a check for her wedding. There are these external things which cause us to say, “I’ve got to speed up the process, value the process.” Value, the process of purchasing value, is not a process that can be sped up. It cannot be sped up. It’s not on your timeframe. The market is not a respecter of you, or anyone else. People don’t really factor in to values in terms of market prices and values, again, making the distinction between all of the other values that we prioritize even more than monetary, economic, and financial issues.
But having a strategic plan today does entail being on the sidelines with real money, looking on the horizon to a point where real assets – the land, the plant, the infrastructure of good quality companies all over the world, the real estate that may be right next to your house, next to your business, your ability to improve and grow your franchise if you are a business-owner or an entrepreneur. There are times where, strategically, you want to put that money to work for you, and there are times when you just want to hold back and not get sucked into the fray. That is why I wanted to start with that idea from Irving Kahn: “If the market is overpriced, an investor must be willing to wait.”
