The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“The market now knows that the central banks have been neutered. They can’t generate economic activity and everything that they’ve tried in the past hasn’t given us what we needed for a sustainable economic recovery. Ergo, anything they do in the future? Lipstick on the pig. By the time we get to QE-4 you would think that the market would say to themselves, why are we at number 4 now?”
– David McAlvany
Kevin: David, we live in the day of tetrads of blood moons. We live in a day where the pope is talking in front of the United Nations and meeting with Obama. We have Putin here this week. We have Rouhani from Iran giving his speech about that is going on. We have people fleeing Syria. This is a very, very full week and I’m not even talking about some of the economic things going on.
David: At home we usually go back and forth between an awareness of what is happening in the present moment, prognostications of what that means for the future, and then also kind of look over our shoulder to see what’s already happened.
Kevin: This is with your family.
David: Exactly. So, you are right. The blood moon was this weekend, here we are in 2015 and taking us back in history, 1943 and the similar event that occurred then in 1949 and 1967, and it is interesting to put it in perspective and let my kids know, “Hey, this is a pretty unique period in time, both with a historical perspective, and for what it may have for the future.
Kevin: Don’t you give the kids a topic that they can choose and you just go ahead and elaborate, a little like the Commentary?
David: Last night was finishing up preparing for the Commentary. The boys wanted me to choose a topic of conversation as I was tucking them into bed, so I just simply said, “Do you want to talk about Asia, or do you want to talk about Europe?” My oldest was the first to pipe in and he said, “Europe.” And that was the choice. So we started, we covered Syria, we covered the immigration issues into Europe, 300,000 people who have died in that conflict, 11 million people displaced, we talked about what it means to be a refugee, what a refugee camp looks like.
Kevin: This is much larger than we can actually feel here in America. This is a huge immigration of people.
David: Oh, absolutely. And one of the things that my son mentioned, which was to my surprise, he said, “Well, you know those three little countries just north of Poland? I understand there is a rise of neo-Nazism in those countries.”
Kevin: Your son said this.
David: Yes.
Kevin: And he’s ten.
David: Nine. And I looked at him and I thought, “How do you know that? (laughs).
Kevin: He’s your son.
David: So I said, “So which countries do you have in mind?” He said, “I don’t remember the names of them.” Latvia, Estonia – that’s the area that he was thinking of. And then we transitioned the conversation to Catalonia and the vote in Parliament for separation from Spain. We talked a little bit about Russia and the fact that they have sort of gone silent and have been redirecting attention from Ukrainian issues to Assad.
Kevin: Yes, Syria.
David: And that really is capturing everyone’s attention at this point—what is the U.S. position on Assad? What is the Russian position on Assad? How are we going to deal with the Russians to solve the Syrian problem? What are we going to do, what are we not going to do? And Obama doesn’t have much of a voice on this issue. He would rather throw mud at Republicans as they get ready for their primary. But the reality is we have this need right now in the present to be aware of what is happening so that we can anticipate, better anticipate, the future. And some of that we do draw from the past. What does this mean in context?
Kevin: And Dave, I’d like to unwrap that a little bit later as far as how we’re moving from a centrist world to an extremist world. And you know, that Catalonian vote is just one example of that. And I know you can expound on that, but in the meantime, there are alarms going off right now for the future of the economy, which plays into everything.
David: Well, and just to clarify what you mean by extremist, because I don’t know that the Catalonians are necessarily extremists, they just want separation from the core theme of, “Are we Spaniards or are we Catalonians?”
Kevin: And we’re Catalonians. This is nationalism.
David: That’s right. So in terms of the arbitrary political spectrum of far left and far right, what you are saying is that people are less in the middle and are moving to those extremes of either a farther right perspective or a farther left perspective.
Kevin: Like your son talked about, there are rises of these movements now that actually identify people with a race, or identify people with a nation.
David: That’s right. Now, you mention deflation and I think this is pretty critical. You might recall our conversations with Ian McAvity, and he pointed out that the deflationary sirens, or canaries in the proverbial coal mine are one, the price of copper, two, the commodity currencies, two and three I suppose you could say if you are looking at Canada and Australia combined, those are your canaries to indicate whether or not you are moving toward, or are already in, a deflationary context.
Kevin: And these canaries, if they were screaming, they would be screaming deflation right now. They may be already dead on the bottom of the cage.
David: Yes, what’s interesting is, Goldman-Sachs just lowered their expectations of copper, and I think, “How interesting. The timing is…”
Kevin: Welcome to the party.
David: Welcome to the party, a little bit late, sorry, but the canapés are all gone. But better late than never, I suppose. But those are the signals to us that are sufficient to suggest that we are in an economic environment that is not comfortable, and not going to be getting more comfortable in the future, in fact, it is going to be getting uncomfortable.
Kevin: And Goldman-Sachs also lopped off an extra 1% from Chinese growth predications, so again, welcome to the party. I mean, you had talked to Chow and he felt like China could be possibly down near the zero level.
David: Right. Well, commodity weakness is reaching lower levels with each day and week. In fact, they are now at levels we haven’t seen since the worst days of the global financial crisis, and of course, that’s in part because of the slowing growth in China. I think Peter Chow was onto something, suggesting that the growth numbers, if you are just looking at the official statistics, those have been massaged and should realistically be closer to 3-4%…
Kevin: Instead of 7%.
David: Exactly, close to 7%. And if reality was looked square in the face, I think Peter would suggest we are closer to zero. And you might wonder, “Why does that matter to me? Why does that matter to us? Is it really significant—Chinese growth?” Well, if you look at global GDP growth, the majority of economic growth in recent years has come from China. So take away their contribution to growth and you being to see how weak other areas of the global economy already are because again, you are sort of averaging up the number. If theirs is very strong and others are very weak and you average out a more moderate number that looks positive, take away the strong number from the average and all of a sudden global GDP growth looks, not only anemic, but negative.
Kevin: Well, to look at the other side of the coin, though, a couple of years ago we were talking to people who were in the know on China and they said consumption is going to have to increase from within, and consumption has increased.
David: Right. And that is a bright spot, consumption growth is on the increase in China, which, that is a long-term positive. Most of that consumption growth is in the 20 to 30-somethings. They have experienced steady income growth and they stand out in sort of stark contrast with older generations whose lives were marked by life under Mao and the transition under Deng, and they’re not so eager to indulge. If they have an increase in wages their tendency is to save more, not spend more, in contrast to the 20 and 30-somethings which is, basically, “I have more, why not buy more?”
Kevin: You had brought out a couple of weeks ago that exports and imports, both, are on the decrease in China right now.
David: Yes, and there is a tremendous amount of weakness there, but keep in mind, they’re falling off the competition grid in terms of exporting goods, that is, finished products, tradable goods, etc., because of a rise in wages.
Kevin: Their stuff is getting more expensive.
David: Exactly, and because over the last several years you have seen an increase in the value of their currency. So these things are pricing them out, and as I say, they’re sort of falling off the competition grid. A lot of manufacturers can just take their needs and move elsewhere to have the same products manufactured at a much cheaper price point.
Kevin: Isn’t it amazing how cyclical commodities are? There are some things that are a little steadier, but commodities seem to be such a cyclical market.
David: Yes, and the move in China away from importing a tremendous amount of goods, and building out infrastructure, etc., it has gone a long way toward explaining the rout in global commodities. And as you say, the last five years have really been an extension of a cyclical boom in commodities, very cyclical. In that context, the last five years, there have been massive mergers, massive acquisitions. There has been a massive spending spree where debt was necessary to take over competition, Glencore taking over Xstrata was a major deal, and then they also attempted to take over Rio Tinto. Glencore, if you don’t know, is a Swiss based commodity trading firm. Not only do they trade commodities, but they are also one of the largest miners of things like zinc, cobalt, copper.
Kevin: And this isn’t a small business. We’re talking about businesses bringing in revenues of close to a quarter of a trillion dollars for 2014.
David: Well, right. And 2015 is a little bit shady in that respect, but this is the old Mark Rich company. Rich was an oil trader in 1974. You might remember that he circumvented the Iranian prohibition. He was trading in Iranian oil when he wasn’t allowed to.
Kevin: This was back during the hostage crisis, right? Back in the 1970s?
David: Yes. And so he fled the United States, lived in Switzerland for a couple of decades, could not come back to the United States, and then was ultimately pardoned by the Clintons. No one is saying that there is a direct connection, but as he is pardoned on the last day of the Clinton administration and within a few weeks of that, Mark Rich’s wife makes a multi-multimillion contribution to the Clinton family library.
Kevin: For the sake of good literacy.
David: (laughs) Well, of course. So again, this company goes from top 10 in the global Fortune 500 companies to life support this week, and it is an 80% drop in market cap for this company.
Kevin: And that is because of the exposure to commodities and leverage, right.
David: Exposure to commodities and debt, of course, those are two very big things. So, if they get downgraded, if their credit gets downgraded, it’s probably the end of the company. So you will have had something that was top 10 in the global Fortune 500 companies to literally gone. Panasonic—everyone knows that company—they’re pulling a number of their products which were previously manufactured in China and they are now going to be made in Japan. It is just signs of the times and I think these are very important signs to keep in mind because of the timeframe that we are in.
Kevin: Well, it seems that the repeating theme—this was last week, this was the week before—many of our guests have said the same thing, is too much debt. Too much debt really comes to bite you when you have something cyclical, like you are talking about—commodities—Glencore. Glencore, if they were a business that was running something a little bit more like McDonald’s hamburgers, which isn’t that cyclical, it can drop, it can rise, people still eat at McDonald’s. But copper—how much has it lost over the last couple of years?
David: 40-60%.
Kevin: And that is going to directly impact Glencore.
David: Absolutely. So I think several features that are worth mentioning. We discussed the importance of Chinese growth to the commodities markets, and as you say, the dark side of any growth story is tied up in the balance sheet. What sacrifices have been made to expand a financial footprint? In the context of a boom and bust cycle, on the boom side you find that people are afraid they are going to either lose out in terms of an opportunity, or they are going to be gobbled up and simply not exist anymore. So corporate execs look and say, “We’ve got to grow, or someone will grow in the process of absorbing us. We may be their growth story, or they can be ours. And so, again, it is leveraging up. And you mentioned it, leveraging up in a noncyclical business may be safer than leveraging up in a highly cyclical business, but you have Glencore, you have Freeport-McMoRan, just as two examples of very high-debt entities suffering from the volatility in the commodity pricing. And this critical drop in demand for commodities that they procure and provide to the world is now compromising their ability even to exist.
Kevin: Even the producers.
David: Alcoa. I watched football back in the day when Alcoa was the primary sponsor of commercials. “This was brought to you by…” Do you remember those?
Kevin: Oh, I do. I do. And they are the aluminum kings of the world.
David: (laughs) Well, they’re suffering, too, and they are choosing to separate themselves into two separate businesses just to survive. Debt is the death knell that many companies are facing. Debt is the factor that is also exaggerating the trends in government circles around the globe as they have accumulated a ton of this stuff, future obligations, in the aftermath of the global financial crisis. And they need to see higher rates, but they can’t afford normalized rates of, say, 2½ to 3%.
Kevin: Well, and everybody’s caught between a rock and a hard place, because you can either own commodities, and I’m not talking about gold, here, I’m talking about nickel, copper, aluminum, what have you, or you can own the currency that purchases that. Now, the currency that purchases it isn’t really backed by anything, so as long as there is faith in that currency, which right now, I just read something yesterday, Dave, that for the first time in 25 years, cash is outperforming stocks and bonds. And so we’re sitting in cash, we know that cash is devaluing over time, yet it is still the number one performer. This is crazy, but the consensus, Dave, is that commodities are actually going to drop further.
David: Right. And this echoes back to our conversation with Andrew Smithers where he said, “I’d rather know the losses that I’m going to take because of central bank gerrymandering with the value of the currency, than be subject to the radical, unpredictable, volatility of the marketplace where it could be a 10% decline, it could be a 70% decline. You don’t know. And his honest admission was, “I’m of the age where I’m not willing to take that risk. Perhaps a braver soul, a younger soul, is willing to stand through the vicissitudes, the ups and downs of the market.”
Kevin: Well, Smithers is a man whose family made their fortune in the stock market. He is not scared of owning stocks, he’s just scared of owning stocks now.
David: Now. That’s right. Well, the consensus is that commodity prices will trade lower and that on the back of a stronger dollar they very well may do that. Our contention is simply this, that you could see a major snap-back in the commodities space, pricing rising, and that that would start commensurate with a significantly weaker dollar. When is that brought about? Probably by acceleration of monetary policy accommodation. Now, we’re talking about, and assuming, that we’re going to tighten. Meanwhile, the signaling from the Fed has been, verbally, verbally, verbally, “We’re going to tighten,” but actions speak louder than words. I was reminded of that song, I don’t remember exactly what the point of it was, maybe I don’t want to know, but “You need to have a little more action, a little less talk.” Do you remember that?
Kevin: Yes.
David: Okay. So, well, that’s the case with the Fed. So what I’m saying is, contrary to what the market is expecting, which is a tightening cycle, we have current global, and to some degree, U.S. domestic economic weakness, and we as a firm anticipate the need for more quantitative easing stimulus. We’ll talk about that a little bit more in a moment.
Kevin: Well, let me ask you, is this a series of dominoes that could start to fall right away? I look at Glencore, which is really the name that represents commodities right now, and usually, when you are about to see a trend change in a market, you have consensus all saying the same thing, which is that commodities are going down, you have the companies that are involved in the commodities declaring bankruptcy or coming close to declaring bankruptcy. Are these dominoes that are actually signaling possibly a near-term reversal?
David: Well, it’s a good question, and I don’t know if it is sort of a chicken/egg thing where, does art reflect culture or culture reflect itself in art? We have Glencore which is clearly signaling weakness in the commodity complex, the commodity complex is signaling within the larger global economy there are issues, and that is really the bottom line. You have tough times, slow growth, and a return, perhaps, in the equity markets, to valuations that make sense, and these are things that, again, are being signaled by something like Glencore’s implosion. I would guess that there is more pain ahead in the commodities complex because you are dealing with such a massive over-supply of product and fairly tepid demand. But that remains to be seen. Sometimes these things take years to get cleared out in terms of supply and demand disjunctions. So, I think what is clear is that stock prices are still expensive—their valuations are not as expensive as when the Dow was at 18,500 but we still think that over a two-year period you could see those valuations, whether it is the cyclically adjusted price earnings multiples or Tobin’s Q, cut in half from current levels, which implies a significant decline in price for your equities indexes. And that’s not going to be in a straight line. I think there will be some room for recovery and bounces, and what have you. But over time our advice is going to remain focusing on cash as a valuable asset, you can pick your denomination, we’ve already told you what our preference is on that front.
Kevin: Sure, you treat cash and gold somewhat the same, it is just paper cash or gold, but it’s good to have a little bit of both.
David: And we mentioned this last week. Hetty Green’s preference for gold bullion in the context of financial crisis. She was a stock trader made famous as a sort of curmudgeony type lady but very successful in trading equities, had millions of dollars and then she wanted to pull her marbles out of the game. She went to Chemical Bank, she went to “old bullion” and she put her money in the bank. And she went to “old bullion because they didn’t invest in anything but gold and she paid to be there as opposed to being paid to be somewhere else. And it just says something about a mindset of, “I want control of the asset and the only way I can guarantee that I have control is to know that games aren’t being played behind my back.
Kevin: Right, she bought insurance. I mean, she paid to have a deposit at Chemical.
David: We live in a different timeframe where that kind of move is discounted as commodity speculation, but she was actually moving out of the speculative markets of stocks and bonds and into the guarantee of cash, which, in that day, and in that form, and in that bank, was bullion bars. So again, just looking back and looking forward for some perspective, most investors today would say, “Why would you want gold? Why would you even equate that with cash?” What they don’t know is that the majority of history compellingly says that this is the case. It’s only really since 1971 that we live in an era where cash and gold are not connected in some vital way.
Kevin: It is paper assets that have always been questionable. I want to go back to something you said a couple of weeks ago, Dave. You discussed technical analysis. We don’t do that very often on the program. It reminds me of the Car Guys, “Stump the Chumps.” These guys will go back a few months later and they’ll say, “Hey, were we right or wrong?” And you said there was a wedge formation forming and that we were going to get an answer on the stock market, as far as the trend, is it lower or higher? Are we getting the answer now?
David: Yes, following the August declines we described something of a wedge formation, out of which prices either need to move up strongly, or break down and retest the August lows, and it looks like we have our answer. Prices are moving toward the August lows—the S&P 500, that would be at about 1867—and we are likely to see that retested. The challenge at this point is that regardless of the quantities committed from monetary policy wonks or the central bank mandarins, the market has already reappraised the claims that rate suppression, the claims that asset purchasing by central banks are, in fact, effective tools to boost the economy.
So as the stock market declines, keep in mind that what we have seen over the last five years as a patterned response by central bankers is now being discounted in a different way by market participants who again are saying, “Yes, you’ve done this before and you told us it was going to result in economic activity, and it didn’t. But thanks for the increase in asset values. Now, the question is, was your idea legitimate in the first place because you said X would equal Y, and it didn’t, it gave us Z? We do appreciate Z, but X does not equal Y, your equation is broken.”
So again, there is this greater awareness that these types of measures are at best a Band-Aid and may, in fact, have many long-term detrimental consequences.
Kevin: What a contrast, though, Dave. A year ago we were talking about, in frustration, how people were just completely asleep while central banks were at the wheel. The Federal Reserve was at the wheel, it’s like, “Well, you can sleep calmly because they are in control.” That’s being questioned at this point.
David: And what do we talk about in terms of the fix, the volatility index, the measure of puts and calls?
Kevin: It was dead.
David: It was dead. You know what you get when you have a dead VIX? You go from low values to high values. That’s the way the market works, so sit back, buckle up, and get ready for volatility. Why? Because the VIX is dead. The VIX is saying, we live in a perfect world. The problem is, we know we don’t.
Kevin: And the VIX in August jumped more than we had seen since the financial crisis.
David: (laughs) Well, again, we may have an announcement of QE-4. I think whatever happens in the market immediately thereafter is likely to be short-lived because the backdrop has shifted. Sentiment is not so naively bold and bullish as it has been over the last five years, and I think you can have a number of traders who still try to play games with an opportunity of, again, more cheap money in the marketplace. But long-term investors, including institutions, are already shifting their allocation models into a more conservative posture.
Kevin: I had mentioned earlier about a centrist posture, starting to move to the wings, left wing, right wing, you name it what it is, when everyone was on board with the central banks there was comfort level, there was a lack of volatility. Now you have people starting to cry out for whatever their own position is, or what their goal is.
David: That’s right. You tend to see a localization of interests in the context of panic, and what I mean by that is, Europeans quit thinking about themselves as Europeans and they start thinking about national identity. And in the case of Spain, it’s even beyond the national identity, it’s a local identity. You know, you have Barcelona, and this is the richest part of Catalonia, a region in Spain, and they want to separate out. It’s really no different than what we’ve seen for years in Belgium, where the Flemish have asked the same thing. They want to be separated out from the Southern part of Belgium because they are looking at it as sort of dead weight (laughs). And I think that the Catalonians are looking at the rest of Spain and saying, “Yeah, we can go it on our own. We’ll build our own military, we’ve got the resources, the finances. And from Barcelona, we’ll rule our small part of the world.”
Kevin: Doesn’t it boil down to financial security? When someone starts to feel insecure they are going to find some other solution.
David: That’s right. And this is reflected, I think, in a recent Economist article, and it highlights the political impact of financial security or insecurity. The information in the article is based on a Latinobarómetro poll, and of note in that poll were the following trends. You have Latin America, which has been hit particularly hard by the end of a long-term commodity boom, and that’s how the article begins. And in this context, you now have political polarization which is occurring. You have centrist positions which are being ditched in favor of far right and far left political platforms. 42% had considered themselves to be centrist as recently as 2008 and it is about 33% which consider themselves centrist in their political positions now.
The poll also suggested that support for and satisfaction with the idea of democracy is dependent on, is reliant on, the health of the economy. 2010, which was sort of the region’s, Latin America’s, strongest year for GDP growth, it witnessed also its strongest support for the idea of democracy, satisfaction with it, etc. And 2010 was a big deal because as recently as 2000-2001 the whole region was in a recession, and democracy was definitely out of favor. Now we are turning there again, where a lack of confidence in the courts, in the legislature, in the established political parties, is reflective of growing uncertainty in terms of the economy.
Kevin: And those are the seeds of revolution. Democracy can be a good thing in good times and it can be a dangerous thing in bad times.
David: Well, it’s dangerous at the extremes of either economic success or failure, because at one extreme, we see an electorate so fat and happy they support anything as long as it is perpetuating the status quo. And at the other extreme we see the electorate supporting anyone—so from anything to anyone, they will support anyone that promises pain relief and a change from what has become an intolerable status quo. So, somewhere in the middle, I would contend, is sort of the safest place for human and societal flourishing, and it’s a place where you have to exist with tensions.
You probably remember the timeworn phrase, “Lord, don’t let me starve, and don’t let me lose sight of you in the midst of great wealth.” What is that verse?
Kevin: That is from Proverbs 30. It says, “Give me neither poverty nor riches. Feed me with the food that is needful for me, lest I be full and deny you, and say, ‘Who is the Lord?’” So obviously, the extremes of poverty, and riches also, can throw things out of kilter.
David: Yes, like I’ve been telling my six-year-old, Aristotle says that virtue is the midpoint, or the mean, between excess and deficiency. Whether it is a little bit of bubble gum verses a lot or not at all, or a little bit of toothpaste versus emptying the whole tube or none at all, how much do you need? You need enough. You need something that is a modest amount, not too much and not too little.
Kevin: Well, then let me tie that into central banking because we’ve seen something over the last few years that no one has seen anytime in world history, and that is, central bank domination, that the markets were no longer necessary. The central banks actually killed the markets. Now if you go back 50, 70, 100 years, whether you agree with central banking or not, central banking taken in moderation sometimes can help a market. Just recently, ex Fed economist Stewart Weiner tweeted, “Give me the Bundesbank. Give me back in the days when the central bank was able to tweak the market but they weren’t completely disqualified. “
David: Right. His criticism was that the Fed is floundering, they appeared confused, they were even panicky.” And then he referenced the Bundesbank as having a solid idea of what they’re supposed to do.
Kevin: But they used to say, “We’re not going to take any inflation.” That’s what Bundesbank used to do, and they acted accordingly.
David: Yes. And at the extreme you’ve got Andy Haldane at the Bank of England, a chief economist there, who basically says, “Not only have we not put enough money into this project, but we will make this baby fly. We will make our models work. You just have to give us the right tools.” As if they haven’t had ample tools and exotic tools already. He is basically saying, “Listen, we need to take rates lower, we will take rates lower, we’ll take them negative if necessary.”
Kevin: But we need to eliminate cash, just like you talked about last week.
David: Right now he said there is this sort of growing audience, or chorus if you will, of people who basically say, “We can’t do our job if you allow people to move out of the marketplace and move to a market neutral position. We need to eliminate cash. And QE, what is the benefit of QE? It’s gone to governments more than anyone else, via lower interest cost on debt. And it has allowed for them to accumulate a tremendous amount of debt. And yes, it’s done things like flatten the yield curve, yes the primary loser has been the person living on a fixed income, or someone who is generating interest income from their investments. He is suggesting, “If this has been painful for you, we can make it worse. And by the way, we don’t really care about you, the fixed income person, we care about the system, and we care about our ideas, exonerating our ideas.”
At the heart of the central bank community I think you have an exercise in hubris, an exercise in pride, an unwillingness to say, “Maybe we got it wrong.” They don’t even have to say, “We got it wrong.” Just even that suggestion of maybe would be so refreshing, because instead they are basically saying, “You don’t understand, we can throttle this further.” And by throttle they mean you and me. By throttle they mean increased taxes surreptitiously on you and I, the depositor, by taking away our freedom to act and choose as savers, as “hoarders of capital” if, in fact, the allocation of capital, that process, becomes awkward, or ugly, or dangerous for us. They don’t care, they would rather us put our capital at risk, keep it at risk, than somehow be able to take our marbles home.
Kevin: It reminds me, since you are bringing up Greek philosophy, it reminds me of Greek tragedy. Because hubris always turns into humility. That’s what Greek tragedy is all about, reducing hubris to humility. Now, we may have listeners, Dave, who have heard you say over and over and over that the stock market is too high, that may still have stocks in their account. Now, is there a number that they should be looking toward to say, “Okay, I’ve heard that it is too high, but this is my trigger point, I will sell and move to cash if we hit this number, let’s say on the S&P 500.
David: I don’t even mind if someone keeps a permanent allocation to equities of 20-25%, but at this point if you’re invested in the general stock market indexes, something like a composite Dow, S&P 500, NASDAQ, which gives you exposure not only to technology, but the delivery of goods and services, the development of goods and services, this is where I think you need to be market neutral. And what do I mean by that? You could have a portfolio of stocks and hedge that portfolio, and you should be hedged if you are not already. It doesn’t mean you have to liquidate everything but you should hedge. There is a cost to doing that, and that is perfectly acceptable.
And you should have raised cash long ago. We have been talking about raising cash for two-and-a-half years. Maybe we have been talking about it early. I would rather be early than late in matters of public and financial panic. So to me, you should be in cash, you should have a hedged equity portfolio if you own equities still, and you should now have a healthy position in gold and silver. And quite frankly, if you have done none of those things, and you are just kind of putting a fleece out there trying to figure out the direction of the market and if there is a point at which you should be taking action because you haven’t done any of those things that I just mentioned yet, then watch 1867 on the S&P. That was the August low.
And if we breach 1867 we can go a lot lower. We know what the lows were in 2009—666. So 1200 points is the difference between 2009 levels and the current. And I would suggest that we dip somewhere below 1867. Is it to 1600? Is it to 1500? Is it to 1400? Is it to 1200? I doubt we will see the 2009 lows of 666, but we could very well see something closer to 1000 on the S&P if this really gets to be a real rip-snorting bear market.
Kevin: And sometimes the price of something isn’t the indicator as to whether you should buy it. Sometimes a low price doesn’t necessarily indicate it is going to have a high price, but supply and demand—I can remember a number times, your dad walking through the office sort of chuckling and saying, Straw hats in the winter. You’ve got to buy your straw hats in the winter.” It’s a little bit like gold and silver right now.
David: I think one of the distinctives in business is being able to do something at a time when no one else can. For instance, you’ve seen in recent months demand for one-ounce silver eagles and silver maple leafs. It has outpaced supplies from the mints, and current delivery times on that kind of product are one to two months.
Kevin: Yes, but you took inventory, Dave.
David: We made a strategic decision, we can deliver product immediately, we have live inventory of tens of thousands of ounces. We took steps to fill the gap and have product available in spite of current market constraints. We’ve done the same thing with gold ounces and I suspect we will see a market with no available product on the gold side within six months.
We reflect back to, say, 1984. We’ve done this before. We’ve seen this before. We know what the market dynamics are in an environment where demand picks up and we deal with inelasticity, which I will get to in a minute. But we’re taking bars off the exchange and having them refashioned into something that a consumer would be interested in—thousand ounces bars converted to 1s, 10s and 100s. We can do this if necessary, we will do this if necessary, and I think we will have to do it shortly.
We saw the same thing in 2008 where supplies evaporated, and we are seeing those same signs now. What I’m saying is that when we saw them in 2008 it was in the context of the failure of Lehman Brothers and Bear-Stearns. We are beginning to see premiums on U.S. gold and silver products like we saw in 2008 and 2009, but where is your Lehman? Where is you Bear-Stearns? We don’t have an institutional failure. On the other hand, we may find that the institutional failure is the company that we’ve been talking about. Maybe it’s Glencore. Maybe Glencore is our current-day Lehman. Now, obviously, they are not as interconnected into the financial world as a Lehman, as a Bear, as an AIG.
But again, we are dealing with demand for metals which is suggestive of an audience having concerns with systemic stability. And so even though you see a sticker price for gold at $1150, I’m telling you the price of that is much higher in the wholesale market because when you buy physical metals as opposed to dealing with paper contracts in the futures market, you are already paying premiums because of scarcity, scarcity that is not indicated in the futures markets.
You know what it reminds me of? We went to Argentina last year at about this time of the year, and we had a conversation relating to the value of the Argentine peso. And you had the official rate and you had the blue market rate, and it’s almost like the physical gold market today is operating in blue market status. It has its own pricing structure, and what happens in the futures pits is completely irrelevant. The problem is, what’s quoted every day, and what is the primary reference is the “official” number that you look at in the newspaper, the published spot or melt price of gold. It, frankly, is like the Argentine peso. You need to know the blue market rate. The official rate is an interesting reference point, but it has nothing to do with reality. And that is kind of where we are moving, and I think it’s going to intensify over the next 24 months.
Kevin: And I think that is a mistake. There is a moral to this story. There is a mistake that people make. They mistake gold for copper, and copper for gold. You will hear these newsletter writers saying, “Oh, we’re going to have deflation, which means copper is going to go down.”
David: “And gold, too.”
Kevin: That’s not what we’re experiencing here.
David: No, over the last several weeks copper and the industrial commodities have sunk as gold has risen, and this is important. That is a point that stands on its own. I also look back to last Thursday and this is a stand-alone point, I think, which is equally important. Last week, Thursday, stocks were tumbling. We had a surge in the precious metals. We are getting closer to a comprehensive reallocation which includes precious metals as a favorite. The last move of precious metals and the other commodities circa 2008 through 2011, and a resurgent peak there, was confused and undifferentiated, and it was a move based on liquidity raising all boats. That, I think, was supported by the belief that China would be the engine of growth to pull the world economy out of its post-crisis stupor.
Kevin: But what you are saying is that things are changing now, you think gold will rise while commodities and other things continue to fall.
David: I think gold will rise against a falling commodity complex in the next round as economic contraction slows demand for basic materials, but the fears of reflationary policies pushes the precious metals group higher. So that is just to put a cap on the commodities complex. At the same time, if you have stocks falling off of the investor interest radar in that same timeframe, you are going to find that the gold supply will not allow for a comprehensive reallocation into the sector except by an exponential move in price. And that is precisely what we do see occurring in the future, gold in U.S. dollar terms, selling at a multiple of the current price. The double driver will be a currency devaluation showing price strength even without a fundamental demand component, but secondly, that fundamental demand component, where demand growth accelerates that price trend.
Kevin: And as you have said, Dave, we have seen a number of times, over the last 40 years, when the price of gold or silver doesn’t really reflect the quantity that is out there for supply. I just remember during the financial crisis we were allocated five ounces a day from one of our suppliers. That was it—five ounces of gold a day.
David: We had clients that wanted to send us a quarter of a million dollars, a half million dollars, a million dollars, and we would say, “Well, it’s going to take us a little while to fill the order at the current pace. Be patient with us, and we will do what we can.”
Kevin: So supply and demand—there is an inelasticity. You brought the word up earlier.
David: Yes, the word of the week—inelastic. Let’s put it in context. The gold and silver supplies in this context are inelastic. What I am saying is that supplies are insensitive to a change in price. There is nothing you can do about it. As the price goes up, you can’t go out and double the amount of metal available, which makes the metals impressively volatile. Again, watch and see if stock selling continues. If the equity markets sell off, if we trip past that 1867 level on the S&P 500 and gold is moving up at the same time, I think what it is signaling to you over the next four to six months is one of those comprehensive reallocations, a systemic distrust, if you will.
Kevin: Don’t you think a realization of history and a full understanding of history is the only way to get through this next two to three years? I remember a book, Dave, that you had us read eight years ago from a guy who has been a guest a number of times since then on the Commentary—Russell Napier. He wrote a book called Anatomy of the Bear. This guy paid his dues, he went back to every Wall Street Journal and read every issue from about 1907 on—I can’t remember what the date was—but he understood stocks and understood a bear market. The reason I bring this up now is that Russell Napier is starting to see this education pay off. He is talking about a bear in the stock market, and he is also naming numbers as to how far it should fall.
David: Russell was recently reflecting on this and he noted that since the inaction of September 17th when Yellen could have raised rates and didn’t, that is basically an extension of low rates, we have seen the dollar move higher, which again, if you’re going to keep low rates for a long period of time, the dollar should be moving lower, not higher. So something counter-intuitive is occurring. Emerging market currencies have suffered even more severe losses. Brazil, for example, was down 10% just last week before verbal intervention occurred on Thursday.
You have the TIPS market, Treasury Inflation Protected Securities, which are indicating that there is more deflation ahead of us. And it signaled this since that announcement. Copper, since that announcement, has dropped an additional 7%. Global equities have fallen since that announcement. U.S. equities have fallen since that announcement. Corporate debt is now increasing against treasuries. That is, the corporate spreads are increasing, the interest rates are increasing above treasuries. That is typically a sign of trouble. And that, by the way, was further highlighted in a Wall Street Journal article this week titled, “U.S. Bond Markets are Flashing Warning Signs.” So as Russell says, the decision not to tighten was followed by a tightening of monetary policy.
Kevin: It just happened in the free market.
David: It happened in the free market, exactly. The cost of corporate borrowing is higher, he says, and inflation expectations are lower. Russell suggests, as only Russell can, that we are at a phase shift—I don’t think he described it as that, but that’s how I’m describing it (laughs)—a phase shift from monetary policy reliance to a deflation which is now beyond the control of central bank activism. He anticipates the return of government to the capital allocation process, which he thinks is going to be responsible for knocking equity valuations down by at least half and bringing about a reflation in the economy via enlarged government activity.
Kevin: And Higgs calls that the Leviathan.
David: (laughs) Well, right now his recommendation is sort of the purely deflationary allocation of cash and long government bonds with an eye to major allocations in the gold market as the government reflation gains traction. So gold is certainly on his radar, cash is certainly on his radar, being long government bonds.
Kevin: But he sees the Dow dropping down into the 1300s.
David: Well, look at the evidence. You have the Japanese manufacturing PMI which was weaker than expected in September, you have the Japanese CPI which has turned negative in August for the first time in two years. So what are we talking about? This is a further discrediting of the aggressive monetary policies known in Japan as Abe-nomics.
Kevin: It didn’t work.
David: The only regret that they are going to express is that they didn’t do enough. What are they going to want to do? Probably more QE? At the same time, further evidence. Caterpillar announces to cut 10,000 jobs. They expect a further drop in revenue. Who is Caterpillar? What do they do? They make heavy equipment. It is used in construction, it is used in energy, it is used in transportation. It is used in natural resources. These are the fundamental components of products and their shipment all over the world. Caterpillar is signaling a global malaise, and that’s just putting it politely. It is indicating a significant slowing in trade and economic activity.
What Russell Napier is suggesting is that even when, on September 17th Janet Yellen says we will continue to accommodate, the market responds negatively to “we will continue to accommodate” letting you know that the market now knows that the central banks have been neutered. They don’t have an answer. They can’t generate economic activity, and everything that they’ve tried in the past hasn’t given us what we needed for a sustainable economic recovery. Ergo, anything they do in the future—lipstick on the pig. It’s not going to be any more of a solution than QE 1, 2, 3 have been. And think about that. By the time we get to QE4 you would think that the market would say to themselves, “Why are we at number 4 now? 1—was it effective? No, we needed 2. 2—was it effective? No, we needed 3. 3? No, that was a failed project, too, but we’re going to try 4 anyway.
And Russell’s point is, the market gets it.
Kevin: And Russell’s point is, cash and gold.
David: (laughs) Well, gold in the future. In fairness, he certainly is looking at gold on the horizon. I would say position on it now, because quite frankly, what he doesn’t know as an internal dynamic within the gold market is that by the time you want it, you won’t be able to get it.
