The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: People want real gold right now, David. I think the story of the week is just how long gold has been in this concept called backwardation, where they are willing to pay more for gold right now, as long as they can get it now, than the futures contracts. Now, that’s not normal, is it?
David: It’s not, and we’ll get into some of those details in today’s conversation. We also want to talk about equities and how vulnerable they are, with significant selling pressure very likely, and upside really predicated on Fed credit creation and other forms of market intervention, So we want to talk about gold a little bit, certainly, where the market is, its precarious place, and yes, circling back around to gold, not just the issue of backwardation, but we do see the likelihood of a bottom in gold already having been put in. The most vulnerable of the charts are the monthlies where momentum takes a good 3-9 months to change direction, but we actually see the moving averages, even on the monthly charts, beginning to improve. So daily, weekly, monthly, the very short-term, the intermediate, and the long-term judgments of gold, beginning to turn around.
Kevin: Before we get to the debt ceiling, and some of the other things that are coming, would you say that you feel that gold may have put in a bottom at this point, and that it’s positive from here? What’s your thought?
David: It appears so, and I think, if we retest, that is a possibility, but I think we do have a positive bias over the next 18-24 months, and again, that’s supported by both the daily, that’s the short-term charts, the weekly, the intermediate-term charts, and the long-term, or monthly charts. But there are issues that we have to address of a general economic and macro nature here in the U.S., including the debt ceiling, that debate approaching.
Kevin: I have to admit, David, every time I see debt ceiling is approaching, I just sort of get a little bit of nausea, because I’m just sick of it. I’m sick of them actually talking about a debt ceiling approaching, and then the politicians getting together and acting like they really care, and that there actually is a debt ceiling. Is this really posing a threat to the economy or is this something that is just another distraction from Washington?
David: Your revulsion, Kevin, is, I think, a common one, and it’s what we see reflected in Oliver Sacks’ book, The Man Who Mistook His Wife for a Hat. He was a neuroscientist, and had done a number of case studies, one of which was a brain disorder where people are generally comatose, except when they’re witnessing someone lying to them, and then they just laugh hysterically. They go from being completely comatose, and basically almost brain dead, to laughing hysterically when someone is lying.
Kevin: That was one of the case studies that he looked at.
David: And they couldn’t figure it out until they were watching politicians in season. Okay, so you’re in election season and there’s this uproarious laughter all the time. We have that same sense inside of us that, “Wait a minute. I don’t know if it’s Kabuki theater, or what it is, but this is not reality, they’re posturing.”
And, we have a number of things, a host of other curious economic events. You have the new Fed nominee, who will they be? You have QE or not to QE, that is the question. And then, in the middle of all this, is the assumption that Washington has done little, and the Fed has done all the heavy lifting.
Kevin: Well, thank you Ben Bernanke. Yeah, Ben Bernanke has done all the heavy lifting, and I guess it’s not all that heavy when you press a button you make another trillion, you know.
David: Well, that’s only partly true. If you recall, while cutting the budget is a very difficult task, a herculean task, if you will, that is where Congress has basically been on strike. So in essence, they have done nothing when it comes to cutting the budget, but increasing the budget…
Kevin: That comes easy.
David: (laughter). Yeah. And that does count for something, in terms of D.C. market activity. They haven’t been completely absent. They have been spending, and deficit spending, to the equivalent of about 10% of GDP. It’s essentially, if you want to look at it this way, like corporate welfare. We’ve got, now, a record number of people on food assistance, which actually makes up about – if you are looking at revenues by your chain groceries stores – between 12% and 13% of their revenues right now are coming from the food assistance programs, in the equivalent of food stamps.
So we have the other form of corporate welfare, and you have, basically, the deficit on the government side of the equation, which is balanced nicely by the surplus of corporate profits – deficit on the one hand, surplus on the other. Corporate profits have been very healthy and how is that? Well, this concept, we actually explored this with Michael Pettis about a year ago as we’ve looked at U.S. trade deficits, not budget deficits, but trade deficits, and the corresponding surpluses elsewhere in the world. We also discussed how the European imbalances, with Germany running the surpluses, forces the other side of the equation, deficits, onto the peripheral European countries. It’s not just a question of the spendthrifts in the south, and those who are very responsible with their money in the north. That’s really not an accurate depiction of what happens. When you run a surplus, it naturally creates a deficit elsewhere with your trade partners.
So we have that in Europe. We’ve done the same thing domestically, not with the trade deficits, but with our budget deficits, with the hope and expectation that the combination of Keynesian monetary policy from the Fed, along with Keynesian fiscal stimulus via government deficit spending, that these things would re-ignite a virtuous cycle of consumption and of growth.
Of course, we could hold our breath on that, and you’d either be blue in the face, or already dead, but the debt ceiling debate comes into this, and yes, it’s a total farce. We’ve already moved beyond the official number. We’ve merely borrowed the funds from another source to be paid back when the political charade is over. So yes, your instinct, my instinct, I think the general audience’s instinct is, this is a bit of a joke, isn’t it?
Kevin: The thing is, it angers me that we’re talking about this much debt. You were talking about 10% of GDP is going toward the debt and they are calling it a recovery, Dave. Granted, they are saying, well, maybe it’s 1% or 2% for the recovery, but if you pull the quantitative easing out, and you pull all this debt spending out, we are shrinking big time. What is a recovery like when you’re really just borrowing to call it a recovery?
David: And this points to the fact that the GDP figure is an irrelevant number to begin with. We are on life support, to talk about slow growth of 1% or 2%. It’s balderdash! We are stuck on life support. We’ve used this analogy before. It’s like pretending that someone’s in the recovery room, when in fact, they’re still in the ICU. Take away government deficit spending and you have an economic picture which is more dire and ugly than the 1930s, and we’ll talk about the 1930s here in a minute, but you’re right. We have a recovery. Do you like a recovery enabled by borrowing against the future? Because that’s what government deficit spending is. You can retitle it, and that’s essentially what you have, a recovery enabled by borrowing against the future.
Kevin: And who gets hurts on that, Dave? The middle class, the guy who actually goes to work every day, he is paying his taxes, he is buying what he can, but he’s still running out of money. I mean, the savings are dwindling.
David: So, do you like a recovery bought with the savings of the middle class? We’re talking, really, about those living paycheck to paycheck, and having to dip into savings to make ends meet. These are savings that would have otherwise supported future investment, would have supportive retirement, and those things are being displaced by the demands of rising consumer prices. You have U.S. growth, in the last five years, which is slower than in Japan during their lost decade.
Kevin: Now, that’s remarkable, because we look at Japan and say, “Gosh, we sure don’t want that to ever happen here.” That’ what you hear from the Fed, that’s what you hear from the economists. But what we are experiencing is what has happened in Japan.
David: Only worse. And so, yes, the pressure is on for the middle class. We are putting the next generation in hock so that we can pretend that we have an economic recovery here and now, and this is where the Fed is really challenged. The activities that they have had in place haven’t really been effective in stimulating growth. They know what they know, and they know what we know, which is that the numbers really don’t add up.
Employment? No, actually 7.4 doesn’t accurately depict the stabilization of the employment picture. And no, GDP, we just created 560 billion dollars more in the economy than existed just a few weeks ago. That miracle, which delivered us 2% growth instead of the 1% growth, or 0.6, which was expected, they know it’s a farce, too, but listen, this all ties into confidence. It ties into how you create a psychology, which then perpetuates growth in the economy. Confidence begets spending, spending begets growth, and it feeds on itself, so what they have to do is support confidence through any means necessary.
Kevin: And that’s the lie. Let’s address the elephant in the room. In fact, to be fair, let’s address the elephant and the donkey in the room, okay? It’s big government, Dave. I remember one time hearing a story of your dad’s. This is when you were just a little kid, he was riding to someone’s house on his bicycle. Now, your dad is not known for his maintenance of bikes or cars, it’s just not where his head’s at, but he rode all the way over, I think a couple of miles, maybe it was five miles, and he thought he was going uphill the whole time. Well, he had not identified the problem. The problem was, he had, I believe, at least one flat tire, maybe two. Okay, he needed to identify the drag. Now, the drag on the economy is not a flat tire, the drag on the economy is what happens to any government that gets too large. We’re paying for a government that we can’t afford.
David: That’s exactly right. You have at least half a dozen studies that have been done in recent years, so this isn’t from the 1860s, or from the 1920s. This is present tense, growth of government equals slowing of economic growth. So there is this correlation. One article: “Government Size and Growth, A Survey and Interpretation of the Evidence.” This is from The Journal of Economic Surveys. This is where they’ve found that a significant negative correlation existed between the size of government and economic growth. An increase in government size by 10 percent, the findings were associated with ½ to 1% annual growth rates.
We continue to see the growth of the leviathan, and it puts pressure on economic growth, and then on top of that, I want to thank Lacy Hunt for putting this group of studies together, but on top of that, you have The Impact of High and Growing Government Debt on Economic Growth: An Empirical Investigation for the Euro Area. And the conclusion was, if you have debt-to-GDP of between 90-100%, you’re going to have a considerable impact to growth in those economies.
Well, that corresponds very well with what we saw in the Reinhart and Rogoff studies where 90% was the threshold and above that number you began to see a significant impact to the growth in the underlying economy.
And then another one, this was done by the Bank of International Settlements in 2011, called The Real Effects of Debt, and they put the threshold at about 85%, where if you grow beyond a certain level, debt is bad for growth. Government debt, and the number for them was 85% debt-to-GDP. We’re already at 105%. Add to that the fact that we have private debt-to-GDP of 273%, and you understand why, between corporate America and private households, we don’t have an ability to step back into the market. We don’t have the ability to, once calm has re-entered, just simply go back to spending the way we were ten years ago. We don’t have the ability because we’re already leveraged out the eyeballs.
Kevin: You know, I think it’s an irony, Dave, that if you love your country, you actually are going to want to shrink your government. Loving your country does not necessarily mean loving your government, and I love my country, so what I would really like to do at this point is shrink the government.
David: And that’s exactly what Alexis de Tocqueville was talking about when he said, We can state, with conviction, therefore, that a man’s support for absolute government is in direct proportion to the contempt he feels for his country – contempt he feels for his country. There is this notion that if you love your country, you should love your government, as you say. But at what limits? Because what we are finding is that there is not enough room for both of us to continue to grow and flourish. That is, us, the common man, the businessman, the household…
Kevin: Which is the private enterprise. That is the country I love.
David: That is the country.
Kevin: Yeah.
David: Exactly. Set aside growth in government. Now, government has grown and displaced, or taken up that space that the consumer filled, and government is assuming, again, the Keynesian model is that you fill the gap until the consumer returns. But the consumer cannot return. 273% of debt-to-GDP, when you combine both corporate and household debt – that’s the private debt stock against GDP. That is an unsustainable number. That is a number that, along with government debt, means that the economy will be slow-growing, or no-growing, for the foreseeable future.
Kevin: Dave, I think that the carrot that is just hung right out in front of us right now, making us think that maybe things are okay, is the stock market. There is quantitative easing coming into the market, what have you. But we do see the stock market still performing like a bull market. I know there are opinions that would say that it is still a bear market, but what are your thoughts? Is the stock market real, or is it a phenomenon right now that can’t last?
David: It’s a phenomenon that can’t last, it’s a place where you’ve seen a mass manipulation of perception, and it’s because that’s where the easy credit, the easy money, has flowed. If you look at equity market valuations today, you have earnings which are at an all-time high, you’ve got price-to-earnings ratios today that are not a bargain, 19.29, that’s trailing earnings, and, again, that’s not an all-time high, because you have prices which are pretty elevated, too. But they’re not cheap. As a general rule of thumb, you’re talking about paying up front for 19 years’ worth of earnings.
Kevin: I think we should explain that just for a moment. Let’s say that you had a business that was earning a million dollars a year, and its overall stock was selling for 10 million dollars. That’s the overall equity valuation. That would be a 10-to-1 price earnings valuation, correct?
David: Right, so you would basically get your money back from the earnings of the company in a ten-year period. What we’re saying is that you’d have to wait over 19 years to get your money back, based on the earnings of the S&P.
Kevin: Which, historically, is when the stock market is getting close to turning back down.
David: Well, unfortunately, it gets worse, because when you look at a ten-year rolling average, the ten-year PE, also known as the cyclically-adjusted price earnings multiple, or more commonly known or referred to, it has been popularized by Robert Shiller, as the Shiller PE. That’s trading at a 24½ price/earnings multiple – 24 ½. Again, we saw 27, a slightly higher number in 2007.
Kevin: Look what happened in 2007.
David: I know, and we’ll get to that number, I think, very quickly. There’s no doubt we’ll see it. We’ve seen these kinds of numbers, this elevated range, in 1968. You had this massive technology boom, small cap shares went crazy in between 1967 and 1968, the NASDAQ stock market didn’t exist, so it was small caps that went crazy just before going into, along with your large cap companies going into a bear market, from 1968 to 1982. But the same kinds of valuations were there in 1968. The same kinds of valuations, if you want to turn the clock back, were there in 1929. The same valuations, at an even more elevated level, were there in the year 2000, and then 2007.
Kevin: I remember in March of 2000, nothing looked like it could go wrong, and then everything went wrong.
David: But here’s the bottom line. The bigger the number, the longer the time frame, of sub par, or in some cases, even negative real returns. So, what you do when you look at the cyclically-adjusted price earnings multiple, and look at it at 24½, you’re basically saying that over the next ten years your average rate of return is going to be under 2%, probably closer to 1%. Your average return, year after year for the next ten years, is going to be roughly what we’ve had over the last 13 years, which is about 1% per year.
Keep in mind, 1% per year doesn’t take care of the inflation factor over that same time. This is just sort of nuts and bolts, don’t factor in inflation. How much money did you make in nominal terms, no real terms, but nominal terms? 13% in 13 years, 1% per year. That’s basically what you have to look forward to, something like that, with a cyclically adjusted price earnings multiple of 24½. Can it go higher? Sure. Do we expect it to go higher? Sure. Why? Well, we’re in a period where confidence is, to some degree in the market, again, at least there’s the manipulation of perception to where investors are participating. They’re in. This is where I think you go back to this notion of the greater fool theory. I believe that this was the origin of that theory, if you want to call it that. It’s just someone who came up with a quip or a quote that encapsulated the truism.
In 1890, from the Chicago Tribune, they said, “In the ruin of all collapsed booms, is to be found the work of men who bought property at prices they knew perfectly well were fictitious, but who were willing to pay such prices simply because they knew that some still greater fool could be depended on to take the property off their hands, and leave them with a profit.” There’s your greater fool theory. And it’s in the house today. It’s in the market today. It’s what we have operating today, because you don’t buy a price earnings multiple of 19, and you don’t buy a Shiller PE of close to 25, except on the greater fool theory, because this is, classically, where you see a market top.
Kevin: Dave, in the 26 years that I’ve done this with your family here, I’ve just observed that when somebody is paying too much for anything, they start to justify it. You start seeing it show up in Fortune magazine and Forbes, saying, “Well, maybe we shouldn’t actually judge the value of stocks the way we used to.” They even called it the New Economy back in the late 1990s, where you really didn’t want to look at price earnings ratios, because the companies that were skyrocketing didn’t have any earnings. They just had future ideas. Of course, we now know that that bubble popped.
Something else, though, can change price/earnings ratios. Without the stock market ever rising, you can see executives, and people in the company, themselves, decide to buy back stock. We talked about this last week. That reduces the amount of shares in the market, and that can also make things look better than they are.
David: Before we go there, I think it’s important to realize how vulnerable all of us are, and I’ve realized this in the last two or three weeks. I looked at a project, and it’s not something I’m going to be interested in, but I looked at a project, a real estate deal, here in the last couple of weeks, and the income is immense, until you dig into the details and look at what the actual cost of the project is, compared to your earnings, and it actually turned out to be about an 18½, the equivalent of an 18½ price/earnings multiple, or in real estate terms, about a 5½ cap.
At a 5½ cap the cash flow was very alluring, the income is very attractive, and as long as you’re fixating on one variable, and one variable alone – I need income – guess what you’re going to do? You’re going to be buying something that may not be appropriately valued. That’s the same exact thing we see in the bond market today, Kevin. You remember 2007. We had 96.6 billion dollars that went into covenant light loans. Covenant light loans were the ones where there really weren’t many safeguards for the lender. Limits on debt. Again, we were setting all-time records in 2007 with things that were lightly investigated.
Well, fast forward. This is no longer 2007. You have 155 billion dollars of covenant light loans so far this year. We’ve already beat the 2007 record, comparing the numbers year-to-date. You have junk bonds – the demand for junk bonds has risen 24% above last year’s demand, to 235 billion dollars. This is through August 9th, and comparing to last year that’s an increase of 24%. What’s the fixation? The fixation is on income. What is the element that is being neglected? It’s the numbers, it’s the risk. It’s the credit risk, the illiquidity risk. All of those other things are being ignored.
Just like this temptation that I experienced in the last few weeks, looking at a real estate project with great cash flow, but as you dig into the numbers, and look at how it’s actually valued, I don’t want to pay up front for 18½ years’ worth of earnings. That’s called playing the patience game. And when you make a poor investment, you’re forced to wait. It becomes a creative investment after 18½ years? No thank you. No-thank-you.
You make money when you buy an asset, not when you sell it. You make money on the basis of having paid the right price up front, and what you see in the junk bond space today, what you see in the fixed income space, what you see in a lot of real estate, not all, but in a lot of real estate, is that things are actually priced for a perfect world, and that’s what we are saying. We actually don’t have that perfect world as a backdrop.
Back to your point on earnings-per-share. We’ve seen major improvement in earnings per share, in part, due to corporate share buy-backs, in part to do with what we were talking about earlier. We’ve seen this balancing act between deficit spending, on the one hand, and corporate largesse on the other. We’ve had a magnification of profitability in corporate America, as a subsidy, if you will. Those things balance – deficit and surplus – surplus corporate profits.
Kevin: What we were talking about, then, on earnings-per-share, you can adjust the numbers, or you can make the numbers look like they’re better than they are, with the company-itself buying back their own shares. That’s what we were talking about. You reduce the amount of shares out there.
David: You pretty up the picture, and you can actually keep positive momentum going. We saw previous peaks, specifically, with corporate share buy-backs, 1987, hmm. 1987 – remember?
Kevin: That was painful.
David: 1989, not so painful. But 2000?
Kevin: Painful.
David: 2007 – according to Steve Hochberg and Pete Kendall, and what you’re doing is, you’re shrinking the shares outstanding, and they observe, as we have in the past, that what you’re essentially doing is accelerating earnings growth, and that’s how you’re getting growth in the S&P and the Dow. You’re accelerating earnings growth, but it’s being done on an artificial basis. You could say that you’re exaggerating earnings growth.
Now what we have is actually a slowing of that earnings growth trend. You have to wonder, if that’s the case, then what is going to drive the price of equities higher? Again, we’re saying, other than Fed accommodation, other than other forms of hopium, I think we’re nearing a major top in the equity markets, and you’ve got PEs that, again, are not in the nosebleed section, but just under 20, that’s a long time to wait for an investment to be accretive. You are playing the greater fool theory, back to the Chicago Tribune from 1890.
The number is likely to rise quickly. We think that that PE of 20, of 19.28, is likely to rise quickly, as prices stay elevated and earnings begin to fade. We can rehash the PE again, but it’s just the price of a stock divided by the earnings, or to look at is another way, you’re counting the number of years’ worth of earnings you’re willing to pay up front for the privilege of ownership.
Kevin: Let’s move to real estate here, because just about everybody who listens owns real estate. Some are contemplating buying some, some are contemplating selling some. The housing market has some headwinds, to say the least. One of the headwinds is just the fact that interest rates really can’t go too much lower, Dave. So what’s going to happen to real estate when interest rates rise?
The other question is, do people even have money right now, here in America, let’s say, to actually buy real estate? I look at people the age of my kids. They are still paying back school loans, they’re doing things like that. They’re not thinking about buying real estate right now.
David: Yes, you have, as you say, a number of headwinds. Demographics, on the one hand, where retirees are wanting to scale back, and if you had a four-bedroom home, and the kids aren’t coming back to visit as much, you figure that a condo or a two-bedroom home, a condo where you can walk away and not have to worry about maintenance and upkeep if you go and travel, and it’s just a turnkey operation. That’s great! But you see a downsizing of America with the demographic issues, and the baby boomer generation moving toward retirement.
In addition to that, as you mention, we have the next up-and-coming generation. Let’s look at the Gen X and Gen Y, particularly Gen Y, because in the last ten years, and we have the bridge between the two groups, you have the burden of student loans which are now being carried by graduating seniors, which are creating, really, a perfect renter culture, not a culture where people would be stepping in and buying for the first time, because number one, they’re not accumulating savings for future investment. They’re entangled in a web of debt payments, not only credit card, which is very common today, to see kids with $5,000, $10,000, $20,000, even $30,000 worth of credit card debt, just little things that have added up through four years of college. Ten years ago you were talking about a total stock of student loans outstanding of about 200 billion, a decent-sized number, relatively large. But in a ten-year time frame, it now stands at close to a trillion dollars.
Kevin: Wow. So a five-fold increase in ten years.
David: And obviously, this was pushed. So we have the American dream which is fostered by an American education, or at least, an education, and you have this debt which has been accumulated to pursue the American dream. You get a better job, and you can have the house with the white picket fence. You can have two dogs, and a cat, and a couple of kids, and the tire swing out front. Listen, I’m not saying that any of this is bad, but we’re at a place in time when people are having to postpone. People are having to say, “I can’t afford it. I have student loan payments to make, I have credit card debt to pay, there’s no way I can take on a home mortgage, as well.”
There’s an interesting thing with student loans which I’m sure everyone is familiar with, but student loans are unique amongst debts. They’re nonextinguishable in bankruptcy – nonextinguishable in bankruptcy. In fact, as you move forward, you can actually have wages garnished for their repayment, or, one step further, you can have social security, disability, or retirement benefits reduced in proportion to the amount owed. So, they’re going to get paid. They’re going to get paid, again, squeezing them ahead of you. If your financial circumstances are such that you need to file for bankruptcy to alleviate the burden of debt, just understand, student loans never go away. They never go away.
So there is this common theme of debt restraining growth. We have the size of government, we talked about that earlier, and that restraining growth in the economy. The amount of debt acquired by households and corporations, 273.3% of GDP, it restrains future growth. You have the next generation’s inability to grow, to invest, to save, because you are servicing debt.
Kevin: When you are speaking of restraining growth, that still takes us to the stock market. We’re seeing it still rise, but the earnings – that’s going to depend on growth. The prices of stocks seem to be losing some steam at this point. Yes, we’re at high levels, but we’re not seeing anything that would really push it much higher, are we?
David: The market’s looking for a new catalyst. It’s not finding one. It wants an all clear, from the concerns that we were talking about earlier, September, October, whether it’s the passing of the baton in January, but with a nominee for who will run the Fed, and really, who will run the world financial system on that basis, by proxy. There are a lot of changes in flux, and it is unclear as to how people should proceed.
But you’re right. You have a stalling with the Dow at about 15,500. We’ve mentioned this for a couple of weeks now, because again, this is a long period of time to be moving sideways, and I think what you are seeing in the underbelly of the market is almost a churning where constructive interests and major holders of equities are stepping out. Meanwhile, you have folks who have some hope of this recovery story stepping in, and I think the middle class, in large part, will be caught holding the bag again.
It’s not just the Dow. The S&P sitting around 1700, the other major index, is also stalling out. Confidence has been reinforced by moves higher in the equity market, but this is really critical. When confidence has been reinforced just by a move higher in equity prices, and not in the jobs market, there is an extra degree of frailty in the economy. Remember that to most Americans, a rising stock market may tell you things about something getting better for someone.
Kevin: Right. It’s interesting, if you were sitting at a coffee shop and talking about the stock market, people may be interested in whether it goes up or down, but in a group of maybe 20-30 people in a coffee shop, most of them aren’t going to have any stock. It doesn’t matter. They’re still just trying to figure out how to pay the next bill.
David: Yes. Most Americans are not materially improved by asset price appreciation. So the increase that we’ve seen as a result of Fed money printing, and the benefit to asset price inflation – that has not been a broad-based improvement for people. Incomes are stagnant, still, and that is really what affects most people in terms of their standard of living, and their ability to increase their standard of living. You’ve got pink slip jeopardy, which is still a real and present danger for most American workers. Consumption has improved, in line, strictly, with the socioeconomic status.
Kevin: Well, it’s the rich. The rich are able to spend right now, Dave. That’s the socioeconomic strata you’re talking about.
David: Right. It was probably six weeks ago, we talked about Saks Fifth Avenue stock and a number of high-end stores, the Bergdorfs and the Saks Fifth Avenues, and they’re not hurting. But you look at the Dollar Store and Walmart where people are watching every penny, and pinching every penny, and notice that earnings and revenues … you’re dealing with companies that have either missed their earnings expectations by a penny, they see a decline in revenues.
Think of what this implies. Dollar General and Walmart see a decline in earnings and revenues, and yet Bergdorf and Saks are doing okay. This really does speak to the wealth effect and the fact that you have folks who are in the top 3-5% of the socioeconomic strata which have benefited from Fed activity, but that’s 3-5%. Let’s do the numbers, let’s see. 100 minus 3-5, that leaves 95-97% of Americans who say, “Listen, we still think we’re in a recession.” And guess what? They’re right.
The technical support that … Carl Swenlin is a great technical analyst, and from his website he concludes, and I quote: “Price, breadth, and volume indicators have failed to confirm the recent price highs in the Dow and the S&P, and they are all reflecting persistent weakness. This is no guarantee that a correction will occur, but the internal conditions show that the market is very vulnerable.”
Kevin: David, for a person to protect themselves against the propaganda that is on financial TV, they are going to have to turn it off, because they are being told, “Stocks for the long-run, stocks for the short-run, stocks, stocks, stocks.”
David: Margin debts are high, cash allocations are low, cheerleading is loud; these are the factors that we see, and we think that what you really have in the backdrop is a psychology that is extra frail. Investors are super-sensitized to the pain of declines after what they experienced and witnessed in 2008 and 2009. So really, I think we are extra-vulnerable here, in part, because people who are invested in the equity market are a little twitchy. They don’t want to experience what they did in 2008 and 2009, and if there is any reason to believe that there will be a decline, sell first, ask questions later.
I guess that’s where you do see valuations playing a significant role. We’re at a level of valuation where bear markets typically begin, which is what we were talking about earlier with the price earnings multiples, and the Shiller PEs, as well. This is, I think, a decent opportunity to step back and ask, “Where were we in the 1920s and 1930s?” Because there are some similarities, then to now, 1928, specifically, leading into 1929. In the collapse from 1929 to 1932, stocks fell from their all-time highs, again that was about an 85-89% decline from the peak to the trough, left about 11% still on the table, so you weren’t completely wiped out, but it did take a while to get back to break even.
Important, though, in the sequence of events, was that commodities fell from lower levels. I say lower levels, because they had peaked many years before that, about 1919, and then you had bonds peaking one year before equities did. That was 1928. Bonds peaked before stocks peaked. Bonds started to head lower, even while the euphoria and enthusiasm of the day kept stocks at an elevated level before they declined.
Kevin: That could have been an indicator, if you would have known that bonds peaking may be an indicator of the stocks peaking later.
David: Right, and stock investors are generally the last to pay attention, generally speaking. So you have the excesses, you have the frailty. Many of the market mavens of the day were witnessing this and actually were moving to cash. You had Mr. Merrill, you had the Kennedys, and a number of families that were Wall Street-oriented speculators, at the time they said, “No, we’ve been here, done this. This is a speculative mania. We’re out.”
Well, you know what they watched? They watched as prices continued to move higher and higher and higher, and they were fools for the moment, but ended up being the geniuses in retrospect, because what they saw was accurate, was true, was reality. So it is an interesting sequence, I think, because you had the sequence of commodities first, and then bonds hitting a peak and declining, second, that’s 1928, and then equities, third.
So commodities, in the current environment, peaked in 2008. Note, very importantly, that bonds peaked, I don’t know if it was all-time highs, but certainly for the last 50-70 years, in 2012. And the question really is, will equities put in a major top this year, following their new all-time highs?
Kevin: David, you had talked about, let’s say you ride that market down. The long-term hold guys would say, “Well, it’s not going to take that long to break even.” But I think it took quite a while after 1929, didn’t it?
David: Not so much buy-and-hold as buy-and-hope, because yes, if you wanted to recover full principle from your 1929 investment, you reached break even in 1953. That’s a mere 24 years – a mere 24 years. But I think it’s also worthy of note that bonds, in that environment, offered no comfort, whatsoever. Equities went down, bonds went down, commodities went down (laughter). If it wasn’t nailed down, it was sold at any price offered. And actually, gold was, then, as it has been through every deflationary environment for the last 600 years, looking at British and American history, if you want to read about this, look at Roy Jastram’s book, The Golden Constant, a fantastic book, and he looks at this history of how gold performs well during a deflation.
But again, all of your other asset classes, whether it was equity or fixed income, it didn’t matter if you had a “diversified” portfolio, and that’s really not what Wall Street teaches you. Diversification is considered to be an absolute necessity. It’s just important to remember that many of the merits and benefits of diversification get thrown out, and they’re not consistent or predictable through time.
So, again, that question of 2012, leading to 2013, history offers us a bit of a reference point, not necessarily a crystal ball, but 2012 and 2013, that sequence with commodities already having given up the ghost, we have 2008, 2012, and 2013, very reminiscent of 1919, and 1928, and 1929.
Kevin: You bring up a good point, and this brings us back to gold, Dave. We talked about in the beginning, the fact that people right now are paying more for gold now than gold later. That’s called backwardation in the futures market, but it’s a unique period of time, and sometimes it only lasts for a short period of time, most of the time.
David: Three weeks and counting, which is remarkable when, as you say, it’s usually a day, or a few days, but for weeks on end now…
Kevin: We haven’t seen that.
David: No, and that’s very unique. It’s where the front month is more expensive than the later-dated months. Essentially, what you are talking about is, physical demand for gold is very strong, and it shows up in the form of backwardation. That’s an indication of how strong physical delivery is, and physical demand is, at this juncture. People want the product, physical metals, and don’t want it on delay. It’s not good enough to have your toe in the door in that market. You want it now, and you’re willing to pay a premium for it now because you don’t know what tomorrow holds.
I think that’s very telling, particularly when you look at investors clamoring to own income-oriented investments. Without regard for the risks involved, I think what you are doing is packing in a tremendous amount of credit risk into this world, and smart investors are saying to themselves, “Where there is much credit risk, there will be great pain, and we want to eliminate credit risk. We want to eliminate counter-party risk. We want to eliminate all risks possible. What are the few asset classes that you can do that with?
Kevin: Strangely enough, Dave, as we grew up, the dollar was always where you saved money if you didn’t want to invest. But what does it say for the dollar when people are moving out of the dollar and into gold?
David: And this is interesting, because the price on the dollar is back below all of its major moving averages, with the 50-day ready to cross below the 200-day moving average, which would be, as and when it happens, a very strong sell signal, and frankly, one that opens up the possibility of the dollar trading to the low 70s. The last time we saw that was August to October, that time frame, of 2011. I don’t need to remind you of the August to October time frame for gold.
Kevin: That’s when it got to $1900, Dave.
David: That’s right. It was trading from $1700 to $1900, with the dollar in decline to those critical levels. The dollar breaks down below 80, and I think you see a resurgent trend, supported by the daily, weekly and monthly charts on gold, and yes, I think the bias is positive over the next 18-24 months for gold.
To wrap up, we have what we see in equities as a real vulnerability, a vulnerability to significant selling pressure, upside, predicated on Fed credit creation, and other forms of direct market intervention from the Fed.
Kevin: So Dave, from our talk today, equities are not the place to be. Bonds are not necessarily the place to be. You’ve talked about the dollar, so currency is not the place to be.
David: Well, as we mentioned earlier, we do see a high likelihood of a bottom in gold already having been put in – the most vulnerable of the charts, as we mentioned, the monthlies, only from a momentum standpoint, and that takes 3-9 months for it to sort of catch up to the price, long after prices have significantly improved. The weekly charts are very attractive, and they are offering buy signals with the dailies, the shortest-term trends. Well, there’s good and bad news in the daily trend, but again, that’s probably more relevant to a very short-term orientation, or a day trader.
Kevin: Since you are concluding then, what should people do right now? What would be steps that they could take to take advantage of what’s going on right now?
David: Specific advice, I would pare back general equity positions. That is, I would sell many of the shares that you own in the general equity space. I would say an exception to that is the gold and silver miners. They are an exception, they are attractively priced, and I think over the next 18-24 months could be very, very interesting.
Kevin: But you’re not saying sell 100% of the portfolio, necessarily.
David: If you sold 100% of your equities, I think another way of approaching that is just creating a hedge within your portfolio. If you are used to using put options, or you are used to using inverse funds, ETFs and things like that, you could maintain an equity exposure, just make sure it’s well-hedged, or move to cash. We would be paying down debt, and again, from a balance sheet perspective, I think you keep your debt-to-assets at less than 25%, preferably under 10%. Frankly, if you have gains in the equity space, I would be taking some gains and paying off debt, pretty up your balance sheet as much as you can.
And lastly, I would aggressively add the physical metals, whether that is dollar cost averaging, if you have ounces at higher prices, I’d take the opportunity to lower your cost basis right now. We’re heading into the strong months for the metals, and recall that we’re just leaving the weak months, seasonal weakness. It’s not just that June, and the shorts in the market, they haven’t all coincided at once, but we’ve already seen about a 10% recovery off the lows and that was in the context of the weak months. Now we’re transitioning toward the strong months for gold and silver.
Lastly, I would look at something, specifically in the metals space, palladium to platinum. If you own palladium, I would be swapping it for platinum. It’s a 2-to-1 ratio today, and looking at going back into palladium at closer to a 4- or 5-to-1 ratio. These are the kinds of things that we do on a consistent basis, compounding ounces. You can do that gold-to-silver, you can do that platinum-to-palladium, palladium-to-platinum, depending on how the ratio is trading, but at a 2-to-1, I would be selling palladium and moving to platinum.
Kevin: I think we should probably state the reason we come up with that is that platinum is used in so many functions, but when platinum gets to be too high relative to palladium, palladium can be substituted as a catalyst. So, that 2-to-1 ratio is an equilibrium, or it’s a time to go back into platinum, but then palladium, when it falls back down, when it’s 3-to-1, 4-to-1, 5-to-1, like you’re saying, it becomes a very nice opportunity to stock up on something that’s like platinum, it does what platinum does, it just takes twice the amount to do it.
David: And it’s not that palladium and platinum can’t go to a 1-to-1 ratio, it’s just that they’ve only done that about once every 40 years, so the 2-to-1 ratio is more of a tradeable ratio, where 6-8 times in that same kind of a time frame, you’ve had the opportunity to compound ounces and grow them.
Those are some practical things that I would be putting into motion today and look forward to some very interesting months ahead as we see, not only folks in D.C., again, Kabuki theater, live, you can tune into CSPAN, or just looking at how we address many of our other imbalances.
As an individual investor, take the bull by the horns and get active. Don’t sit by and wait. I don’t think you can wait much longer.
