Your Questions Answered Part 2

Weekly Commentary • Jan 04 2017
Your Questions Answered Part 2
David McAlvany Posted on January 4, 2017

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

“Would I want my options open with private capital outside the financial system as we challenge political relationships and geopolitical relationships? I’m very comfortable owning gold, and I’m very comfortable if the price drops $100 to $200 from here. I think the probabilities are far higher that we see $1500 gold before we see $500 gold. What kind of probabilities? 95-98%.”

– David McAlvany

Kevin: Last week, Dave, you answered a number of questions from our listeners, and we’re going to continue that today, but I think we want to reiterate here, as we come into the first of the year, just how much we appreciate, not only the questions, but the loyal listenership of all involved.

David: There are problems, there are potential solutions, and many of these things revolve around sort of the world out there, and I want to encourage you, as you look at 2017, to maybe embrace it slightly differently. The problems that represent sort of the world out there, whether it is economic in nature, political in nature, or what not – look at the areas where you have the greatest influence and control. Where are the variables that you can learn and grow and become better in 2017? If you get a chance to start a conversation with your family this year, I hope the book that I wrote this last year, The Intentional Legacy, is something that adds value to structuring proactive ways that you can solve the problems, really, from a grass roots level, from the ground up, from the family, and moving out from there to your town, your community, our nation, and the world.

Kevin: I like that approach because, really, many of these things we talk about, Dave, we cannot solve on our own – movements of governments, movements of large financial industries – those types of things you have to react to. But one thing you can change – you can change what you have effect on in your family and in your own personal life.

David: Again, I love the scope and scale and size of the questions and the problems we’re trying to address in the Q&A, both last week and this week, but I want to encourage you that sometimes focusing on the micro will be far more productive than on the macro issues, as you try to do something productive, yourself, as an individual and within the context of your family. Let’s dive right back into those questions again.

Kevin: The next question is from Lionel. It’s a good question, Dave.

“If every country and person is loaded to the gills in debt, who owns the debt and collects the interest payable? Somebody must be earning a huge income.”

It’s a pretty simple question, but you know, we all probably wonder who is receiving the interest income off of this incredible – just look at the 20 trillion dollars just in U.S. debt.

David: It’s primarily the banking sector. You have a new artificial buyer, or owner, of liabilities, which is central banks around the world, and those are your two largest sectors that own the debt, so to say. What enables that to happen? You look at the way banks are structured today and it is very normal in the context of a fractional reserve banking system, to have a very small amount of capital compared to the amount of loans outstanding – multiples of debt compared to the actual capital base.

What kinds of multiples of debt? It is considered today, for a bank to be conservatively leveraged at 10-to-1 leverage, or at 12-to-1 leverage. If you think about that, that means they essentially have, in the case of 10-to-1 leverage, ten times the amount of outstanding debt compared to the capital, or assets, of the bank. And they are collecting revenue on that ten times, which makes them a very profitable enterprise. So don’t cry for me, the banking sector, even in a low interest rate environment, because they are able to harness the power of leverage to make up for that.

Kevin: Just don’t ask for your money all at the same time. That’s the key.

David: We just finished Christmas, and one of the things that we watch every Christmas Day is It’s a Wonderful Life, with Jimmy Stewart, and you see that classic bank run where, “No, you don’t have access to your capital.” You can have it in dribs and drabs but if more than a handful of people ask for it at once, the capital base is too small relative to the loans outstanding and there is not enough liquidity there. So the inherent flaw within the banking system is the fractional reserve nature of it. The inherent profitability of the banking system is in the fractional reserve banking system that we have today. So in answer to the question, who owns the debt and collects the interest payable, the banking sector and central banks are your two primary recipients of income streams from debt outstanding.

Kevin: The next question is from Ryan. He said:

“I’ve been a long-term viewer of your weekly YouTube podcast, and I’ve been wondering your thoughts on purchasing oil stocks in the same sense as you would own gold stocks and the possibility of a global recession. Oil could be used for energy, plastics, asphalt, and alternatives that are scarce. Would the world view oil as a safe haven commodity? It will always have a use since peak oil has passed.”

What are your thoughts on oil right now, Dave?

David: A couple of things. Ryan, to your point – this is a great question. Oil can be used for energy, plastics, asphalt and alternatives which are scarce. One of the things you have to note, and this is why it is different than gold, is that you are talking about something that is far more economically sensitive. So you have the potential for a collapse in demand with oil, given a global recession. So if you’re saying, “Do I want to own gold stocks or oil stocks? Do I want to own physical gold or oil itself?” Obviously there are some limitations to owning physical oil, but you can own it through the futures contracts.

I think you’re looking at a couple of things. Let’s talk about the fundamentals of the oil market, first and foremost. Who controls the asset? The two primary players in the oil market are the cartel and governments. So in terms of the free flow of oil and looking at things from a strictly supply and demand dynamic, you have two primary players. You have to look and say that oil and diamonds have that in common. There is a massive amount of excess supply which is controlled by the cartel and is pumped at the convenience of a particular government to increase revenues.

Kevin: So it is very political, very similar to the way the central bank uses the printing press to print money.

David: And it is difficult to get a very clear picture in terms of supply and demand when you have a guy, or a whole team of people, that are basically turning on and off the tap, not unlike De Beers does with diamonds. If there are too many diamonds in the market, we’re just not going to put as many on the market this year, and allow for supply and demand to come back in balance. So you’re talking about something that is managed from the top down, to some degree, and of course, you have the role of commodities traders in the futures pits, which in the short run can drive prices bonkers. But I think that is one of the key differences.

The second difference between gold and oil is that there is much greater supply in elasticity with gold. What I mean by that is, if the appetite for gold grows at all…

Kevin: You can’t turn that spigot on.

David: You can’t turn that spigot on to meet demand. And that is one of the reasons why you tend to have a much bigger increase, in terms of the price swings, up and down in the gold market versus the oil market. And I touched on a third difference there at front, which is, the driver of price in a global recession is very different when you’re talking about gold versus oil. Oil can have a collapse in demand, along with a collapse in demand for its by-products. A collapse in demand for gold is driven by something very different. That is driven by real rates. A collapse in demand for gold is when you have positive real rates of return which are in the 3-5% range.

Kevin: On interest products.

David: That’s right. Or if you have a very attractive risk and reward profile in equities, then you can see people – again, that is where your collapse in demand for gold comes from. It’s not economically sensitive, it’s investor sensitive, given their alternatives.

Kevin: Isn’t it interesting, Dave, that we really have not had a collapse in demand for gold? Even though the price came down off of its peak at $1900, gold actually, in this bull market, has continued. I know a lot of people might wonder about that, but the demand for gold has been continuing to increase. It’s right at the edges of what can be supplied. Oil on the other hand, like you said – they can turn those spigots on any time that they want.

David: Right. The commonality between both of these markets is when you look at the futures markets, when you look at paper contracts versus the physical market, both oil and gold can be bullied in the futures market.

Kevin: Right. And we’ve seen both in the last few years.

David: That’s right. So looking at weakness in price is not always an indication of supply and demand. You can have speculators, sort of trump, if you will, the normal supply and demand dynamics by creating more sells than buys in the futures markets. And again, that may have nothing to do with the physical demand, or economic dimensions. It’s just literally a bullying of the price. That doesn’t last long, but it does occur, and it does occur frequently.

Kevin: This next question is from Tom, and it is in keeping with this theme that we’ve seen with a log of questions, Dave, about a cashless society. Tom says:

“I put some assets into gold and I see it as wise, but I have a question and it’s been bothering me. If, indeed, the global economy goes cashless, then is gold useful only in a black market way, being analog money in a digital world?”

What is your thought, Dave? Cashless society and gold? We’ve talked about it before, but address Tom’s question.

David: The first thing that came to mind is that we need to get proactive in lobbying, and this has already happened in Great Britain. If you’re a British citizen and you own a sovereign, whether it is a current minted sovereign, or a sovereign minted 100 years ago, you pay no capital gains tax on it. Why? Because the sovereign is coin of the realm.

Kevin: It’s considered money.

David: And even though they use the pound sterling and paper fiat for ease of transaction, it is considered money, and there is no tax on money. So if your money has “appreciated” there is that carve-out. I think that is something that we should do proactively – no capital gains tax on U.S. minted coins, whether they are 100 years old, or current minted bullion coins. That would be consistent with their role historically as a part of our currency system.

That has nothing to do with Tom’s question, and to his point, if indeed the global economy goes cashless, then is gold useful only in the black market? That’s possible. The black market is a reality. It’s been a reality since the beginning of time, in part because people have attempted to control prices and market dynamics since the beginning of time.

Kevin: Look at India right now. They’re going cashless, yet gold has played such a significant role this last month or two.

David: And Tom is exactly right, it may be analog money in a digital world, and that may be its primary merit. Rather than a negative, I would see that as a positive. You may say, “Well, it’s an anachronism.” No, just because it’s analog in a digital world doesn’t mean it’s no longer relevant. It, in fact, may give you the opt-out that you most desire in a world that is going digital more and more.

Kevin: Let’s pretend for a moment – I know we talked about this on a question earlier – let’s pretend that we are cashless right now, Dave, and you and I came in here to work at ICA and someone called and said they want to buy gold. Really, in a cashless system, we wouldn’t have done anything different. They can buy a coin, whether it is bullion or collectable, from us. We send that to them after their money is transferred from their bank into our bank account. When they sell it back we do a transfer back into their bank account, so actually, a cashless system does not necessarily nullify buying and selling, it just changes your ability to take cash out of the bank in the form of cash.

David: Right. What I would like is a carve-out where I have the ability to save in the denomination that I prefer. And I can still transact business digitally. So the transactable nature of the account that we were talking about earlier with kilo bars custodied in Canada, that, to me, is very compelling, if you’re contrasting analog versus digital money. I just don’t want to be forced into the digital side of money where I don’t have some degree of control over the value of that money. And so by having a gold alternative in the digital space, I think that represents a wonderful alternative to cash sitting in the bank. It doesn’t mean that I’m not going to hold physical gold. It doesn’t mean that I don’t want something sitting in the bank vault downtown at the bank in a safety deposit box. But it does mean that I can use a debit card and easily transact business. Again, sort of sitting the fence between analog and digital.

Kevin: This next question is from Arthur. He said:

“I’d love to know your thoughts on the efficacy of whole life insurance in our current economic times. Whole life, from the point of using it as a store of value as promoted by the infinite banking concept. These companies and products have lasted since the 1800s and I was wondering if it was truly a viable solution, in addition to precious metals.”

David: It’s interesting, because I’m intrigued by the concept of infinite banking, and was exposed to this probably 20 years ago, and did some due diligence on it then. I’ve considered it as an interesting complement to savings or fixed income, and that is really the kind of allocation that I would have for using a whole life insurance policy as a savings vehicle. It is a partial replacement for a fixed income allocation and does represent something of a savings alternative. It is developed and sold by insurance agents. They have radically increased their whole life sales through having what is a brilliant conceptual sale, so appreciating something about the business process and the sales cycle having a conceptual sale.

I appreciate what they’ve done, but it is still a sales pitch. So does it have merits in and of itself? I think it does, but again, I wouldn’t say that this is your road to riches, by any stretch. The efficacy of it is as a savings alternative, which gives you some flexibility in terms of taking loans from your own money and paying that money back to yourself.

Kevin: One of the things you’ve always recommended, Dave, and we can provide for any of our listeners, is a safety rating of whatever insurance company that is being looked at for this whole life policy, or any policy.

David: Yes. I don’t think this is something that you should have as anything more than a partial allocation for fixed income. So if your cash and fixed income represents somewhere between, let’s say, 25-30% of your net worth, then this represents some slice of that, not the majority, but some slice of it, where again, you have some flexibility in terms of borrowing money from yourself and paying the loan back to yourself, given the cash value of the policy. But I recognize its limitations, too. It is not a road to riches, as it is sometimes marketed.

Kevin: Next question from Michael:

“Will India call in the gold after their cash sweep? If so, what will the gold-holders of India get for their metal?”

David: At least on a local basis, they are already confiscating gold. And again, I don’t know if that is happening on a national basis. All we know is the people that live in certain regions of India where basically the local tax authorities have been given the right, or the privilege, to go in and say, “You can have this amount and no more.” And confiscation, in this case, may not come with compensation. So there is nothing that says, like we had in 1933, here in the United States, that there is some market price for the gold that you have. It may be just, “Hand it in, or else.”

I think one of the interesting things about that question, and sort of cross-applying it, not only from India, but to other parts of the world, you do create a bit of an existential crisis for people. Do you want all of your money in the banking system? Do you want all of your money in rupees? Or Canadian dollars? Or U.S. dollars? Or Malaysian ringgits. Whatever the currency is, you have to make a choice. Are you going to comply with rules and laws which put your savings and net worth in jeopardy?

And that is a very personal decision, and it is going to be based on the kinds of ramifications involved. In 1933 less than 10% of the gold outstanding was ever collected. And it was not done on a house-by-house basis, but there were things which were set in motion which were highly punitive – a $10,000 fine which was the equivalent of two single-family homes. You could buy a single family home, a very nice one, for about $5000.

Kevin: But you wouldn’t need one because there was also a ten-year prison term.

David: A ten-year prison term. So it was and/or – and/or a ten-year prison term, if you didn’t hand in your gold. And I love this part because you have to appreciate that 90% of the gold remained outstanding, and I don’t know what percent of the population that is, but a high percent of the population either thumbed their nose at the government, or used some other digit to express how they felt about that, and whether or not they were going to comply. 10% came in, 90% stayed outstanding. The vast majority of Americans, when asked to make a decision to trust their government, and have the government be in trust of the value of the currency, have chosen wisely, on an existential basis. I think, probably, because history is a bit of their guide.

Kevin: Dave, sometimes we focus on the price of gold, as if it is stock or something else, but actually, gold does so much more. This question actually is about the price trend on gold, but I’d like you to address the larger picture as we look at supply and demand, as well. He says:

“The Weekly Commentary has not really addressed the current and future gold trends at any length lately. Harry Dent, et al, is continuing to forecast the continuing steep decline in gold for some time to come. But inflation seems to be picking up. But the Fed will raise rates, which maybe that means gold is going to go south with those decisions. So should we sell gold and come back another day?”

He’s flip-flopping. “What do I do? Do I sell my gold and come back for another day? Is it going up? Is it going down?”

David: I think this gets to the heart of why you own gold, because if it is strictly price performance then you probably don’t own it for the right reasons. You’re missing something that is very critical. Gold is an asset class that is outside of the financial system, that is not encumbered, that is devoid of counter-party risk, and has been a cash alternative for 5,000 years. It is interesting that when people want it, they’re willing to pay anything to get it, and that doesn’t guarantee that they can get it when that day comes, that is, when they finally decide that they want it. Say, for instance, in India today you can pay a $300 premium to own it in India today. In China, you can pay a $40 premium if you want to buy gold today. So the markets are already, “If you want it, you don’t get today’s price, you get yesterday’s higher price, because it’s not available at the day, and the time, and the price that you want it.”

Kevin: Dave, I remember in 2008 when we were in the financial crisis, we were allocated five ounces a day from our top supplier. So you can’t always get gold. I remember there was about a six-week period when we couldn’t get what we would have wanted to come back in. Say we had sold our gold and then come back in another day, when you want that gold in that other day you can’t guarantee that you can get it.

David: It was a unique period of time, but I think it’s worth reflecting on because we were in that 2008 period with the price of gold in decline and available product at zero. So the price indicator, if price was what you were focusing on, the price of the commodity on the exchange was in decline. And yet, the physical available metal, you couldn’t have snapped your fingers and said, “I want to own three kilo bars today.” You could do that over a multiple-day period, staging into the market, but that’s how scarce the supply was of the easily divisible product.

So I look at 2011 and I look at the weakness that has persisted from then until now. So as we transition from 2016 to 2017, we look at having held up quite well in the gold market all throughout 2016. In stark contrast to 2011, 2012, 2013, 2014, and 2015, 2016 is a very interesting year. For those who were paying attention, it put up one heck of a fight.

Kevin: And don’t forget the 65-week moving average, which has fallen for five years, reversed this year, and every time we’ve seen a reversal in the past, that shows that we are seeing a reversal in the market. Even if the daily price doesn’t show it right away, there is a catching up to the movement of the 65-week moving average.

David: Let me address a couple of other things that are implicit to the question. One is that rising rates are somehow a negative for gold. It is, if we’re talking about real rates, so net of inflation. And that is the question. What are the real rates, at present? And we’re still in negative territory. If you’re looking at what you actually keep based on taxes and inflation, you are still losing money in a bank deposit. You are still losing money, even if you head out to about the ten-year treasury. Factor out inflation and what you owe Uncle Sam on the gains, and you’re still at a negative rate. You start to move into positive territory when you get to the 30-year treasury, right?

So when you’re looking at rising rates, you need to be three or four percent positive, net of inflation, for there to be a real negative impact to the price of gold. Rising rates, in nominal terms, means nothing if you’re not keeping track of the tax bite, and if you’re not keeping track of the inflation bite. So what is debilitating to the gold price is the real rate equation, not the nominal rate equation. I think as long as we have asset price mania in play, you will continue to see people prefer stocks over gold, and that is certainly a part of the current negative backdrop. Perception is that all is well, and I do think that that perception can switch on a dime.

We had the same thing happen December of 2015. Perception was that all was well. That’s why the Fed was going to raise rates. They did it once and we saw the global equity market sell off between 30% and 50%, the U.S. stock market sold off over 20% before they moderated their language and said, “Well, maybe we won’t do anything the rest of the year. We’ll just have to wait and see, and be data-dependent.”

Kevin: The one thing you didn’t mention is an inflation surprise, Dave. We probably, with the Trump administration, are going to see the re-emergence of the perception of inflation.

David: There are things that represent sort of a negative backdrop for gold, and that is sort of the current asset price mania which makes stocks a better deal than gold in the minds of investors today. I disagree with that, but nevertheless, there is the perception that all is well with the Trump administration, and again, I would suggest that we should probably have bought the rumor and sold the news. By the time he actually announces the initiatives, I think we’ll be a little bit disappointed. And we’ve addressed the rising rates issue in terms of that being a negative backdrop concern, but not really, in real rate terms.

What you just mentioned fits sort of the positive backdrop. An inflationary surprise in 2017 would change investor expectations, specifically, inflationary expectations, and the drive into the metals, I think, would increase silver even more than gold in that instance. And you’re looking at two markets, both gold and silver, which are oversold, they’re unloved, and we know that bull markets are born out of bear markets, in this case, a cyclical bear for both of those metals. But they’re unloved and oversold, to a degree that we didn’t even see back in December of 2015 where everything was as bad as it had been in 15 years. And actually, sentiment for gold and silver are more negative today.

What does that mean? You say, “Well, it’s negative. That means it’s bad.” No, that means it’s good, because it means that you just ran out of sellers. That is what comes before a major move higher, before a major rally in price for those kinds of assets, actually, for any asset. If something becomes absolutely hated, it is worthy of consideration. If something is utterly loved, it’s worthy of letting someone else take it, own it, and you need to move on to greener pastures.

So we’re at this interesting juxtaposition here at the beginning of a new year where the most loved asset in the world should be hated, the most hated asset in the world should be loved, and it does still take a contrarian to see, and move, and take action. And now, it’s in spite of five years of feeling rotten if you’re a gold-owner, or feeling great if you’re a stock-holder. The stock-holder is going to do what? He’s going to hold too long and not sell. Why? Because it feels so good to own it. And the gold-holder may even consider selling, and as this question indicates, come back another day. I just want to come back to the point that, you come back tomorrow, or next week, or next year, and just because the price is $100 cheaper, you may still have to pay $400 more to own the real thing.

Kevin: This next question is from Peter:

“I listen to your podcast almost every week. Thanks for your insights. I have one question which you might like to put into your end of year question and answer session. In most of your podcast episodes you talk about the importance of economic growth. However, it seems very improbable that the economy can keep growing forever. There aren’t physical resources on the planet to allow us to keep producing and consuming more and more physical stuff each year, year-on-year, forever. The same goes for the so-called knowledge economy. There is no advantage to me to get increasing numbers of emails or to have access to increasing numbers of web pages year-on-year, forever, because again, like the physical stuff, there’s a limit to the quantity I can consume. Do you foresee an end to growth, and if so, what do you think this will look like?”

David: I think one of the things that I come back around to whenever anyone hints at sort of a Malthusian, we’re just going to run out of resources, is that there is something in nature which kind of takes care of that, and as much as we have seen population explosion over the last 25-30 years, and the population is radically different than it was in the 1970s, 40-50 years ago, the 1960s, the 1950s. We have a very different planet, right? And the stress and strain on resources is greater today. And yet one of the greatest concerns amongst the intelligentsia is bacteria that is resistant to antibiotics, something that would unleash on the global population a scourge which we haven’t seen since the flu epidemics of 100 years ago, but could cull, literally, a third of the world population.

We really don’t talk about that much on the Commentary, and we really don’t talk about your demand dynamics and the destruction of value, the destruction of an investment thesis in the context of a collapse in demand from something health-related because it’s an X factor that you don’t know when or if it will strike. No one was really thinking Ebola until there were 11,000 people dead on the other side of what happened with Ebola, but there is a tremendous amount of money and attention being given to this idea of bacterial strains that are antibiotic-resistant.

Kevin: We had a very, very interesting guest on this last year, Tomas Sedlacek, who brings out the fact that the only reason we worship the need for growth – and he used the word worship because it’s like a religion – is because we have a complete debt-driven economy and we have to have growth. Both Richard Duncan, who is not necessarily always a favorite because he comes to conclusions that we don’t like, but both Duncan and Sedlacek are really questioning the whole growth model. Duncan is saying at this point we have to keep growing or we die. Sedlacek is saying, “Why? Why do we have to keep growing?”

David: I think one of my favorite reads this year was Sedlacek’s book, and if you wanted to prioritize a 2017 read, I would look at The Economics of Good and Evil.

Kevin: And 2018 and 2019. It’s one you go back to.

David: Yes, Tomas Sedlacek – that’s a book that I would definitely prioritize. You’re right, it’s not an accident, it’s not a coincidence, that our addiction to growth runs in a parallel…

Kevin: With our addiction to debt.

David: That’s right. And there are natural limits to both in terms of the quantity of debt, and the cost, if you’re talking about interest rates, and I think those costs will present themselves shortly. We will, I think, go through a period where we re-learn contentment, because there is this idea, and Peter is suggesting – physical stuff. Do we need more and more emails? Do I need more and more knowledge? Do I need more and more? I certainly need more wisdom, but not necessarily more knowledge. And there is a contrast, because if you’re just stocking up data points, that may or may not be helpful.

Kevin: The wisest man who has ever lived, Solomon, at the end of his book, Ecclesiastes, said that there is no end to it, but it doesn’t add to wisdom.

David: Right. So I look at Peter’s question and I say, “Actually, getting to limits is, in some sense, helpful, because it requires that we re-learn gratitude and contentment.

Kevin: Jim writes:

“Thank you for the Weekly Commentary. I listen every week. The Commentary is invaluable to me as you teach me so many things I didn’t even know I didn’t know. Thank you for utilizing your many connections, and by the way, thank you, Don McAlvany, as well, which allows us to hear the thoughts of so many amazing people. And thank you for choosing people with such diverse perspectives. I’m trying to reconcile inflation and deflation. The official inflation rates are close to zero. Real inflation rates have been 5-10% per year recently, by my own personal anecdotal observation. My son’s rent for an apartment in Southern California, for example. But officials all seem to be concerned about deflation triggering another Great Depression. Deflation would be great for consumers such as me. I’ve come to the conclusion that there are really two completely different categories of inflation and deflation. There are consumer prices, and then there are assets. The people on Wall Street, and the bankers, are not concerned with my plight as a citizen getting squeezed by real inflation, even though official inflation numbers are tame. In contrast, they want inflation, but it’s the inflation or their assets, because deflation would cause the big banks to be under-capitalized and therefore insolvent. Have I come to the correct conclusion? Please expand on the subject.”

David: That’s correct. It’s true, people on Wall Street and the bankers are not concerned with the plight of average citizens getting squeezed by real inflation. They are interested in asset price inflation, and they’re interested in doing that through a variety of means – financial engineering, which we talked about earlier, taking advantage of cheap capital rates, another means of doing that. Seeing money actually flow from the central bank into the financial markets has been a great boon to asset prices. Deflation? Deflation, as noted by Jim, is great for consumers, and it’s terrible for those who are in debt. Inflation is great for those with assets, not good for consumers.

There is this conflict and contradiction of interests, if you will, and you see a system that has been ginned up and asset prices have been pushed up by our allowance of greater and greater debt levels in the system, and it allows for a continuation, a perpetuation of growth and asset values. But ultimately, the concern by banks is that they have to make sure that those new debts are never marked down because you then deal with a very fragile financial asset base.

Kevin: Let me ask a question in addition to this, Dave. Have we really experienced deflation? I mean, really experienced deflation since the 1930s? If you look at it, inflation shows up in a lot of places. It’s a little bit like somebody saying, “I’ve got a cold and it showed up right here, right on the side of my neck.” We had the real estate inflation of the early 2000s. We had the tech stock inflation before that. We had inflation that hit the debt markets that then transferred into the asset markets, the stock market. So, do we really experience deflation anymore where prices just get lower and everybody just sort of benefits from lower prices? Or are we finding that this expansion of money is showing up somewhere and when the bubble pops, each time there is a bubble that pops and then it shifts to another area.

David: It is interesting, I read a Bloomberg article about two weeks ago, and one of the commentators was saying, “The recent increase in the price of oil will help us get away from deflation.” And I’m thinking to myself, “Yes, but what about the average consumer who would still prefer lower oil prices and doesn’t care about there being greater deflation. Why? Because if I’m paying $4.00 a gallon versus $2.69 a gallon, it matters to my pocketbook. But the whole twist was, actually, higher oil prices are good because we’re getting the inflation that we need and that moves us away from deflation.

Kevin: That sounds like what the central bankers have been trying to tell us for years, that you really need inflation.

David: The magic here, if you’re talking about sort of magic and showmanship, and sort of a diversion away from the realities of inflation, the diversionary effect comes from looking at year-on-year changes to the inflation numbers. If you’ve got 1% change this year, 3% next year, 2% this year, 4% next year, and it’s just a year-on-year comparison, it kind of smoothes everything out and it doesn’t look that bad from one year to the next.

Kevin: It sounds small.

David: But if you ever do a base-year comparison and say, “What was the cost of college tuition 50 years ago versus now?” And then run how much it has inflated, you’d be shocked, you’d be horrified. If you look at what a loaf of bread cost 50 years ago versus today, you’d be shocked, you’d be horrified. We mentioned in an earlier question, the average single-family home was between, actually, $3,000 and $5,000. $5,000 would have bought you a tremendous house. We had a client that was building houses in the 1930s and was selling them like hotcakes at between $3,500 and $4,000 per home because they were very well priced. So we’ve gone from the 1930s to the present, and the average single-family home was under $5,000.

Kevin: It’s between 50 and 75-fold higher. And that’s depending on where you live.

David: That’s right. So looking at base-year comparisons you get a very different feel for what kind of inflation has occurred, and you really do get a sense that the only thing that has occurred since the global financial crisis is the central banks of the world trying to make sure that asset prices stay inflated. They don’t care about consumer prices. They may talk about the CPI and wanting to target a 2% rate of inflation, but all of their activity has related to keeping the assets. And keep in mind the assets of a bank are loans. They don’t want to see anything go negative. They don’t want to see anything get a haircut. Why? Because you’re talking about mass insolvency across the board.

The banking system is very fragile because of how much leverage is in it. We saw the extremes of that with Bear Stearns and Lehman Brothers, with 40-to-1 balance sheet leverage. And we have “conservative” leverage in the banking system today at between 10 and 15 times leverage. So they cannot allow for any of their assets to be marked lower. Why? Because their capital base is this thin sliver relative to the total loans or assets outstanding. Again, not to confuse you, but the assets of a bank are actually debt (laughs).

So inflation and deflation continue to be challenging concepts, and Jim has hit the nail on the head. We’re talking consumer prices, we’re talking about assets, we’re talking about two different categories, and we’re talking ultimately about the priorities of a central planned economy which are, do not let asset prices go down – do not – because you have vested interests which have to be protected.

Kevin: Even if you have to devalue the currency to do it. Scott writes:

“I thoroughly enjoy and am very grateful for your podcasts. I took your advice in the first quarter of 2016 and invested heavily in gold mining stocks, and sold just before the peak, for an incredible gain. Huge thank you. I’m considering a re-entry in miners as my portfolio’s physical gold allocation percentage is already on the high end. Below are my questions:

What is your 2017 forecast for the gold mining stocks?

If 2017 marks a major correction in the stock market, but a dramatic jump in gold prices, then would you expect gold mining stocks to follow the rise in gold prices, or would it follow the fall in stock prices?”

David: First of all, thank you, Scott. The riches and wealth dichotomy are worth talking about here because on the one hand, miners created riches in the short run for you, in the first and second quarter of 2016. To convert that to real wealth, I think, is always a good idea. In other words, whether it is a boon in real estate, a lottery ticket, an investment in pharmaceutical shares, whatever it is that may have, in a period of time, turned one dollar into ten dollars and created riches for you, you have to realize the illusory nature of riches. What the market gives, the market can take away.

And so, to convert riches to real wealth is always an important thing to do. So, taking 10%, 20%, 25% of what was created in terms of excess growth and turning that into physical gold, I think, makes sense. I think of Richard Russell’s comments that a lifetime goal of 3,000 ounces of gold is what every wealthy individual should aspire to, not as a position that they trade in and out of, but as almost like the keel to a ship, something that goes under-appreciated, under the waterline, but adds a tremendous amount of stability and power to everything else that you do financially.

Maybe you scale that to 300 ounces, or 30 ounces, or 30,000 ounces, depending on who you are and what your financial position is. But again, generally speaking, 3,000 ounces is kind of what Richard Russell targeted as an ultimate objective. Any time you have a win in one category, can you then shift it into real wealth that cannot be destroyed or taken away by the market, in the form of physical gold? I think that’s a great strategy.

To your point, specifically, Scott, what is a 2017 forecast for gold mining stocks? Well, let’s start with the direction of gold. If I’m right, and I may not be, but if I’m right and inflation expectations shift, then we see higher gold prices, and the mining shares are absolutely predicated on higher gold prices. So, lower gold, lower gold mining shares. The interesting thing about gold mining stocks is that they do very well vis-à-vis the gold price. In a rising gold market, take this year as an example, gold going to its June highs was up 30%. The miners were up about 150%. So you see a three to five times gain, relatively speaking. Now, also, when it comes to losses.

Kevin: On the downside you give it back.

David: On the downside, it is proportional, and it is three to five times as painful. But that is the nature of those shares. So, seeing gold at $1,000, I’d love to see gold bottom at $1,000 an ounce, recover, get back above its 65-week moving average. And regaining that territory, I think, adding to gold positions between here and there, and adding real money to a gold stock position with the price above the 65-week moving average, would make sense.

You’ve got a little bit more confirmation of a directional shift in the short run and I think that, again, gold price in 2017-2018, the inflationary surprise is what is likely to drive the price of gold in U.S. dollar terms higher, and on that basis, whatever gold does, the miners are a three to five times winner relative to the physical asset. One represents riches, one represents wealth. One is illusory, one is enduring in its value. So, great strategy, always, is, to the degree that you have gains to take, take them, and put them into something real.

And by the way, that may be raw land, that may be farmland. I’m interested in all real things. I’ll just give you an anecdote. There was a small South African company that I owned in the period of 2002 to 2004, and the shares did exceptionally well, in part, because the South African rand was devaluing at the same time the price of gold was going up, so the costs of the company, which were in rand terms, but their revenue stream was in dollar terms. They had basically had a double benefit in that period of time, 2002 to about 2005.

Kevin: And didn’t that reverse after that, though?

David: Oh, absolutely.

Kevin: The opposite occurred and it wiped a lot of that out, didn’t it?

David: That’s exactly right. But I will always value a piece of art that hangs in our living room because I sold shares in that company and bought this piece of art. And I don’t know if the piece of art is worth more or less than I paid, but I do know that the shares that I owned in this company in South Africa, a full-on roller coaster, and I’m so glad to have extracted value at the top in that short time frame near the top of the first cycle of gold 2003.

Kevin: The next question comes from Marty:

“Financial advisor Harry Dent predicts that gold will be at $450 an ounce by mid 2017. Now, the Aden sisters said on your Weekly Commentary that precious metals looked very good, and that they would be going up next year. To whom should I listen? Thank you for your consideration of this question?”

David: I would listen to your gut. What does your instinct tell you? $450 gold either means we collectively discover Shangri-La, in which case the merits of owning gold as an investment, as a store of wealth, becomes less relevant. That’s the context of Shangri-La. Or we could experience, Marty, something like the 2008-2009 crisis on steroids. We saw an initial drop in price in 2008. By the end of 2008 as we transitioned into 2009, actually, the gold price was positive, if I recall correctly, between 5% and 7% for the year. What we encounter in a second global financial crisis would be similar to the 2008-2009 crisis, massive defaults, and I would just want to recollect that there was the initial sell-off in the price of gold by folks that had to make payments on their debt to keep things in motion.

Kevin: Right. And then it resumed. The buyers came right back in.

David: Well, there were huge capital flows into the gold space for this one reason alone – counter-party risk. And the concern of whether or not people were going to get their money back. You watch Lehman and Bear Stearns go under, you watch Merrill be merged with Bank of America, you watch, eventually, Smith-Barney get merged into Morgan-Stanley, and you watch Goldman-Sachs seek the regulatory safe haven status of being a commercial bank instead of an investment bank so that they can have access to the Fed money. All of these things are happening and smart investors say to themselves, “We don’t know if we’re going to get our money back.” And there is a massive shift in the financial sector as a result of counter-party risk.

Kevin: Dave, I think it’s important to point out, sometimes when you’re selling newsletters it’s important to be the lone voice on a particular issue. Now, if Harry Dent was just now coming out and saying, “You know, I told you that gold would rise for the last 15 years, and now I’m thinking it’s going to fall,” he may have more credibility. But as far as I’m concerned, I’ve listened to this for 15 years. He’s been saying gold is going to go down the whole time.

David: He doesn’t manage money, he manages his subscription list.

Kevin: That’s exactly right. He tries to sell a subscription, and that seems to sell.

David: Right, well, because it keeps people on their toes. “What’s going to happen next? We don’t know, but we think it’s something bad.” You’re right, Kevin, Dent has basically been calling for lower gold prices for about 15 years.

Kevin: And if we were to look at that 15 years, as you just pointed out, gold has grown a little over four-fold since that time.

David: At least the last five years he’s been less embarrassed. In fact, he’s been right. The price of gold has been going down. Yet, gold is still, as you say, three to four times higher than that 15-year period where, again, he has been saying for 15 years, “We’ve got a demographic crisis ahead of us.” For 15 years he has been saying this. “We’ve got a demographic crisis ahead of us. We’re going to see a major downturn in the stock market, and it’s going to be a deflationary collapse which will take gold into the low three digits.”

$250 was actually his original call, not $450. I’ve seen $250, $450, $700, all of them clustered together. In the last 12 months he has claimed all three. So what is it going to be? $250? That’s the central bank induced selling lows when the Bank of England dumped tons and tons and tons of gold onto the market under Mr. Brown in the late 1990s. Do we really get back to those levels? Or is it $450? Or is it $700? Who do you listen to? I think you listen to your gut.

I look at the world around us and say that it’s a world which is charged for change, and not all change is of a positive nature. And not all battles that have a positive outcome come without paying a very high price. And I look at the next several years – we’ve had several years, past tense, of financial and economic strain, change, challenge, but nothing real structural in terms of a shift, and I look at the changes ahead of us as being primarily political and geopolitical. Would I want my options open with private capital outside the financial system, as we challenge political relationships and geopolitical relationships which may, in fact, have a negative feedback loop into the financial and monetary and economic realms?

I’m very comfortable owning gold, and I’m very comfortable if the price drops $100-$200 dollars from here. I think the probabilities are far higher that we see $1500 gold before we see $500 gold. What kind of probabilities? 95-98%.

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