August 21, 2013; Gold,Stocks,Treasuries: Strange Valuations

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: David, as much as gold fell, we’ve already seen a 16% rebound from the bottom on gold at this point. We’ve got numbers coming in that are actually quite positive.

David: Silver has recovered 24% off the lows, so these are definitively positive signs, as you say, and it is in an interesting context. It is in the context of the Fed purchasing 103.4% of new issued treasuries. That may seem almost statistically impossible.

Kevin: How do you do that? You buy more than 100% of your own debt.

David: Ask John Williams, I don’t know, but that’s the number he comes up with. 103.4% of new issued treasuries are being purchased by the Fed. And I’ll be quite frank. That looks and smells more like a Ponzi scheme than anything I’ve ever heard. You don’t have to have real money, you create credit out of nothing. With that credit created out of nothing, you go and subsidize the national debt.

Think about this. We’re spending about a trillion dollars more per year than we actually have, and that’s fine, because the Fed comes along and wipes the slate clean and says, “No problem. We’ll buy those treasuries.” And economists are today suggesting that the Fed is simply acknowledging strength in the economy. And that’s why they’re moving away from QE. Again, it’s strength in the economy, and that’s why they’re moving way from QE.

Kevin: So where’s the strength. We really have not experienced the recovery they’re telling us that we have, and the quantitative easing just simply hasn’t worked, Dave, that’s the problem.

David: Yeah, the other side of the coin is, of course, really an alternative interpretation, and this is one that we hold to, that is, that the Fed is recognizing that the QE projects did not deliver the intended results, and as Mr. Fisher from Dallas has suggested, the costs now outweigh the benefits. So the suggestion of a slow withdrawal of that form of stimulus, however slow that may be, having previously targeted prices in the housing market and equities market, the Fed is now going to have to take a fairly big hit, if it wants to see prices normalized, if it is willing to allow interest rates to also move to a more normal level.

Kevin: And there is a great danger in that, Dave. Back in 1994 I remember when Greenspan raised rates. It was just a quarter of a point and the stock market went down 9%, just like that, within a 3-month period. The long bond lost 9% of its value on that single move, as well.

David: Policy has the potential for lighting off a powder keg, and you are right, the rewind of 1994, the bond market volatility of the day, up to, and including, the collapse of Orange County, California. February 4, 1994 was the day the Fed moved rates 25 basis points. The rest is history. One small move was enough to change expectations and catch people who were on the wrong foot off guard.

Kevin: And we were not at the end of the interest rate declining cycle at the time. Now we’re at the end of a very, very huge bull market in bonds, which, conversely, would mean that interest rates have come to an unusually low low, and been held there.

David: That is the larger concern today, that we’re at the end of an interest rate cycle, with bonds having reached nosebleed levels in terms of price, yields, of course, being at record lows. The volatility could be even greater, and it’s not just at the community or the municipal level like it was with Orange County in 1994. You have sovereign bond problems which are, by nature, bigger problems. Of course, they are less likely to occur, but when they do, they are far more costly to contain, and that’s the question of if they can be controlled. The cost of control is, in our opinion, most likely a currency collapse. We’re talking 20-40%.

Kevin: 20-40%. See, that’s the thing. When you talk about a sovereign bond collapse, what we are talking about is government bond collapse, federal government bond collapse, and when you have municipal bond collapses, that still is the municipality’s problem.

David: You go hat in hand to the guy with the bigger wallet and you say, “Can you help me here?”

Kevin: Right, but the currency is the bigger wallet at this point.

David: The only way that the Fed can help bail out a major collapse in the bond market is to print and print and print, do more of what they’re doing already. And this is the strange thing. Theoretically, I understand how you eliminate QE, or taper, or what have you, but there is an unhealthy dependence today on the Fed purchases of treasury bonds, bills, and notes.

Kevin: You’ve called it life support. It’s like someone in the hospital who is on life support. Their body may look like it’s still alive until you unhook the machine. So, okay, you said 20-40% down on the dollar. Where would that bring us, Dave, as far as when we look at the dollar rate?

David: This has a lot to do with positive expectations being disappointed. We suggested a moment ago that economists are of the mind that this has strengthened the economy, therefore we’re seeing a walk away from QE, and therefore we have all the evidence in, that this is actually a recovery. The move in the opposite direction from positive expectation to negative expectation takes the dollar from the current 0.8, 0.85, the range that we’ve been in for the last month to two months, and brings us down to 0.5, down to 0.65.

Kevin: What does that do to gold?

David: Let’s put it this way. The similar moves, in percentage terms, over the last 13 years, have been accompanied by a 500% increase in gold, and a 600% increase in silver, and I don’t know that you see those same moves. Maybe it is far less, and maybe it is far more, because what you are dealing with is really a change in expectations from “happy days are here again” to “oh my, this is the mother of all bubbles coming undone.”

Kevin: What’s your time frame?

David: I think 2014-2016 promises to be interesting, if not a little dangerous. And I think this is sort of where the final and biggest moves are immediately ahead of us. Some have argued that this type of devaluation would actually have a positive impact on stocks, taking the Dow to 20,000, or what have you. And I find that hard to believe.

I think the challenging idea here is when you already consider the steep decline in revenue and sales already in the corporate picture, with profit estimates being revised lower, earnings expectations being guided to levels that can, I guess, if you want to look at it from a PR standpoint, effectively manage the public’s expectations of where earnings will be.

That’s what they are doing. Earnings are, in all likelihood, going to decline, even as prices stay relatively elevated, making the point even more clear to the general investing public that there are no real values to be found. It’s almost like value investing in sound, fundamental analysis has become irrelevant.

Kevin: But people still need a yield, Dave, and so I think they’re out there trying to take in more risk without knowing that they actually have a risk. I mean, look at the junk bond market, it’s crazy right now.

David: Issuance is now double the 2007 levels, 241 billion dollars year to date. We have yet to finish the year, and people continue to gobble up yield without respect for the risks that are inherent.

Kevin: They haven’t felt the pain yet, of the risks that are inherent, because we’ve been on this life support, Dave.

David: And you begin to see sort of an overreach, a stretch into the risk markets, when people have a tremendous amount of confidence in tomorrow. What is the confidence based on? The confidence is based on this closed cycle, or closed circle, if you will, of information. And they’re getting it from the Fed, they’re getting it from the news media, they’re getting it from official statistics, and they’re all building on each other.

I read a number of articles in Bloomberg just last night that were referencing the improvement in GDP statistics, and that’s how we had yet further evidence. We had the first quarter number, it was 1.1, now we’re at 1.8. Everything is glowing in terms of growth in the U.S. economy, beating economists’ expectations, a complete rewriting of what we had in the first and second quarter, and ignores the fact that GDP actually was massaged by adding, as we mentioned last week… (laughter)

Kevin: Five hundred-plus billion dollars.

David: Unbelievable.

Kevin: It was crazy. Okay, but on that, if we took the 7% or so out of what the quantitative easing was adding to the economy, Dave, we’re shrinking. We’ve talked about this before, but our growth is not positive, it’s negative by 5-6%.

David: That’s precisely it. If you take out Federal deficit spending, government deficit spending, you have a hole in our gross domestic product number, somewhere between 7 and 10%. And that’s a very significant number, and if you say that GDP is, in fact, shrinking by 7-10%, you realize that now you’re in league with Greece. And it appears that we’re fine only because the government has the ability to spend an extra trillion to trillion-and-half a year to make up the difference between what the consumer used to spend in credit card access and what they’re spending now because they have, in fact, cut back significantly.

Kevin: David, maybe it’s just because they don’t have the money anymore, but Obama’s here now. At this point, he’s made a commitment to narrow the gap between the rich and the poor.

David: Before we move on beyond the junk bond issue, there is something I think that you have to realize. Interest rate risks are being ignored completely. We talked about the risks inherent. Well, what are they? Interest rate risk, credit quality, the spread, that is, the difference between treasuries and your low-quality debt. That spread, the difference between them, has shrunk dramatically. And that is, of course, indicative of demand for those products.

Why? Is it because you’re looking for the prettiest product out there? Well, it’s pretty in terms of yield, and that’s why you’re saying yes. It is indicative of demand, but the narrowness of the spread is unnatural, and that should be counted as the first loss for those yield-starved investors out there. We’ve frequently noted this. The Fed has completely altered investor behavior.

Kevin: People don’t feel risk, Dave. They don’t understand the feeling of pain right now.

David: It’s a little bit like having that disease that kills all of your nerve endings. You can put your hand on the fire and you don’t feel anything. This is called leprosy.

Kevin: But the damage still occurs.

David: But the damage still occurs, you just don’t know it, and the Fed has basically taken away consequence and emboldened the market to take unreasonable, or certainly blind, risks. This is very dangerous.

Kevin: And don’t you think the Fed’s involved, actually, in this gap that I was bringing up before, as far as what Obama has said he is going to narrow? Whenever Obama talks about narrowing a gap, I get worried, because I guess anybody who has a little bit of money might be considered rich, and the redistribution aspect continues.

David: There is a gross irony in the sense that on July 30th, in his speech, he made very clear that he wanted to narrow the gap between rich and poor. That was a priority, one of his top priorities. To us, is it going to be via helping people figure out how to pull themselves up by their own bootstraps?

Kevin: Which is American.

David: That would be kind of interesting. How do you incentivize? How do you create a business dynamic? How do you inspire entrepreneurship? Or is it through wealth redistribution? The blindness here is really what I find grossly ironic and dangerous. There is an irony here because he’s all for the Fed printing and creating easy money and liquidity. He’s all for it. It’s been the hallmark of his administration. Since he came into power the Fed has done what? How much debt have we added to the national debt since Obama was elected?

Kevin: And it hasn’t added anything to my wallet, Dave. It’s added to the Goldman-Sachses, the Merrill-Lynches, the J.P. Morgans, the Wells Fargos, I could go on and on.

David: And I’m directly connecting the dots here between Fed activity and the asset inflation that we’ve seen, which has, yes, created a greater divide between rich and poor, and if we would simply allow for a mild disinflationary trend, let the Fed disappear into the history books. (laughter)

Kevin: Oh, you’re making me dream. You’re making me dream.

David: No one, single element has created more of a wealth gap than Fed policy over the last 25 years. We’re not just saying Bernanke, but if you combine Greenspan and Bernanke, then you have the makings of the modern-day robber baron. That, today, if you wanted to look at the billionaire class who just a few years ago, if you wanted to say the last 15 years has turned your wealthy person with 50-100 million dollars into a billionaire. And I’m not sneezing at 50-100 million, but that person, over the last 15-20 years is now a billionaire. On whose watch, and by what means? Easy money policies. The Fed has exploded the balance sheets, improving the balance sheets of the super rich. Meanwhile, it’s asset price inflation. Again, we say that’s driven by monetary policy.

Kevin: Sure, the printing of money.

David: The rich getting richer. Meanwhile, the poor, well, they don’t have any assets, and the subsequent effect of monetary policy is consumer price inflation.

Kevin: They feel it.

David: Not exactly positive. So they’re bearing a greater burden with each passing year, and again, this is witness to the diminishing purchasing power of their dollars.

Kevin: Something that we’ve seen in other countries, Dave, when inflation starts showing up, we saw this in Egypt a couple of years ago. We’re seeing it in India right now with the rupee just falling so far, that the man on the street has to survive. He has to find a way of fighting inflation, otherwise he doesn’t eat.

David: And you see a change in investor behavior. The man on the street ends up leap-frogging the wealthy, not in terms of net worth, but in terms of the motivation, and ultimately, the actions taken, in the purchase of gold and silver. And I think this will happen in the period immediately ahead, because the man in the street knows something the wealthy have chosen to ignore. Generally speaking, they have great confidence in the system. The wealthy rely on official statistics versus more direct, visceral, existential experience.

Inflation is the specter of 2014-2015, and this may be in the face of deflating assets, selectively deflating assets, but the Fed and other monetary authorities have already proven what their playbook is, and it doesn’t have to be QE. It can just be the extension of what is already in place, cheap money, made available to the banks and the leveraged speculating community. Guess what happens? The printing press and credit creation gives our monetary mandarins the illusion of control.

Kevin: The markets have changed so much in the last 4-5 years. We saw Greenspan, before, controlling an awful lot in the market, but after the crash in 2007 and 2008 we saw the Federal Reserve really take on a whole new role where they are literally setting the price of everything, from interest rates, to managing the stock market, making sure it doesn’t go down too far, or up too quick, to turn into a bubble. It’s almost like they are some sort of superman, behind the curtain, like the Wizard of Oz, even.

David: There is a perception management, and again, with the printing press there, and the incredible creation of money, and through that power that is exerted by our monetary mandarins, they have this sense that they are on top of it, and nothing bad can happen. Whether it is a Superman complex, you have exceptionally bright people hiding behind horn-rimmed glasses, with a Ph.D, and XYZ, but that’s the personage. What are they creating? Amongst the wealthy they’re creating the belief that all is getting better.

Kevin: They’re steering the ship.

David: And what’s the evidence? The evidence is, “Look at my assets! Look at my balance sheet! The last five years has been brilliant! Yes, it was a tough go, 2008 and 2009, but boy have we made a comeback.” At what cost to the man in the street? Underneath it all there is the belief that outcomes can be determined. Quite frankly, the historical record offers very different evidence. In the end, it is the mass judgment in the market. That is the mover of the market, the mass judgment, not an individual monetary mandarin, not the wealthy who are currently getting the benefit of asset-priced inflation, but it is the mass judgment that is the move of the man in the street, collectively, that is already, in our opinion, changing at the edges.

Kevin: David, I know you are going to be doing some spear-fishing here soon, and so I’m going to use an analogy that you may just go into la-la land after this, because vacations are nice, and spear-fishing, I’m sure, is going to be fun, but when you see a school of fish, they can be going one direction for a while, and then all of a sudden they’ll shift direction. That may be because they see a threat, but let’s face it, the fish on the other side of the school don’t see the threat. Somebody sees a threat and everybody moves. Is it coming that we could see school-of-fish kind of event?

David: Yes, there’s collective action, but not necessarily collective cognition. Where does the change begin? What is the reason, precisely? You are right. There is at that outer edge, an awareness of something that needs to change, and the fish press right, press left, press up, press down, and everything else changes in light of one action. You don’t have to understand it, it’s just the way it works. And that is mass psychology. I think it’s a great picture because you have all movement ending in a concerted effort, but it’s following the lead of a movement at the edge. And I think you can apply a great deal there, with foreigners who are currently selling U.S. securities.

Kevin: They’re selling more than ever right now, Dave.

David: Friday, the TIC flow data, the treasury data, was as bad as it gets. We thought it would be, given the trend that we’ve been looking at since the beginning of the year, but net purchases of long-term securities, U.S. denominated securities, showed a single-month liquidation of 66.9 billion dollars. Then they revised the previous month to 27 billion dollars of liquidations, and these are from foreign accounts. Again, if you imagine that school of fish, you have those at the outer edge making a movement and we in the middle of the pack are assuming that we understand the movement.

This is the illusion. This is the delusion that we are all under. Our economists are saying that rates are increasing on the basis of economic recovery. They’re in the middle of the pack, they’re not at the edge, they have no idea what the broader market is responding to. They’re just trying to make sense of market movements, and give some sort of an explanation, a justification.

What is actually happening, is that foreign currency traders and foreign purchasers of U.S. treasuries – what are they doing? They’re moving away from the dollar, they’re moving away from our treasury market, and it is beginning to affect treasury prices and yields, regardless of the fact that the Fed is now purchasing over 100% of new issued treasuries, in an attempt to bring rates down. Rates are doing just the opposite. The Fed is, in essence, losing control.

Kevin: This is one of the reasons why we do this program, Dave, so that we can remove the person who wants to be informed outside of that school of fish. It’s not just us, there’s great information out there, your dad’s newsletter, plus many of the people that we interview, but you have to think outside of the school. You can’t be in the middle just wondering what’s going on.

David: You don’t want to be in the flow of events, you don’t want others determining your course from the edges, and this really describes the vast majority of U.S. bond and U.S. dollar holders. They don’t know what’s happening, they’re just dealing with long-term trends, and frankly, this is where they’re in danger.

If you have a mutual fund that is a fixed income mutual fund, if you have a third party manager managing bonds, go ahead and look at their CV. See how long they’ve been in the business, because we’ve been 31-32 years in a bull market in bonds. That means they don’t know what a rainy day looks like unless they happened to be in business February 4, 1994, and that was just a shot across the bow. That was a cyclical snap in a long-term secular bull trend in the fixed income markets.

Today what do we have? Today we have the beginning of a bear market in bonds. That’s not to say that a good manager can’t make a good return in the bond market. But we’re talking about few and far between. The vast majority only know one direction, and don’t know how to manage anything but success. Again, it is said that everyone’s a genius in the context of a bull market. That would be true of the fixed-income community today. They’re all geniuses. Let’s see how they do in a bear.

Kevin: That’s the vulnerability of our short life-spans relative to longer types of trends, David. We’re talking 30-year cycles where interest rates can drop for 30 years. I was just getting married at that time, and now I’m seeing the bond marking peaking out and the interest rate cycle bottoming out. You know, mortgages are like that. Just about everybody owns a house or is buying a house, and those are a 30-year cycle. The idea is to be able to pay your house off in a 30-year period before retirement. We’re starting to see mortgages come up, as well. It’s not just in other markets right now. We’re seeing interest rates changing.

David: I know a few people who were able to refinance their homes at about 3.125, unfortunately, not I. But 3.125 as an actual low, of people that I know who refinanced. Let’s say, on average, 3.25 was the low, across the country. We’re now 40-45% above those levels. We’ve gone from the low 3s to above the mid 4s and we’re basically 40 basis points away from a 5% number.

Kevin: That’s still below historic norms, but if you take 3% and turn it to 4%, the increase is much larger than if you take 6% and turn it into 7%.

David: That’s true, and getting back to the 6½% number, which is a pretty reasonable place to be, if you’re looking back over the last 30 years of financing a home, 6½ was always a pretty good rate. My first home purchase was financed at a rate higher than that. 6½ is pretty decent. But if you expect to see your mortgage payment remain constant, the price of the house has to be reduced as the rate rises. Going from 3½ to 6½ implies a 30-40% haircut on the sticker price. That is something that most homeowners will be very resistant to, repricing their homes instantaneously. So it’s not axiomatic that rates go up and tomorrow the home price is down. The question, then, is how long does it take for the market to figure out what it can bear, as people recalibrate, as people figure out they’re just going to have to buy less house with the money that they have to spend for that allowance in their budget? It makes desirable homes unaffordable to new entrants into the housing market, or just forces them to lower their expectations altogether, buy less house, or choose a different neighborhood. That’s basically a downgrade.

Kevin: People who need income either jump into the junk bond space … but there are a lot of people who are much more conservative. This is really the investment of the wealthy. The municipal bond is the bond that you earn interest on, you don’t pay tax on it, but the municipals right now, we’ve seen what looks like a topping out on the munie bond market.

David: Yes, the last 12 months, if you want to look at the 10-year municipal bond rate, it’s up 56% in the last 12 months, and I’m not choosing the 30-year.

Kevin: That’s a drop in the value.

David: I’m not choosing the 30-year, mainly just to say, hey, there’s volatility across the yield curve, and it doesn’t have to be a long-dated fixed-income instrument to be incredibly volatile. But 56%, rising rates have, and will continue to, impact consumer confidence negatively. And I think when you see investors and people who are trying to finance a first-time home or refinance, the rise in rates is not on the basis of recovery, but on the Fed’s loss of control in the bond markets, and rates are now trying to seek that equilibrium level.

Kevin: You’ve used an example in the past that I think is an excellent one. When you’re out in the swimming pool with the kids and you want to put a basketball underneath the water, you can keep it under water for a while. The Fed could control rates, keep those rates down for a while, but the further you hold it down, the more that ball flies out and you’d better watch out. You’d better not have your chin right in front of it.

David: Yes, it’s the course that it’s going to take. Inertia takes rates above equilibrium, and in the short-run, what does it mean? I think by year-end we could see the 10-year treasury move from its current 2.8, 2.9, 2.7, this range we’re in right now, up to 3.75. That would take mortgage rates well above 5%. That’s cheap by old standards, but it does have a material effect on purchase prices and required cash flow moving into that kind of long-term commitment.

This goes back to Knut Wicksell. He was a 19th century economist in Sweden.

Kevin: Sort of a hero of the Austrians going back before the turn of the century.

David: That’s right, an Austrian economist, and frankly, no Keynesian has come along to refute him. But when you keep rates extraordinarily low, and keep them low too long, what do they ultimately do? Wicksell’s notion was that they go much higher than they ever should have gone. Again, throwing it back into the world of physics, it is an opposite, but not necessarily equal, reaction. If you keep them too low, too long, they will go higher, and probably higher than they ever should have gone. That is the nature of interest rates, and that is the cycle that we’re in.

Kevin: Speaking of trying to control something, or trying to manage something from the top, look at China right now. China has become addicted to the growth that they’ve had. They’ve had double-digit growth through the years, and it has backed off a little bit, but now it’s backing off quite a bit, and so instead of saying, when we’re growing we see people actually coming to the city and becoming more productive, now they’re just bringing people to the city hoping that they become more productive. It reminds me a little bit of the movie, Field of Dreams. “If we build it, they will come.” Well, that was a movie.

David: There’s an interesting analysis right now on China, which would imply that they’ve over-stated their GDP by close to a trillion dollars – close to a trillion dollars.

Kevin: Oops.

David: Oops. Minor bookkeeping error. China’s solution to slowing growth is basically to urbanize, and move a few hundred million bodies off rural farms into the cities, which turns on its head the idea that urbanization is driven by growth and opportunity, where people are sort of gathered around and are attracted to, almost like moths to a light outside your front door, they are attracted to something that is interesting, intriguing, compelling, rather than the other way around, which would be growth and opportunity created simply by urbanization.

It looks to us like a short-term fix, and an excuse to continue to allow state-directed investment to be the dominant theme in the Chinese economy. It’s a long road from fixed investment and exports to internal consumption and the model which they have idealized.

Frankly, I’m not sure that it is something that should be idealized. There is a phase in the development of a culture where I think consumption can be very productive toward GDP growth, but in the end, what it does promote is what we’ve experienced in the West, overconsumption, materialism, and a massive ratchet higher in household debt. In the short-run, that may show up as radical growth in the economy, that’s all well and good, but if you take a 20 or 30-year view, you are looking at enslaving the man on the street to credit card debt, mortgage debt, and debt of any other sort that he can acquire in the consumptive process.

Kevin: Isn’t it interesting that our model, which seems to have been so successful, over the last 40 years, especially, going into debt and being able to spend as much as we want, urbanizing, becoming more of a service society than a production society, that model is now being not only imitated by China, but Japan. This lowering of the value of the yen has just completely backfired. It’s not working out, because their imports are starting to cost so much, and it hasn’t made their exports competitive enough yet to fight the inflation, so it’s backfiring.

David: And I think what many central planners from around the world are missing is that our model has run its course. We’ve done the consumption thing, it did benefit GDP growth for the last 20 to 30 years, and now, what do you do for an encore? It was driven by debt, it was driven by credit expansion, and we’ve reached the natural limits of debt and credit expansion, without dissipating those debts through inflation.

So we’re at the end of that cycle, and yet, because our current stock of economists are suggesting that we are in the context of recovery, we all assume that we’re going to go right back to where we were circa 2006 and 2007 and start spending like we did circa 2006 and 2007, or even ten years before that, in the roaring ’90s. We can’t get back there without an elimination of a huge portion of that debt, that overhang.

I think it is very interesting, Michael Pettis, going back to China, reminds us that urbanization accommodates, but it does not cause, growth. It’s coincidental, but not a causative element. As you mention, the build-it-and-they-will-come commitment from the government is fine, as long as it accompanies growth, but it’s not necessarily the case that jobs created by building and infrastructure projects, ultimately, are wealth-creating for the country, any more than that old idea of breaking and replacing windows is somehow additive to an economic picture.

Of course, when you’re building, you end up with something new, as opposed to merely replacing old windows in the classic broken window fallacy. But you take away resources that otherwise would have yielded a positive return in the economy. That’s the temptation of state planners, over there, over here, it is to over-apply the investment fix, rather than stimulate innovation and creativity.

I think it’s worth looking back, and oftentimes we are critical of U.S. policy, of this milieu. But listen, I looked over the list of Nobel prize winners over this weekend, and the U.S. remains the dominant player in every category, with the exception of one, Literature, and the French beat us there. They’ve won more Nobel Prizes for Literature.

Kevin: Shall we give them that?

David: They can have it, they can have it. I mean, I love literature, but the U.S. remains the dominant player in every category, with new ideas continuing to emanate from our students and professors. Again, we’re talking about all areas except literature. We have received the most awards, by a wide margin. That may not always be the case, but I think it is worth looking back and asking, “How did this become the case?” It was a social issue. It was a context issue. This has been, and continues to be, an incubator for new things, better things, new ideas, better ideas.

And the question is, can we continue to encourage that innovation, or in that context of redistribution, if that is, in fact, the course that the current administration takes, toward closing the gap between rich and poor, do we not, in fact, dissolve and move the opposite direction? Will we see a growing number of Nobel prize winners from other countries as innovation, creativity, new design, new insight, comes from a different environment? Unfortunately, I think that’s the direction we’re headed.

Kevin: Our success as Americans is in that innovation. That’s where the success came from. Of course, then we abused it with the debasing of the dollar and with the debt that we came up with. But it was the innovation that did that. We have cities. We have urbanization, but not because we built the city first, and then the creativity occurred, the creativity…

David: People come there because there is opportunity there for them.

Kevin: Exactly. People have to adapt to whatever system they are in. I’ve mentioned China, I’ve mentioned Japan, but the rupee in India right now, there is inflation, and people are having to adapt because the government is basically clamping down and saying, “Look, you can’t defend yourself against the inflation. We’re not going to even let you import any more gold coins.”

David: The rupee continues to decline. You have inflation concerns which are lingering. Think about this. The rupee has declined 26% in the last two years.

Kevin: That’s painful.

David: And, all of a sudden, what are their oil imports, about 75% of what they consume they have to import?

Kevin: So they are paying more for oil.

David: More, and more, and more. So as the rupee declines, the cost of imported oil and rupees continues to rise, and that drives a broad-based consumer inflation. India is number 5 on the world list of energy consumers, with the disadvantage that the majority of their oil is imported. It is very curious that gold is now taking the rap for unsettling the Indian trade balance, when inflation continues to drive import costs. You have those rising, exports are garnering less and less. Theoretically, volume should be increasing in terms of their exports, because the rupee is circling…

Kevin: Sure, they should be more competitive.

David: Yes, but as the rupee circles the drain, that is the argument. You lower the value of your currency, and it stimulates export growth. And yet, the consequence of lowering the value of their currency is inflation, and we’re seeing the same thing in Japan. Consumer prices are moving up at a more rapid pace than the improvement to export growth, and it’s hurting them. It’s hurting them terribly, because guess what they didn’t get – and we mentioned this six months ago – guess what they didn’t get, but needed? They needed inflation in wages, and it never came.

Kevin: So what the government does instead, since people no longer have the value in the rupee that they did before, the government is just basically saying, “We’ll solve the problem by not letting you buy gold.”

David: It’s a causation issue, and it’s a causation problem. They are misconstruing the role that gold is playing in the Indian economy. It is an important element culturally, and it is, in the context of any global inflation, regional or global inflation, something that investors flock to, and yes, they have an inflation, but they are insisting that their trade balance is being driven off the rails by gold imports. Meanwhile, we would contend, it is the devaluation of the rupee, and that is causing consumer price inflation, and a massive skewing of the numbers, given the amount of oil that has to be brought into the country.

Kevin: David, let’s say that I’m an Indian farmer at this point, and I have to be able to keep my money in the bank in rupees, or I’m going to buy gold. Let’s face it. If the gold is keeping up with the inflation and I can maintain buying power, whether the government lets me do it or not, there is a black market.

David: There is, and this is your day in the sun, if you speak Hindi and are comfortable working on the black market. I mean, there are hundreds of tons that are going to be delivered to the major Indian cities, working around the restrictions, with significantly higher profit margins created by governmental stupidity. Nothing short of the death penalty would prevent this from happening, and even then (laughter) people continue to break the rules.

As we suggested a while back, if you are in that position, you are harvesting rice, you are harvesting wheat, you are bringing in chickpeas, your harvest money, you could, theoretically, deposit in the local bank there in India.

Kevin: And lose 10% a year.

David: Yes, so would you? Would you? Rates of interest are high, so maybe that’s enough of an offset, but you have to contend with official inflation rates. That’s nearly 10%. I mentioned the rupee is off 26% in two years. That’s official monetary policy, which is at odds with investors and savers, and their instinct to survive and prosper. And I think this is what many governmental officials forget. The stick is always less effective than the carrot, in the long-run. Whether it’s in India, or the United States, we have these fiscal issues, we have these economic issues, which cannot be solely addressed through monetary policy.

The globe is facing the hangover effects of a global government finance bubble. We have desperate money-printing in our midst, and more of it around the corner, and so when we see things like inflation in India – food prices! Food prices are up 46% from a year ago in India, and I tell you, official rates of inflation won’t capture that, but households feel it, painfully, as an actual reality, official statistics be damned.

That’s where we are, and we effect change in consumer behavior by increasing attacks on gold imports, and prohibiting the importation of coins and bars into India? That’s the best that you can do? That’s the best that you can do, cause a problem, and then try to address the cure of the problem by making the cure illegal? To some degree. It’s backward, but I guess you could expect it, because it is governmental.

Kevin: Something that also strikes me as backward, Dave, so many people these days are still thinking, “Well, I don’t think I need gold, it’s in a bear market, but I do need the stock market. Look at the stock market, it’s doing so, so well.” Does the stock market represent any real value at this point?

David: We talked about values earlier and the fact that, I think we are seeing the market become less and less relevant, and it goes back to that notion of value, fundamental metrics playing a part in the market today, because they really don’t play a part in the market today, and they won’t, I think, for some time. Alan Newman, in Crosscurrents, pointed out, not only in the March issue this year, but also in the most recent issue of Crosscurrents, that high-frequency trading has created a feedback loop which is reinforcing a positive momentum, on the upside, for the markets, but it has moved us away from fundamental valuation in the market.

Kevin: Let’s define high-frequency trading. This is done where you can see maybe 25 to 500 trades a second, going off on a single stock, just amongst several market-makers.

David: What we are really talking about is computer programs that are the mind of the market today versus the average individual investor making a claim on future value and future income of a company, saying, “It’s cheap today, and I think it’s justified by its future income accrued in the moment.”

What we don’t see is that process occurring. What we do see is momentum traders triggering technical signal traders, triggering filter traders, triggering statistical arbitrage traders, trigging rebate traders, all of these in a positive feedback loop, and all it takes is one positive move higher, and everything else gets triggered. All of these trades feed on themselves, without a reference point except for the one price move. There is a danger here, though. There is a real danger, because we have a surreal sense of reality. The cycle compounds volumes on the upside, but it can also compound volume on the downside.

Kevin: Sure. Traders don’t care whether it goes up or down.

David: The sword cuts both ways. We have momentum traders feeding technical signal traders, feeding filter traders, feeding statistical arbitrage traders, feeding rebate traders. Guess what? The sword does cut both ways. It opens the door in future years to excessive undervaluation. If we’re getting to the point of overvaluation today, and we’ve talked about PEs, we’ve explored, on a number of occasions, ten-year rolling price earnings, multiples, we’ve looked at Tobin’s q, a number of things like that in the past, and we’ll continue to in the future. It’s not on that basis that people are buying and selling. It’s not people buying and selling, it’s computers, it’s black box models which are buying and selling on the basis of the trade which occurred just before it. It’s a blind trade and it’s very dangerous.

Kevin: What you’re saying is that even if the market is overvalued at this point, there is a time when values return. I’m just going to use a hypothetical, Dave. Let’s say the stock market falls to 5000, 6000, 7000, and gold, in the meantime, gets up to about 3000 or 4000. Now you’re in that 2-to-1 range on the Dow-gold ratio, and you’re thinking, are there values there? What’s the PE looking like? Should we start selling some gold and picking up some stock?

David: I think that’s an event that the savvy investor will not miss, and it’s where you have to step back and say, “Listen, I’m not going to participate in something that I can’t understand. In other words, prices are moving today, not on a rational basis. I guess if you include a computer algorithm in the same context as rational, then there is rationality behind it, but you’re not talking about rational actors. You’re talking about computer code with if/then scenarios preprogrammed, and a reaction stream which is instantaneous. Instantaneous.

The mind of the market has been co-opted by technology, and I think that’s a very dangerous place to be. That is what happened in 1987 when the mind of the market was co-opted by what we called protection on the downside. We had this new insurance against demise, and yet it was the new-fangled technological innovation which gave us the 20% crater in the market in one day.

But back to what you were suggesting, I think moving from a bloated metals position, gold and silver, platinum, palladium, two, three, four years from now, toward an excessively discounted or an undervalued market, will serve as one of the greatest wealth legacy enhancements in 100 years. And the key transition on Wall Street has been, and this goes back to that corruption of capitalism theme that we’ve seen with David Stockman and others who have taken on that same mantle, the corruption of capitalism has intensified over the last 10-15 years, transitioning from Wall Street being a capital formation vehicle by the issuance of stocks and bonds, to really a market deformation, the direct enrichment of financial firms who are now abusing the market mechanisms we just described with the high-frequency trading models, allowing them to, today, program trade, high-frequency trade, rebate trade, all manner of proprietary trading, done by these financial giants, and they are no longer in the bread and butter business of lending and accepting deposits.

This is a dangerous place to be. Wall Street has changed, the financial markets have changed, very much like they did in the 1920s, and yet, we don’t have regulation to match. Dodd-Frank is a joke. It’s an absolute joke. It does nothing to keep up with the deformation of capital, which we have seen in the present context via the evolution or devolution of Wall Street over the last 15 years.

Kevin: David, even though a bloated gold and silver portfolio at some point may be a great jumping off place for some of these values, we are starting to see some things in the gold market. We talked about it in the very beginning of the program, gold being up 16%, silver up over 20%, 24% from the bottoms. We talked about backwardation a couple of weeks ago, and what that means is that people are wanting to pay more for gold now than on a futures contract, and that is the opposite of what we see most of the time, but the way these futures contracts work, obviously, when somebody comes in and sells a gold contract, they don’t really own the gold, more often than not, but they know that they can borrow it, and at this point, the rates on that borrowing are at 4½ year highs. It’s expensive to borrow gold.

David: Yes, it takes us back to December 2008, when supplies were incredibly tight, and I think this is where many market participants just don’t know what they don’t know. Being in this business every day for 40 years, as a family, what we’ve seen is the ebbs and flows of supply and demand, and today, you look at these little indicators, the lease rate on gold being as high as it is.

Guess what? It does tell you a lot, it does tell you that supplies, as tight as they are, are not indicative of what you see in the price structure of the market. Prices would imply ample suppy, no demand, gold has been in the tank, it’s in a bear market. I can’t read an article from CNBC or from Bloomberg that doesn’t reiterate the fact that gold is in a desperately, terribly, no-good, very bad day of a bear market.

Kevin: Just tell the Indians that, where demand was up 71%, or the Chinese, where demand was up 87%. They’re not buying contracts, Dave.

David: And yet, that’s the story. The subtext, the substory, is that supplies are very tight, and you begin to see that with some of the internal workings of the market. Let me give you an example – junk silver. Junk silver bags, dimes and quarters, specifically, now have a bid of 8-9% over the spot price, and an ask of close to 15%.

Kevin: When six months ago it was spot price, or less.

David: It is getting very expensive to purchase it, I don’t like to buy it now, this is probably moving toward a place in time where you would want to sell, rather than buy, but the market is tight. No one wants to sell, and there are plenty of people to buy and that drives the premiums higher.

We’re seeing it with the most generic of bullion products in the United States. We’re seeing it, as you mentioned, with backwardation, we’re seeing it with lease rates, and frankly, we’re seeing some technical progress made. We’ve gotten above that $1340 range, now we’ve got $1385 in our sites. We need to clear $1450, $1485, where we broke down in April at $1530, and I think we’re off and running. Depending on the rate of change we see here in the next few months, we’ll either finish in the $1500 range by year-end, or $1700, if momentum really picks up.

Kevin: Now, there will be some surprises in and around that, because the Fed’s going to announce this, or they’re going to announce that.

David: And it’s not to say we can’t retest the lows on our way to $1500-1700. But what we have proven, yet again, is that with lower prices, the man in the street says, “Listen, I don’t like what I see, and there’s only one way that I can protect myself, there’s only one way that I can remove counter-party risk. There’s only one way that I can, whether it is inflation or deflation, move into a position where I’m in control, and not dependent on the market. I want my cash. I don’t want it in my domestic currency. I want it in the currency that has survived five thousand years of the debauching of every currency to ever come along. That’s why I want gold.”