December 16, 2015; Rates Rise, Who Dies? Complements of Yellen

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

 

“Maybe it’s just a pipe dream and I’m just a paranoid guy who owns a little too much gold. Here in the United States I’m glad that I own this. I’m glad that I’m able to move and be, and go, and do as I please, without permission. I like the idea of staking my claim now, and not being pushed into a world that is everything on a permission-granted basis.”

– David McAlvany

 

Kevin: Dave, would you believe that we’re probably going to drop below $2 a gallon at the pump, right here, by Christmas time? It’s the first time we’ve seen that in years.

David: I just got back from Europe and I’m thinking, “That’s a fantastic deal.” It was €1.50 per liter in Hamburg. So yes, it’s doubly welcome, and very inexpensive. West Texas Intermediate, which is one of the contracts – Brent is the other, of course – traded below $35 for the first time since 2009.

Kevin: Natural gas is going down, too.

David: We haven’t seen those levels since 2002 and I think it is attractive at these levels from an investment standpoint. But here is what is interesting. Oil dropped from $115 to $35.

Kevin: In a couple of years, right.

David: And should be a huge boost to consumption. This decline here in 2015, I think of it as sort of a half-and-halfer. You had the 1985-1986 decline, which was all supply-driven, and then you had the 2008-2009 decline, which was demand-driven. Prices dropped as global demand for oil dropped. And this, I say, is sort of half-and-half supply and demand. Many now want to blame Saudi Arabia and OPEC for not lowering their production. And certainly, they haven’t.

Kevin: Let me ask you a question, though. The United States has increased their production. They have almost doubled their production in the last few years.

David: Right. From 2008 at 5 million barrels per day, to 9.3 million barrels per day at present, we have played our part, too, in terms of new supply. The demand side is partially Chinese issue, but more generally, the global malaise that has capped demand. So, economic activity globally – fairly weak. And oil is, in my opinion, from an investment standpoint, not as attractive as natural gas, in part, because we are seeing structural changes to that space. And really knowing what the implications are at this point may be premature.

Kevin: Lest we sound like Debbie Downer on all the economic statistics, we should reach a dividend point where we start seeing economic benefit from low oil or low gas, shouldn’t we?

David: I’m hopeful that sometime in the next 18-24 months we see that energy dividend. Lower prices for a long enough timeframe will add consumer purchasing power via increased savings. But in the meantime, we have had very little evidence of that, really, little evidence of there being a benefit from lower oil prices. And what we have seen, in a dramatic fashion, is the fiscal stress that has been building for the producers of oil, sovereign well funds of most of the oil producing nations are now pulling money home from many of their global investments, just to pay the bills. And that is likely to intensify.

Kevin: Let me bring up again, too, we have had guests in the past who are specialists in this industry who say the majority of the price of a barrel of oil goes toward taxes. Talking about fiscal stress, the governments of the world also have to be stressing, not just the energy producers, but the governments that make so much money on the taxes that come from oil.

David: And I would very focused on the demand side at this point because the supply side, I don’t think, is going to be the issue, the greater contributor to a price decline or price pressures going forward. We’re supposed to have something in the order of 3 million excess barrels per day. U.S. government inventory numbers actually don’t show quite as many millions of barrels per day excess. They are coming in closer to one, versus three million, barrels per day excess. So, I think, quite frankly, with a lot of your new production in the United States not being long-term reliable, you need to focus on the demand side more than the supply side.

Kevin: And this can be pretty controversial. In a couple of weeks we’re going to have Chris Martenson on, a brilliant scientist as far as the energy side of things, and he has thrown warnings out that it may seem that we have plenty of crude oil energy out there, but actually, it’s much tighter than we think. And so, his point is, don’t let the low prices fool you, we still have energy problems long-term.

David: And I guess my one contention with that is that the peak oil concept, not that he is necessarily a champion of that, but the peak oil concept is really peak cheap oil.

Kevin: Yes, it’s expensive to get the other stuff.

David: Exactly. Because there is plenty of oil out there, it’s just harder to get, in awkward places, deep ocean drilling, arctic drilling, things that from an environmental perspective, you’ve got lots of hazards against you and costs are much greater to get it done. But back to that energy dividend, it appears that consumers are tending, at this point, to take any extra that would be a benefit from the lower prices of oil and pay off debts versus increasing their spending. So, that energy dividend is helpful, but it’s not being put toward anything that equals immediate economic growth.

Kevin: Definitely not in a consumption, debt economy. But speaking of debt-driven, we have talked about the Triple B and junk bond markets. They have been primed for a crash at some point. We are starting to see that over the last week.

David: Right. And I think this last week was pretty critical. You can mark it on your calendar, not only because it was my birthday, you can remember that, of course (laughs).

Kevin: Happy Birthday, by the way.

David: (laughs) Except for high-yield funds they gated themselves. In other words, that’s the industry language for closing the ability for investors to withdraw assets.

Kevin: That’s like Hotel California. You can check in, but you can never leave.

David: That’s exactly right. And so they’re in a process of liquidating the entire portfolios, but want to do it in an orderly fashion. You had one hedge fund, another mutual fund, actually, two different hedge funds last week, because one announced at the end of Friday after the markets closed. And so, this is the same type of managed money stress which was occurring in June and August of 2007.

Kevin: Before the crash.

David: That’s really why you should mark it on the calendar because I really only question whether we see carnage in, not only the bond and stock markets, I only question whether it’s a 2016 or a 2017 event. We will see it, though.

Kevin: Dave, I saw a chart the other day. Tell me if I was reading it wrong, but junk bond rates a year ago were 7% and some of them have jumped already to 17% that were being charted at the same point. Did I miss something?

David: Yes, I think so, because what we have basically done is gone off of very low levels. We were 5.5% to 6% and we began to see rates rise this summer, then they contracted again, and now we are seeing them rise again. So let’s say your average junk bond is between 7.5% and 9%, depending how far out to the edge it is in terms of risk. It is on the increase off of a very low level and the difference between that number and treasuries, what they would consider the spread, or the gap between them, that is widening to levels that we haven’t see since the great recession of 2007-2009.

Kevin: So it wasn’t as critical as what I saw, but as a reminder to the listener, the principle value of the bond is really the most important thing to watch right now, because they are dropping as interest rates rise.

David: And just like a see-saw, that is the natural relationship. As interest rates rise, the value of the paper is dropping on the other side, so prices of that paper are falling at this point. We have described the increase of these credit spreads over the last 3-5 months as being very important because they are an indicator of stress in the financial markets. And what you find is that players, as investors reduce their risk at the edges, and they start to limit their exposure to the riskiest of assets, when they begin to have concerns about the big picture, they cut back at what they consider to be the riskiest and most exposed of their exposures. This was occurring this summer in advance of the August stock market selloff, and that minor trend shifted to a major trend in recent weeks, particularly last week, with those credit spreads widening, again, to levels that you would normally see in the context of a recession.

Kevin: Credit markets are usually the canary in the coal mine. They are the first thing to start to show a problem, are they not?

David: They are, and a part of that is because you have more quantitative investors in the bond market, people who are more fixated on math than story, and equity investors are typically interested in story, and they are willing to check a certain part of their brains at the door, although you can do some fundamental analysis of a given company which susses out numbers, and you can do very good forensic accounting, if you will, into a company to see if they are telling the truth, and see if they are a good company to short, or to buy, for the long term. That is not really the approach that most stock investors take, whereas you do have a much more highly analytical approach in terms of credit or bond investing.

Kevin: If you think about the guys who are looking at that, and buying that, it’s pension funds and insurance companies. This is the big money – they have to do the math.

David: Right. Credit markets usually sense problems before equity markets do. So, quite frankly, it’s no surprise that bonds right now, in the high-yield space, and now it’s creeping into corporate bonds as well, are suffering while stocks are just 6% below all-time highs. So, stocks will follow on the downside, but I think this is the step sequence that is pretty ordinary. Credit markets get it first, equity markets are the last to see it. So yes, high-yield is the canary. I think you’re right about that.

Kevin: Interest rates are really just a measure of the potential for a default on that bond. We have talked about some of the European bonds like Spain, Italy, and Portugal, countries that are likely, at some point, to default on their bonds. Interest rates, so far, have not been showing the potential of default because the European Central Bank has come in and backed them up. But when you are talking about municipal bonds, when you are talking about junk bonds, Triple B bonds, you don’t have an ECB to come in and buy them out. You don’t have a Federal Reserve, even, to come in and buy them out. So, as far as default goes, are the forecasts for default increasing?

David: That’s the curious thing. At this point, none of the forecasts for default rates have increased significantly, so what it suggests is that most of your Wall Street analysts, not necessarily the investing community as a whole, but most of your Wall Street analysts think that this is a little hiccup, nothing to worry about, no real problems within the bond market at a structural level.

Kevin: Not a trend.

David: Not a trend, this is just a minor snafu. And so, this is what it looks like. The estimates for 2016 are that there will be about 3% of junk bonds which will default. The long-term average is around 3.6%. So they are assuming that what we saw last week is not the beginning of a trend. Carl Icahn suggested that there is a lot more to follow on the heels of last week’s significant selloff, and I would tend to agree with that, because you look at that 3% which is expected to default, included in that is a very generous allowance for the very high default rates in the energy sector. So 3%, to me, seems pretty Pollyanna, a very mild outcome given the context that we are in.

Kevin: Shifting to China, we have been watching China and Russia, but China in particular, this last year or two, really wanting to tear itself away from dollar dependence. One of the things that China has used for their currency peg, or the thing that China has used for their currency peg, has been the U.S. dollar. Now we have seen the IMF has already said that China is going to be admitted, at some point here in the next year, into the SDR system, which is like a basket of currencies. Now they are talking about pegging their currency to a basket of currencies. What effect does this have for the dollar?

David: It is a long-range thing. The reason we mention it now is because, like oil, which sort of collapsed last week to a surprisingly low level, and high-yield bonds which were very volatile, these are the things which are now on investors’ minds which could have been on their minds six months ago had they been in an anticipatory mode. But no, quite frankly, they’re all surprised that these things are happening. China is taking steps that ultimately have negative impact on the dollar, but again, it is something that doesn’t impact us in the next two weeks, it is of a generational concern.

So the PBOC suggested a new currency peg, shifting away from the dollar toward a trade-weighted index of currencies, and really, what it signifies is that the world is moving on. The world is moving on from the assumed U.S. dollar and U.S. foreign policy hegemony. And we’re losing our footing. I grant you, it is at a very slow pace, but that’s why I position it as a generational concern, not something that impacts us in the next two weeks.

And maybe it is not generational as in so far out on the horizon to be irrelevant, maybe it is within the next two to three years we begin to see pressure on the U.S. dollar – significant pressure. Certainly, we will talk about interest rates and the rest of the world ditching of treasuries. We are seeing hundreds of billions of dollars in liquidations in U.S. treasuries. So there is supporting evidence, certainly, for, again, the world moving on from U.S. centricity.

Kevin: You see the ditching of treasuries, but we also see a lot of the yuan coming out of China. There seems to be a flight outside of their very own country.

David: I think everyone appreciates that there is very little transparency in the Chinese equity markets. It is not uncommon for some companies to have two sets of books, it depends on whether you are presenting it to the tax man or putting yourself up for sale. And you may show much better one way versus the other. And in China you may have as many as five or six sets of books. It depends on what the question is being asked. So it is interesting. If you can’t see the underside of the boat you should pay very close attention to the fleeing rats. In this case, you have China net capital outflows for the month of November at 113 billion dollars. October was 37 billion. This is a lot of money, and a lot of informed people in China moving out with their money. Again, it is that issue of, if you don’t have clarity as to what is going on under the water level (laughs), again, the part of the boat that is not too obvious, just watch the behavior of the rats very closely.

Kevin: Speaking of below the water level.

David: This isn’t the year of the rat, by the way, I don’t think (laughs).

Kevin: I don’t know my Chinese years, but I resent that we even have to bring this up, because everybody has been waiting with bated breath for every word out of Janet Yellen’s mouth, and it makes me think of the song, Yellow Submarine, except for “We all live in a Yellen submarine, a Yellen submarine, a Yellen submarine.” So, we have to discuss this Federal Reserve interest rate rise, and future rises, even though, like I said, I resent it, because the markets should be the ones that actually should be making the decisions, not an academic at the Federal Reserve. So let’s talk about the Fed rate increase, what effect it is going to have, and where we are going from here.

David: You’re right, I think part of the ingrained resentment on my part and yours is that we don’t like the notion that central planning is at the center of the universe instead of individuals aggregating in the market to make decisions that drive prices and trends.

Kevin: Yes, but we’re trapped. It is like a submarine, Dave. I mean, we really are breathing its air. We have everything around us and they’ve shut us off from market reaction in the marketplace. So is it all talk, or are we going to actually see a trending rise from here?

David: It is the most talked about Fed move in history (laughs). If that means anything to you, it means that in most of history these things are irrelevant, but they have become paramount, and that is problematic. Some have even compared it to 1947 when the idea was that maybe – maybe – central planners were getting out of the way for the first time in many years in the post war setting. That really didn’t happen until 1949.

But nevertheless, we have already made history. We have already made history because we haven’t raised rates since 2006, which is an all-time record in all of human history, going back 3,000-4,000 years, in terms of a zero interest rate policy. So number one, it is significant because you are talking about a long-range directional shift which is significant. Most damaging hikes are still future tense, so it is not what happens this week which is of great significance, it is when the market becomes convinced that there is a directional shift, and I don’t think one move higher 25 basis points is that clear communication that yes, we are now in a tightening phase. So repeat after me – we’ve said this before – “Three steps, and then the stumble.” It is typically multiple interest rate increases before the market says, “Ah. Yes, the die is cast.” And then there is the readjustment in the marketplace in terms of prices, usually with equities dropping precipitously.

So that verdict is still out, whether we have the long-range directional shift, but what do we have this week, even? We have support for a move higher, current inflation stats are now supportive of a hike, and I think the Fed is basically cornered – cornered into doing something here in December for credibility’s sake.

Kevin: I have even been reading articles the last few days that say even if we see a couple of hikes there is concern amongst some of the Fed presidents that actually, we’re just going to go right back down to zero, that they are not going to be able to maintain this trend because the economy is not where it needs to be.

David: It is important that they do something now because they are going to be more hamstrung in 2016, but the second point that makes this meeting so important in terms of the directional shift – that was point one – point two is that here, heading into 2016, any follow-on moves, if you raise interest rates even more, January, February, March, April, May, June, July – guess what happens in November? In an election year, if you raise rates or lower them, it appears as a political favor to one party or the other, particularly as the year wears on. The closer we get to that date, it becomes almost like fingerprints – who is doing political favors for whom, and why? So that plot thickens as we get closer to the date. They must do something in December, because they might not be able to do anything as they get into 2016 and remain above reproach.

Kevin: Instead of looking at the economy as a whole – these are economists that are running this – Yellen mainly focuses on employment, and we know how vague that number can be. There are so many different people who can come out with different statistics as to what employment actually is, but that seems to be Yellen’s chief focus right now, as to whether she measures growth in the economy.

David: That also ties into her confidence in the inflation picture improving because it, too, in her world, is tied to the employment figures.

Kevin: Isn’t that the old Phillips curve at work? That was discounted, we have talked about it a number of times. That doesn’t even work.

David: That’s right. So the good doctor still hasn’t realized that the Phillips curve is a joke. People quit laughing at that joke 10-20 years ago (laughs), but when you are a Ph.D. economist in academia, maybe you just don’t get out enough. There is actually one Fed chief that does look at the Phillips curve with some suspicion. Lael Brainard seems to question the functionality of the Phillips curve. And it is basically this connection. The Phillips curve is connecting an improvement in employment with a rise in inflation on the horizon. And this relationship which, according to the Phillips curve, is something that is axiomatic, has broken down – broken down in three decades of real world practical experience.

Kevin: Dave, let’s say you’re sitting at the Fed right now, and you don’t want to look at employment and use the Phillips curve, what points would you be looking at in the economy to make the decision as to whether it is time to raise rates or not?

David: If you’re in those shoes you are nervous for a number of reasons. You are nervous because in the history of the Fed this is the latest you have ever gone in terms of increasing rates late in the business cycle – increasing rates a third of the way through, 20% of the way through, but certainly before you reach the halfway mark. And we’re 85-90% done with this business cycle in a period of time where it would be normal to see a contraction, normal to see a recession, even a mild one.

Kevin: Which is never a time that you would raise interest rates.

David: No, you want to be raising into strength, not raising into potential weakness. So, why would you be concerned today, tomorrow, this week? These are things to reflect on, and I’m sure the Fed is at this very moment. As we mentioned earlier, credit spreads are widening, and the board is still enthusiastic about raising rates. You have to wonder if that enthusiasm is a sense of obligation to maintain your credibility because those credit spreads are telling you something, and it doesn’t take a rocket scientist, it just takes someone with a little bit of market experience to say, “Not all is well here.”

I think something else that they are looking at – corporate profits are falling. And again, if you are raising rates, you want to do it in the context of an increase in corporate profits, so you should have done this a long time ago. Now it’s not very prudent. Companies are already reporting earnings pressures, and as Mohammed El-Arian recently noted, these corporate players are pleading directly to the central bank for relief. They look at a rising dollar, which is a consequence of this assumed interest rate increase, and it’s killing them.

Kevin: Don’t you think we should continue to remember that this economy has been running on life support anyway for the last seven or eight years? So to be able to judge economic statistics when you have quantitative easing, you have zero interest rates, you have the Fed coming in and buying anything that looks like it might fail – how are we getting any real results at all that we can measure?

David: And maybe this hasn’t broken into the minds of the Fed chiefs, but it is something that surely the markets are now aware of. Most everyone I talk to, even if they don’t follow the markets very closely, are aware that the markets are dependent on central bank support, so take it away and even an improving economy may be negative for the markets as they try to find their natural level. That is, stocks and bonds getting to that level at which they would trade without the muss and fuss of centrally planned monetary policies.

So that is something that you have to ask yourself – what is the natural level? If we remove our hands from the pie, what happens, exactly? Other things that I think are worth noting, and these are names that may be less significant to you or me, but are very significant in policy planning circles. Barry Eichengreen is an economist at UC Berkeley. He has been on our program before. He has been scratching his head. Why are productivity statistics dead in the water? Productivity statistics have consistently grown since 1996, and now for the third year in a row are dead flat. And so, he is sitting there saying, “This isn’t quite right, we can’t quite understand this.”

And for anyone who reads Eichengreen, which would be everyone at the Fed, you would say, “Okay, well, we’ve got the productivity figure we can’t quite figure out.” They also look at Larry Summers, who was part of the President’s Economic Advisory Committee, President of Harvard, and of course, famous to us because of his contribution to the Summers-Barsky thesis relating to the relevance of gold in a low to negative interest rate environment, he has been scratching his head here recently, looking at the glaring inconsistency in the economic recovery story where you have prime-aged males, men 25-54, the largest losers of jobs. They are still losing jobs, even as the statistics are suggesting a broad-based improvement in the unemployment picture. And if it was, in fact, a broad-based improvement in the employment statistics, why are males, working-aged men between the ages of 25 and 54, the largest segment of job losses still accumulating?

Kevin: Whereas those who are over 65 years old who thought they were going to retire are the greatest gain in jobs because they are having to go get jobs again.

David: So your headline number of 5% may be impressive, and you may base that on the Phillips curve to say inflation will be improving, we will get out of this economic deflationary malaise very quickly – “We’re almost there, we must be there, and we just had household rents added to the CPI, which gave us a boost in inflation, we must be there.” I think these are the kinds of things that the Fed is looking and saying, “Gosh, okay, the details in the jobs numbers, a little bit concerning. Productivity numbers, a little bit concerning. And guess who is drawing their attention on those points? Economists that they respect. Summers and Eichengreen are respected figures at the Fed. And then, of course, we talked about corporate profits and the other issues, as well, credit spreads, and what have you.

Kevin: Lest we forget the rest of the world, because sometimes we can be centric on what the Federal Reserve is doing, you and I and a couple of other guys went to Argentina last year, and talking to the people, they were hoping for an administration change. It was ridiculous. Remember, the inflation rate there was 40%? Now what we have had is an administration change. Cristina is out and we’ve got Macri in. So what are we going to expect in Argentina?

David: (laughs) Don’t cry for Cristina. She handed out as many favors on her way out the door as possible. You might cry for Mr. Macri and the Argentina he is being handed, because part of the parting gifts – Kirchner in her final days in office has made an extra 13.7 billion dollars in new government spending commitments. That brings the fiscal deficit that Mr. Macri is inheriting to 7% of GDP. That’s the largest since 1982. So he is inheriting one big fat mess.

Now, on the bright side, things have never been this bad, not in 30-odd years. This is a little bit like Turkey in the early 2000s. Argentina may be at such a low ebb economically (laughs) that it either just collapses or it becomes the greatest recovery story of the next ten years. That certainly is what drove Erdogan’s popularity in Turkey. Things had collapsed, the Turkish lira was on the brink, the stock market was in tatters.

Kevin: So there was nowhere to go but up.

David: Right. So, he just steps in and all of a sudden things start to buoy, and he gets the credit for it. Well, Macri may be blessed by things being at the brink, as Erdogan was. But I think if he institutes a few pro-market initiatives the recovery could be impressive. I guess we’ll just have to see. Time will tell. We do need to plan another trip down there, don’t we?

Kevin: That would be a lot of fun. Well, speaking of other countries, the dollar looks so strong worldwide, yet it has only been rising because the rest of the countries have just been falling apart. This last week, the emerging markets, again, the currencies are just plunging.

David: The last two weeks have been absolutely fascinating. Last week I was in Paris and Brussels and Hamburg, so a very different perspective. In Paris, of course, you have the meeting of the world leaders to figure out how they are going to tackle climate change, and what degrees of sovereignty are going to be ceded to some sort of national body to solve what is a global crisis worse than terrorism, according to Mr. Obama.

The issues in the emerging markets are considerable and we’re not talking climate change here. The way that capital flows is from the developed world to the developing world, and this idea that somehow the developing world was ever going to save the developed world – it’s just not the way that capital flows and markets actually operate. So when you see major chaos in the currency, stock, or bond markets of the emerging markets it tells you something about what’s happening in the more developed countries and more developed economies of the world. It suggests that between Europe and the United States things are punk, at best. Things are very, very off-kilter, and not as they should be.

And so I think you are getting very clear signals – mixed signals in terms of the economic statistics and official numbers that come from the various labor department statistics and what not here in the United States and globally. If it is official, I think you can discount it. But what you are getting in terms of a clear signal is from places like South Africa and Mexico, etc.

So, currency volatility continued last week. Many of your emerging market currencies were down 3-4% for the week, which is pretty considerable. South Africa was the worst, they were down 10% in one week, at new all-time lows. But again, the Mexican peso also set new lows last week. What does this mean, exactly? 80% of their foreign trade is with the United States. So if we are in a state of recovery, why are they not in a state of recovery? Why is their currency suffering so greatly? Do you see what I’m getting at here?

Kevin: Yes, well, you sneeze in the United States and it’s pneumonia for the emerging markets.

David: Right, but apparently we don’t have anything like a sneeze or a cold or a sniffle according to the official statistics. And yet, the Mexican peso would tell you that something is not quite right north of the border. That is how it translates to me. And while the ECB in Europe, the European Central Bank, has been redoubling their efforts, buying everything under the sun via their various quantitative easing schemes, it was absolutely telling being in Europe this last week, both concerning the European economic conditions, but also global economic strength, as well. The German Federal Statistical Office reported last month that the economy slowed in the third quarter due to low corporate investment, and very weak exports. And this is with the full-tilt efforts of the European Central Bank, and the huge benefits conferred from a currency trading at multi-year lows.

Kevin: So, it’s like what we talked about here. They’re on life support, as well, and it’s not working.

David: Right. So think about that. The engine of economic growth in Europe, Germany, with massive global exports, and they are flailing, even with the help of steroid-like monetary injections. So again, I think the story is very interesting, if you can pick up on the signal, because again, beyond the official statistics which would, quite frankly, tell you that all is clear and yes, the Fed should be raising rates and it is because they are in a period of strength, etc., but the rest of the world is indicating that actually, it’s not just the rest of the world that has problems, but our closest trade partners, too, are experiencing problems. Why would our trade partners be having problems if we are in an all-clear state?

Kevin: And it is not always necessarily the economic productivity from the old-fashioned sense. A lot of times it is regulation. A lot of times it is just the socialism of the markets. We talk about how the markets will correct things, but if the markets aren’t allowed to – think about a market-maker. You were talking about your trip to Europe, and I would like to talk, before the end of the program, about some of your experiences and what is affecting the free market trade of gold and silver, and other things to a lesser degree, in Europe, and what your experience of that was. So, first of all, let’s define what a market-maker is, and what role they play in actually bringing about a recovery.

David: A market-maker is willing to carry inventory for a given product and create a two-way flow for that product. You can be a market-maker in stocks, in bonds, in gold. Theoretically you could be a market-maker in housing, although you don’t see anyone sitting on a huge stockpile of homes, buying and waiting for the next buyer to come in and take it off of their hands. So, it tends to be “liquid assets” where you have market-makers.

But one of the significant things that has happened, both in Europe and in the United States is, the newest regulatory controls which prevent banks and Wall Street firms, financial entities, from playing the kind of counter-cyclical role that they have in the past – why do I say counter-cyclical? Because when the individual investor has an asset that they want to sell, click the mouse and sell it. That is what we do nowadays, we don’t even call brokers to do that, we just sell it.

Kevin: It is just assumed that there is a market-maker out there.

David: Right, who buys it. Some company buys it and then connects up that inventory with the next buyer. And they are willing to set on that inventory for seconds, minutes, days, months, or years, depending on the asset in question.

Kevin: But Dave, you have to have cash. You have to have liquidity to be able to buy inventory, in any industry.

David: That’s right. So when you change the capital requirements of a financial institution it means they don’t have as much capital to commit to these kinds of assets they have to be in, whether it is government securities, or cash, or what have you, they can’t be committed. What does that translate into? When you see a diminished role for market-makers, you see less liquidity in any market. And this ties into last week’s behavior in the bond market, particularly the high-yield bond market, but the bond market in general and corporate bonds were certainly affected to some degree last week, as well.

With less liquidity there is much greater downside, there is much more volatility in terms of price, because what is the price if the market-maker is not willing to buy it, or if he has bought everything that he wants to, who is going to buy it next? Where does the bid go? And the bid drops until someone else in the marketplace steps in to buy. Bids tend to drop more precipitously when a market-maker’s hands are tied, and that is exactly what has happened as a consequence of regulatory controls.

So last week, other than the oil decline, which we mentioned, the high-yield debacle which was a 3½ billion dollar liquidation in one week, which was a pretty big deal, and the massive emerging market volatility we have already commented on. The two categories that were perhaps even more concerning were bank stocks as a group, which sold off 6%, and broker dealers, which sold off about 7½ percent for the week.

Why is that worrying? Because in an up market these are the guys that play with a lot of leverage, borrowed assets, borrowed money, and they make a lot of money using that leverage. But in a down market, leverage is doubly damning. And so what it suggests is that people are figuring out, not only in the high-yield bond market and in the oil market, but now you are beginning to see cracks in the equity market at the edges.

And why do I say at the edges? Because the financial institutions are the most highly leveraged, so they truly are at the outer edges of the equity market in terms of risk. It’s a different kind of risk, of course, but I think that is why you are seeing them sell off, a reappraisal of risk in general, and it’s going to spread. It’s going to spread to other equity categories, as well.

Kevin: Speaking of equity categories, something startling I saw, and this reminded me of back in the late 1990s, 1998-1999 during the tech stock boom right before the tech stock bust, the S&P 500, which has been doing relatively well, there were only ten stocks that made up the majority of the move. Ten stocks on the S&P 500 had better than a 21% gain. That is very respectable. But the rest of them, if you took them as a whole, were down over 4%. So, when you are looking at a market index, it is good to see just how divided that index is.

David: That’s right. Fred Hickey points to the parallels between now and the early 1970s when fewer and fewer names were driving those indexes. What he recalls as crowding into the nifty fifty then, not unlike the crowding we see in the five NASDAQ stocks today, which are both over-valued, and over-owned, in Fred’s opinion.

Kevin: Just like in the late 1990s, as well.

David: Yes, so that is looking at a broad cross-section of equities. Look, the utility sector is down double digit for the year, as is the Dow Transportation Average, down better than 10%, almost 12% for the year. The S&P and the Dow Industrials are getting by with help from a few names, but breadth, that is, if you are looking at how the broader index is behaving compared to the headline number, is awful. Goldman’s breadth measurements are at a 30-year low. So, just to return to that over-owned issue, in a downturn what that translates into is a far higher volume of liquidations, as well.

Kevin: What you’re saying is, you have a few super-achievers, and then, really, the rest.

David: And everyone piles into them. But everyone piles in on the basis of past performance, and then about the time the market turns, everyone who piled in is piling out, which means your losses can be more concentrated in those names, as well. So, you have Amazon selling at a price earnings multiple of 973, or if you are looking at next year’s estimated earnings, the hoped-for number, what we hope happens next year, then they are only trading at 359 years’ worth of earnings.

Kevin: In other words, the break-even would be 359 years instead of 973 years. Well, I hope those earnings come in. I know I’ve been buying a few things from Amazon, so I’ll try to help.

David: That’s right. Well, Netflix is at a price earnings ratio of 333, from 133, and they are expecting their earnings to be down next year, 2016, so their PE forward-looking is 481. These are the mirror images to the technology wonders of the 1970s – Kodak, IBM, Xerox. You probably recall, Fred Hickey was on the Barron’s Round Table, along with our Commentary guests Felix Zulauf and Marc Faber. And he is suggesting that we are watching the last gasps of a dying bull market and economy. And he is suggesting it because when you get to the end of a market everything is failing on a broad base, and everyone begins to go after the only things that seem to work, so there is a clustering or a crowding effect into the few things that do work, the few names that have gone up.

So you have a few things that are up 50-150% and everyone is piling in. He is suggesting that that is exactly what you get at the end of any bull market. So, he is also suggesting that the leaders, as they roll over, and in this case you are talking about four or five tech names which are driving the NASDAQ and holding up the S&P 500, when that happens, when they fall to pieces and crash, he reminds us that gold stocks are likely to soar, just as they did in the 1970s, and he includes a quote from an esteemed economist, a German economist who published a bunch of textbooks with Stanley Fisher, one of the guys who is currently at the Fed, Rudiger Dornbusch, who says, “In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.” And I think, Kevin, that we are on the edge of things here at the end of 2015, 2016, maybe it’s 2017, but this timeframe is giving us ringside views to an economic death match.

Kevin: For those listeners who are still listening, that didn’t turn you off the second that you said maybe gold stocks would go up – that wasn’t your quote, that was someone else’s quote – but for those who are still listening, they have been asking us, “When will this happen?” It seems like it has been taking forever, because the Fed has just been extending this and extending this. But this quote basically says exactly what we have seen before. It seems like it takes forever for reality to catch up, but when reality does catch up, all you are seeing is the airbag blowing up in front of you as you get into the crash. That’s your only view – it happens quick.

David: I had one of my best friends send me an email last night and he said, “I think I own too much gold, I have to diversify. A friend of mine is recommending a biotech company. Should I buy it?” (laughs) And I thought, as painful as it has been to own gold and gold shares over the last several years, when they move off of lows it is generally a 10-20 fold move. That’s what it has been off of these kinds of levels, multiple times, 3-4 times in the last 30-40 years, and I think we’re setting up for that kind of performance again. Can I guarantee that? I wish I could, but I think it is highly probable. Given the fact that we’re running out of monetary ammunition and are moving and transitioning toward the fiscal stage of desperation where governments around the world try to get creative, both by squeezing people via the tax code, and any other method they can.

Speaking of governments and what they are doing or not doing, the Z.1 flow of funds report came out last week and it was very interesting, the largest asset on the federal government’s balance sheet – can you take a guess what it is? Student loans, of course! The largest asset of the United States government is student loans – 931 billion dollars. Of course, the total number, including privately owned debt, that is, student debt that is not owned by the government, other private programs, brings it to 1.2, 1.3 trillion total.

But 931 billion dollars – you realize that the total stock of gold, if you are taking $1050 as a gold price, the total stock of gold, 8600 tons, is worth less than 240 billion dollars. So the student loans that the government has on its balance sheet is almost four times the value of all the United States gold, and that is the largest single hoard of gold in the world today. You can see how things are a little bit out of kilter.

Well, the Z.1 Flow of Funds report – this is compliments of Doug Noland, done for the third quarter – credit contraction in every segment. And like we said, when we were talking with Marc Faber, we’re probably six months into a recession.

Kevin: And he said it was an industrial production recession, but that transfers on, right?

David: Credit growth – it is slowed in every category. It is slowed in terms of household debt, it is slowed in terms of government debt, it is slowed in terms of corporate debt. Credit growth slowed in every category. It was cut in half, in fact, we were talking about corporate credit growth, it was growing at an 8.8% rate, now it is 4.3.

Kevin: Any rational person who is managing their own budget would say, “Well, gosh, that’s great. Credit growth is not growing, that’s the way it should be. We should be spending what we have.” But we live in a consumption-based – you talked about Richard Duncan. He has pointed out that we don’t grow any more based on productivity, we grow based on debt. So when credit growth actually shrinks, we’re shrinking.

David: We don’t have a demographic dividend, we don’t have a productivity dividend, we don’t have a technological dividend. We are debt-addicted, and that’s Duncan’s point. He thinks like an Austrian and then sort of maneuvers and transitions to what we have, which is a Keynesian world. And he says, “Here’s what we’re left with. All this is relevant because our economy is debt-addicted. And at present we cannot grow without an increase in debt.” And that is Duncan’s point.

Kevin: Which is hard to do because people are selling treasuries, not buying treasuries right now.

David: Right. His point is that if we’re not growing sufficiently in these categories, government debt, household debt, corporate debt – if we’re not seeing those things increase net of inflation by better than 2%, which according to these Q3 numbers we are not, guess what you have? Axiomatically, you have a recession, you are in a recession. Like it or not, our economy is debt-addicted, and it needs an ever-increasing dose of credit or you have an economic fit, and that is what we are on the cusp of.

Kevin: But foreigners sold almost half a trillion dollars worth of treasuries here recently.

David: That is also in the Z.1, the rest of the world holdings of all U.S. financial assets has declined by 299 billion. And the largest category of decline was U.S. treasuries where foreigners sold 492 billion.

Kevin: And that’s how we borrow. So, if we can’t sell the treasuries we have to buy them ourselves.

David: Right, which means we will be mandating that banks and insurance companies and pension funds and others take up the slack, and of course the federal government can step in and through QE programs, buy up any excess, as well. It is interesting, we are moving into the strange phase where we could have a scarcity of treasuries, but it is a scarcity driven by government artificial buying, and the mandated buying that is handed down by regulatory requirement.

Kevin: Speaking of regulatory requirements, you talked to the group here at the office just about an hour ago about your trip. You and Drew went to Europe, and your son, and things are changing over there, but I think you should share that with the listeners because it needs to be something that is prepared for on this side of the Atlantic, as well.

David: I think what is disturbing is the role of the state there, and the presumption of the state continues to grow, and grow, and grow, and grow. We spent time in Brussels, in Paris, and in Hamburg. Of course, we’re in the precious metals business, so it is common for us to be in circles of diamond dealers and gold traders and art dealers and things of this nature.

And what is fascinating is, there are only two places in the world that don’t have a statute of limitations. If you believe that someone is doing something nefarious and you want to investigate them, you can begin the process in these two countries and never formally issue charges or level an accusation, and there is no recourse once the damage has been done initially. These two countries are North Korea and Belgium.

Kevin: Two very different countries in our perception, but actually regulatorily, very similar.

David: They are very similar. The only difference is that Belgium doesn’t have the cult following of a particular leader, it is done more by a diffuse group of technocrats, but the reality is that the rules that emanate from that place are so ominous. Granted, they don’t run slave labor camps and things like that – the North Koreans do. In all fairness, there is a vast difference between North Korea and Belgium. But it is interesting that these two places, if you get on the wrong side of the law, even if you’ve done nothing wrong – for instance, a diamond dealer, 9½ years ago had millions of dollars of his inventory confiscated. Do you know that he has never been charged? With anything? He has never been charged with anything.

Kevin: He was just under suspicion for something.

David: Under suspicion for whatever, and he has no legal recourse. This is the heart of the European Union where you would expect some reference to the rule of law, and he has no legal recourse, and there is zero statute of limitations. This is very, very interesting, in my opinion. We spent some time in Paris. The gold business in Paris has changed dramatically. There is very little product coming to market because the government wants traces and tracks on everything. They want a record of where every last coin was purchased, every last bar was purchased, and this is not just a tax consideration because what the French people resist is sharing information with governmental authorities because their own government has confiscated gold from them seven different times.

Kevin: Seven times. We have confiscated once here in America.

David: And we have American investors who are concerned about a repeat of an FDR 1933 event. I don’t want to disparage that notion, maybe it happens, maybe it doesn’t. But if you are French, you have far more reason to be concerned. This is a pattern. And so what we are seeing is, with an increased expectation of paperwork on every liquidation of every asset people are saying to themselves, “I’m just going to hold on to what I’ve got. It just doesn’t matter.” And so product flow from Europe to the United States is slowly being squeezed off, in large part because of the regulatory apparatus, in large part because of the role and the footprint of the state in the private markets.

Kevin: We talked to Drew several times over the last couple of years about this hoard of coins that he was able to get into and we really felt very blessed. Hundreds of millions of dollars’ worth of exactly what we needed. But we’re coming to the end of that. I think this last trip you were told by our contacts over there…

David: There is no encore.

Kevin: There is no encore, this is it. Yet, you look at these types of things that come down and just like in Argentina, Dave, black markets form as the regulations increase. You had given an example I would like to share. If you were French and you found something on your property, versus being English, in Britain, and finding something on your property, compare and contrast, if you tell that story so that people can understand just how these markets will adapt to regulation, and actually, a black market, in a way, forms.

David: So, roll the clock back to medieval times and just sketch out a timeline from then to, say, the 1940s or 1950s, war-torn Europe. You have been through World War I and World War II, and if you have assets, quite frankly, the gold and silver that you have is not something that you are going to put in a lockbox at your local bank. In the medieval time you didn’t have that option and in wartime you weren’t sure if the bank was going to be around. It might be bombed to oblivion or taken over by the enemy.

Kevin: In other words, get out the shovel.

David: Get out the shovel. There is all kinds of gold buried throughout Europe and throughout England, and in fact, in the last year 105,000 instances in England of people digging up treasure of one sort or another. Some of this can just be an old pottery shard that needs to be recorded with the local authorities. And in England what happens is a unique process. You record it, you document it, you catalog it, and then that catalog is made available to every museum in England, and they have the opportunity to bid for it and pay fair market price for it. You dig it up on your land it’s yours, if you’re in England.

Kevin: Which seems reasonable.

David: You dig it up on your land in France, you have to document it, catalog, hand that catalog over to local authorities, and they arrange to pick it up because its theirs. What you find on your property is not yours because the presumption is, “It’s ours to begin with.”

Kevin: Is it any wonder that the Magna Carta came from England, not France?

David: (laughs) So, 105,000 instances of those kinds of filings last year in England, three in France, and I would be curious to know what kind of people those three people were.

Kevin: (laughs)

David: But this is the market adjusting to a state imposing expectations that are unreasonable.

Kevin: The moral to the story is, the black market formed in France. There were people who were digging up, just like they are in England, they are digging up gold or what have you, but no one is getting a chance to hear about it.

David: (laughs)

Kevin: So maybe that’s why the Louvre is probably filled with just about what it is going to have, whereas actually, the British museums are amazing (laughs).

David: I look and I think, the direction we are heading here in the United States, we have a different reference point in terms of freedom, liberty, the rule of law, certainly, in contrast to France, and it is an extension of what we gained from British common law, the Magna Carta, development of Black’s law and other big keystones in our judicial progress and legal progress, evolution, if you will.

And it’s remarkable, we are giving up ground, that’s true. We are giving up some ground here in the United States. The Constitution is being looked at in a different way – “it needs to be revised, modernized for modern times.” And the problem is that the modernizers are, many of them, technocrats. Many of them are statists. Many of them are central planners. And whatever revisions occur, I am afraid, take us much closer to the sort of things that we see in Brussels today.

Kevin: Sort of like the changes that we saw in Orwell’s Animal Farm. All animals are created equal, but there are animals that are a little more equal than others.

David: I conclude, coming away from this sort of disgusting taste in my mouth experience in Europe – I love Europe, I love the culture, I love lots of things about it. The people are wonderful. But the political dynamics turn my stomach, and I think to myself, the role of gold in these communities has, and always will be, establishing someone’s financial footprint and individual autonomy, regardless of what the state is willing to grant you. It is you staking your claim, regardless of what the powers that be believe your claim is.

Kevin: Do you think those people who have that autonomy really care about the gold price on a daily basis?

David: No they don’t. And I reflect and think, maybe it’s two years from now, maybe it’s 20 years from now, maybe it’s just a pipe dream and I’m just a paranoid guy who owns a little too much gold, but at some point in the future it seems reasonable that those same sentiments are real-time experiences. People say, “Here in the United States, I’m glad that I own this, I’m glad that I’m able to move, and be, and go, and do as I please, without permission.” I like the idea of staking my claim now, and not being pushed into a world that is everything on a permission-granted basis.