February 23, 2011; Interview with Dr. Marc Faber: Measuring with the Proper Unit of Account…Gold

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: David, before we go to our guest today, Marc Faber, the oil market is really on everyone’s mind right now.  It is very volatile.  We are starting to see it hit those kinds of numbers that we were seeing a couple of years ago.

David: Here in the states we have West Texas Intermediate above 90, we have Brent at 108.  We have gold, which is up in recent days, as much as 40 dollars.  It is moving above that $1400 level.  Silver, impressively, above $34.  Kevin, something very significant is happening in the metals market, which is worthy of note for all of our listeners.  We have been in a trading range with the gold-silver ratio above 45, going back to 1983, and we just broke through this last Friday.  We are trading at around 42 currently.

The question is:  Will it hold?  Will silver maintain its advantage in the marketplace?  We want to get an international perspective, not just on the precious metals and commodities today, but on a number of things.  Our guest has grown up in Europe, and has lived for the last 30 years in Asia, so he brings, certainly, an international flavor.

Kevin: This is why we have Dr. Marc Faber on the program today.  He is, of course, publisher of the Gloom, Boom, and Doom Report.  He always has very insightful ideas as to the way we should be looking at the news right now.

David: Let’s start with Europe and some of the things that are happening, specifically, in Germany.  In Hamburg, the elections there, Merkel’s party lost.  This was the second major upset following Westphalia last year.  We had the German election in Baden-Württemberg in late March, in which we watched the dominance of the Christian Democratic Party relinquished.  Clearly, the Germans are saying, “We are not interested in bailing out the rest of Europe.”  How does that play into the future of the EU, the strength of the currency, or the strength of the union, itself?

Marc Faber: I am not a political expert about European matters, and you should ask a politician about this.  But in general, the point is simply this:  The German public is probably not particularly happy about the fact that Germany bails out the PIIGS, in other words, Portugal, Ireland, and so forth.  So there is great opposition to Germany being part of the EU, and Germany supporting governments, including Greece, which have abused the system by not maintaining fiscal restraint.

David: It seems that the pressures remain for Europe.  The debts remain for the individual countries.  As you mentioned, Portugal, Italy, Ireland, Greece and Spain, and as long as the debts remain, the issues, whether it is insolvency or fiscal pressure, are a real burden, still, yet to bear.

What we would like to also look at is the U.S. equities market.  The developed world has had a decent run in prices since March of 2009, and the emerging markets have not done as well, relatively speaking.  Maybe you can speak to over-valuation and under-valuation, vulnerability in the equities markets.

Marc: We didn’t have a decent run, we had a fantastic run.  The S&P has doubled, and in emerging markets we have price increases that are far better than a doubling of the indices.  In general, emerging economy stock markets since 2003 have way outperformed the S&P.  So we had unbelievable moves in markets.  In the U.S. we only had on two previous occasions a move such as we had in the last 27 months from 666 on the S&P to over 1300, and that was in 1934, coming off a major low when the market had declined by 90% between 1929 and 1932, and then another move into between 1934 and 1937, and that was then followed by renewed extreme weakness in the markets.

So stocks have done fantastically well, and I was fortunate to be relatively positive about equities between October 2008 and March 2009.  But if someone had asked me, “Do you think the S&P will double?” I would not have expected a doubling.  I would have thought the market would rebound, maybe by 40-50%, but not a doubling.

The markets in the world, between March 2009 and today, have done actually much better than anybody had expected.   Starting in November 2010, the American market started to weaken, and I think that we have just begun a more significant correction in the U.S., whereby I expect the fact that international investors over-weighted the American economic stock market until recently, and under-weighted the U.S., and now money is flowing back into the U.S.  I think emerging stock markets will go down further, but I would probably just stay out of the U.S.

David: As you look at the cyclically-adjusted price-earnings ratio for the S&P, it recently hit 24, which is very similar to what we saw in 1928, very similar to what we saw at the market peak in 1937, and also in the massive bull market run up until 1966, where valuations were clearly overdone.  But what that implied was underperformance for a number of years following, not necessarily a cataclysmic collapse, but certainly underperformance.

So if investors are expecting a healthy rate of return in equities over the next ten years, it would certainly be difficult to argue for that, based on the cyclically-adjusted price-earnings multiples.  What you are suggesting is that emerging markets and developing world markets are really in the same boat, which would imply that the whole concept of decoupling is not necessarily one that you would agree with?

Marc: I think that there will be some decoupling, and whenever you look at the markets, different sectors perform differently, but generally speaking, in the same direction.  So if someone were to take a very bearish view about emerging stock markets, I do not think he should go into European stocks or U.S. stocks.  I take a more balanced view.  I think we are in a money-printing environment.  If something happens in China, they will print even more than the U.S. prints.  If something in happens in Europe, they will also print money.

They are going to print money everywhere, and with interest rates, essentially on short-term deposits, being zero, or below zero, inflation-adjusted, in other words, if inflation rates everywhere in the world are higher than the interest rates on short-term deposits, I think, for the investor, the question is really, “How do I invest my money for the long-term?”

I think that you cannot make a very bullish case for stocks, but I think you can make a more bullish, or more positive, case for stocks than say, for U.S. government bonds, because the specifics in the U.S. will stay very high, and the quality of the banks will diminish and the interest payments as a percent of tax revenues will go up, and so forth.  So whether you believe in, let’s say, an economic recovery and world growth, or if you believe in disaster, in either case you are probably better off in equities than in bonds.

In terms of returns, I agree with you, I do not think that the returns will be fantastic, but if you print money it is very difficult to say what the returns will be, because it is not stocks that adjust on the downside, but it is the currency that adjusts on the downside.  So in theory, it is possible that the Dow could double if you print money, or it could even go up 10 times, depending on how much money you print, and with Mr. Bernanke at the Fed, I think it is quite likely that a lot of money will be printed.

David: That is a critical observation, that what is happening is really a degradation of global currencies.  Certainly we saw that in Germany in 1919-1923, when the German stock market went up nearly 14 times, yet in terms relative to gold, still diminished significantly, so it was a better bet than buying German bonds, or sitting in German marks, but on the other hand, it was still a relative loser, you could say.

I guess one of the critical issues today, for investors, is existing in a world of negative real rates of return, where you have both an increase in taxation that is a potential, but the reality of money-printing and inflation, which strip away any of your real returns.  With interest rates being as low as they are, isn’t this one of the drivers into commodities and into assets like gold and silver?  Because frankly, aren’t we are looking at negative real rates of return otherwise?

Marc: An investor has the choice to invest in real estate, in equities, in bonds, in commodities, and I separate precious metals from commodities, from industrial and agricultural commodities, because I consider it money.  Also we can buy art, and stamps, and other collectibles.

I have a large subscriber base for my Gloom, Boom and Doom Report, and I asked each one of them to let me know if they have the impression that the cost of living increases, in other words, the percentage of how much they pay every year, more, for their families, is less than 5%.  So far I have not received a single email, so I think inflation is around 5%.  The return on deposits is essentially zero.  And then people begin to worry, because paper money is no longer a store of value, and at the same time, it is a bad unit of accounts, because it is debased by the central bank.

So people buy paintings, they buy real estate, they buy stocks, they buy, to some extent, bonds – last year, we had large inflows into bond funds – and they buy precious metals.  The problem with all these easy monetary policies and artificially low interest rates, is that not everything goes up at the same time.  In other words, we had a bubble in the NASDAQ in 1997 to March 2000, then the bubble burst.  Then we had a real estate bubble 2000-2006.  Then in September 2007 and July 2008, oil went from $78 to $147 and the CRB went ballistic, so we had a commodities problem.  In 2008 everything collapsed.  Oil, in an unprecedented move, went, in July 2008, from $147 to a low of $32 in December 2008.  In other words, in six months, oil fell from $147 to $32 a barrel.

These kinds of moves are brought about by the Federal Reserve monetary policies, and for the investor, there is no point to be overly dogmatic.  From 1999 to 2007 and 2008, gold outperformed equities by a huge margin.  Also, silver outperformed equities by a huge margin.  In 2009, equities outperformed gold, and from here onward, it is going to be the same pattern.  There will be suddenly other assets that appreciate, and some assets go down.

I happen to think that some prices will go down, but they have become oversold on a near-term basis, because over the last three months, the whole world became overly enthusiastic with the inflation phase, so the thinking was, government bonds are bad, and equities are good.  That may reverse for a little while, but I think long-term if you look at ten years, one of the worst investments will be long-term U.S. government bonds.

David: What measures might the Fed and the Treasury employ to defend the bond market as it is so critical to the financing of our deficits and our way of life in America?

Marc: I think they do not necessarily want to support the bond market, because the debt issuance is so huge, they almost have to monetize part of the debt.  I have read Treasury reports in 2010 by Tim Geithner saying the U.S. government debt increased by more than 2 trillion dollars during that period of time.  The deficit, in my opinion, mathematically, cannot come down, because 80% of the budget is mandatory expenditures, in other words, you cannot cut them.  Legally, they have to be met.

Of the remaining 20%, you can cut a little bit, but not that much, because then services collapse.  In my view, the fiscal deficit of the U.S. will stay around 1½ trillion dollars for as far as the eye can see, and maybe even go to 2, or 2½ trillion dollars, and then the interest expenditures on the debt go up.  So actually, over time, in my view, unless taxes are increased significantly, and spending is cut significantly, not by a little bit here, a little bit there, the budget will never again be balanced, and that will then necessitate, in time, QE-III, QE-IV, and QE-V.  Taxes cannot be increased dramatically, because if you increase them very substantially, we will go straight back into a recession.

David: It seems like perhaps one of the best strategies that they have to employ is a manipulation of the CPI numbers so that people assume that real-world inflation is 2 to 2½%, while running at a 5% rate, essentially cutting the debts in half over a long enough period of time.  If real-world inflation is, as John Williams of ShadowStats has said, closer to 8%, then we are alleviating a lot of our existing stock of debt, at a rapid rate.

Marc: Correct.  But you understand, you are not really helping the economy, you are impoverishing, let’s say, the honest people who are decent, who have deposits, who save money and keep it in the banking system, who simply do not want to speculate.  So, it is a tax on people’s savings, and it is a very vicious tax, because it is not so obvious to them, but it will become obvious one day, when with their money they can buy less and less.  In other words, the purchasing power of money goes down.  That is why I am telling everyone, if you already own cash, consider gold and silver to be a component of your cash portfolio, and own some of it, because the government can appropriate it, but otherwise they cannot fiddle around with it in terms of increasing the supply.

David: You made that distinction earlier, that precious metals you do not put in the same category as commodities in general, because you consider it money.  Is that only the case when money that we are used to, here in the U.S., for example, U.S. dollars, or in Thailand, for example, the baht, where money loses its “moneyness?”  Is that the environment where you treat precious metals as a cash alternative?

Marc: Yes, and also, I would say, let’s take a very bearish scenario, assuming there is a collapse in the Chinese economy, which is not necessarily my prediction, but some people say there is a horrendous bubble.  I agree, if we define a bubble as artificially low interest rates, and excessive credit growth, then we have a colossal bubble in China.  But it may go on for another 2-3 years.

But let’s say it breaks one day.  Then it will have a very negative impact on the demand for industrial commodities.  And we may get, at some stage, in some sectors of the economy, the risk of deflation.  In other words, the demand for industrial commodities could, for a year or two, decline, and so, obviously, the price of copper, and of nickel, and also, to some extent, oil – although this would depend very much on political developments – would go down.

In that environment, there will be more money-printing.  If the S&P drops 20%, all the people that are now criticizing Mr. Bernanke for QE-II will go back to their old pattern, as they have done between 1980 and 2007, to encourage the Fed to print money, because they all benefitted from rising asset prices.  But as soon as the S&P drops 20%, the American policy-makers will all again be for further monetary policy measures and further fiscal measures.

At that time, obviously, you could end up with a global economy that is very weak, but where prices go up for certain commodities, such as gold and silver.  They don’t go down because of an oversupply situation, but they move because they are a safe currency.  They become the proper unit of account.  In all hyper-inflation economies, eventually people give up their own currencies as a unit of account.

If you had gone to Zimbabwe during their hyper-inflation, or if you had gone to Germany during their hyper-inflation, or Mexico during their hyper-inflation, nobody in those countries calculated prices anymore in their domestic currency, it was all then becoming a dollar standard, or gold standard.  That is why I think that people should have some of their money in gold and silver.

David: Let me ask a question about silver, because this is a bit of a tricky juncture.  From 1983 to the present, we have seen the gold and silver prices fluctuate in a relationship between 100-to-1 on the high side, down to 40-to-1 on the low side.  You would have to go back to the 1960s and 1970s to find a different pattern of behavior, where those metals favored silver even more greatly, and the ratio traded between 20 and 50.  Are we in a transition back to that earlier period, where silver perhaps continues to outperform?

And as a part of that question, too, let me throw China into the mix.  You mentioned the possibility, not that it is your position that we will see a collapse in China, but if that were to happen as a result of rapid credit expansion, cheap capital, large-scale fraud, the incentives that have been there to ignore risk, if we do see a collapse in China over the next 2-3 years, does that impact silver negatively, because of its industrial component, or is that such a marginal factor, when gold and silver are being treated as money?

Marc: First of all, I think that gold and silver will move in the same direction, but as I tried to explain earlier on, when you print money, essentially, everything goes up, but at different times, and with different intensities.  In a bull market, usually, toward the tail end of the bull market, silver tends to grossly outperform gold.  So, yes, maybe it will outperform gold, but I stick to gold because my safe deposit box is not large enough to put enough silver in it, whereas, it is large enough to put enough gold in it.

Different people have different takes on this, and my friend Eric Sprott, who knows the silver and gold markets extremely well, thinks that silver will go ballistic.  Yes, maybe that is true, but I do not think that silver will go up alone, without gold also moving.  The direction will be same.  Concerning China, yes, I suppose that silver would have a larger industrial component than gold, but as I pointed out, if China collapses and there is a huge deflationary scare, I suppose that it is the real industrial commodities, like copper and nickel and so forth, would be more vulnerable than gold and silver.

David.  Coming back around to the U.S. markets, we have seen, for at least 12 months now, record insider selling.  That has been very pronounced at the banks, starting in about November of 2009, where there has been a disproportionately high degree of selling by insiders, as opposed to buying.  Would you combine that with other indicators, like liquidations from bear funds?

Marc: I would just like to say about the insider selling, this is also something that I follow and that concerns me.  But having said that, and being on the boards of different companies, let me explain to you what happens.  Let’s say I am on the board of a company and I get stock options, and I exercise the stock options and then to diversify, I may sell some of the shares I own in that company through my stock option plan, and then I may go and buy other stocks in the market, or make other investments.

Because of the proliferation of option plans in the last twenty years or so, there is a natural tendency that when a CEO sells shares, it is reported, but when he invests with hedge fund management, or buys shares in other companies, it is not reported.  I think there has been a change in the validity of this statistic.  But I agree with you, at the present, the ratio is so huge between selling and buying, that it is a rather negative indicator.  Then, when you combine that with other indicators that are also negative, a hugely over-bought market, for instance, I think some caution is in order.

David: To look toward the end of our conversation today, one of your recent reports you titled, “The End Game Has Begun.”  What would you suggest is the end-game?  Are we talking largely about the credit markets, interest rate reversals, and an end to the shenanigans that have been played for 30-40 years in those credit markets?  What is your area of greatest concern, and what would be some practical things that investors can do in these harrowing transitions?

Marc: I think we are all doomed.  I think what will happen is that we are in the midst of a kind of a crack-up boom that is not sustainable, that eventually the economy will deteriorate, that there will be more money-printing, and then you have inflation, and a poor economy, an extreme form of stagflation, and, eventually, in that situation, countries go to war, and, as a whole, derivatives, the market, and everything will collapse, and like a computer when it crashes, you will have to reboot it.

For the investor, the question is: How do I navigate through this complete disaster that is going to unfold?  And I think if you look at different asset classes – real estate, equities, bonds, cash, precious metals – I suppose that you have to be diversified.  I think real estate in the U.S. may go down another 10% or so, or even 15%, but I am always telling people, if you can buy the piece of land or the house you like, what do you actually care if it does down another 10%?  If everything I bought in my life had only gone down 10-15%, I would be very rich, because a lot of things became worthless, especially loans to friends, and bonds, and so forth.

Look at the history, for example, of Germany, for the last 100 years.  They had World War I.  They had the hyper-inflation in World War II.  The bond-holders got wiped out three times.  If you owned Siemens, and you still own Siemens today, it was not a fantastic investment, but at least you still have something.  You were not wiped out.  I think that in equities you will be better off because you have an ownership in a company, than by being the lenders to companies, and the lenders, especially, to governments.

David: Do you anticipate an entry point into equities that perhaps rivals what we saw in 1932, or perhaps 1949, or more recently, 1982, as we launched into a massive bull market?  Do you anticipate seeing values even remotely close to that?

Marc: In a money-printing environment, it is very difficult to know what is actually cheap and what is expensive.  Is the price of wheat high, or is it low?  Inflation-adjusted, it is extremely low.  In nominal terms, it is relatively high.  I believe that, in March 2009 when the S&P was at 666, the market was actually much cheaper than is generally perceived, because of the money-printing, and I do not anticipate that we will see 666 on the S&P again, in nominal terms.

In other words, they are going to print so much money that the S&P could be at, perhaps, 2000, but in real terms, it could be down below the lows of March 6, 2009.  Maybe in gold terms, we could one day reach a ratio of Dow Jones to gold of 1-to-1, as we were in 1980.  In other words, the Dow could be perhaps at 10,000 or 12,000, and gold could be at the same level.

That is why I am advising people to accumulate gold.  Can gold have a correction?  Yes, there has been a little bit too much euphoria about gold, and we may have a correction, but I do not think we are in a bubble in the price of gold.  In fact, I could make a case that gold, at this level of $1400 an ounce, is cheaper than in 1999, when I look at the unfunded liability growth of the U.S., at the credit growth of the U.S., and at the household growth, and at the money printing, and at all the wealth creation that happens in China and Russia.

Just consider, when I started to work in the 1970s, it was said there were two billionaires in the world.  One was Rockefeller, and the other one was Mr. Ludwig.  Then in 1980 there were, I think, six or eight billionaires.  Now you have thousands of billionaires.  The paper money has become of lower value, and in that environment, it is conceivable that actually stocks do not go down a lot, in nominal terms, but they go down inflation-adjusted, and not inflation-adjusted by what the government is publishing, but in inflation-adjusted terms, as John Williams points out.  He says inflation is running at 8% per annum.  I have it slightly lower, depending also on the household, whether you have children, or no children, and where you live, but I would say between 5-10% in America is probably a realistic figure, and between 8-12% in countries like India, China, Viet Nam.

David: Thank you for joining us today.  We will look forward to touching base with you, perhaps, later in the year, for your insights and they are particularly welcome, with an international emphasis.  You have lived in Asia for a long time.  We will have some questions, perhaps, as we move into the summer months, specifically, on China, as we explore some of the issues relating to that particular market.  You have been writing on that since 2004 in your book, Tomorrow’s Gold, and we want to unpack that with you a bit more in a future program, but thanks for joining us today.

Marc: Sure, my pleasure.  Thank you very much.  Bye-bye.

David: Have a good night.

Kevin: David, as always, that was a fascinating interview with Dr. Faber.  Something that he brought out that I thought was fascinating, is that we look at things in nominal value in cash, but in reality, we have talked over and over with people, to let them know that they need to be dividing the value of something in something that would be, what Dr. Faber termed, a proper unit of account.  He said he thinks gold will be the proper unit of account.

David: Kevin, it has been that, classically, but I think that point is so critical, because as we discussed with Dr. Faber today, it is being in a money-printing environment that distorts all realities.  You really do not know what you have in equities.  You really do not know what you have in real estate.  You really do not know what you have in bonds or cash deposits.  These things become really irrelevant if you are still looking at your monthly statements or going through a personal balance sheet and coming up with nominal figures.  That is a real challenge, Kevin, to shift your thinking to real terms, but it is absolutely critical if investors want to walk through the next 5-10 years relatively unscathed.

Kevin: David, something that will really make you stop and ponder, he did say that gold, at $1400 today, is still cheaper than it was in 2009, when it was hundreds of dollars less than it is, just given the amount of money that has been printed.

David: Kevin, as I go back through his worst-case scenario step-sequence, it really does follow a similar pattern to what we have discussed in general terms, financial crises becoming economic, becoming political, becoming geopolitical, wherein stagflation leads to an environment where individual countries focus on their individual problems to the exclusion of the rest of the world, and world trade suffers as a result.  That is an environment that is ripe for conflict – war.

We did not get a chance to discuss this with him, but when you look at the recent merger of the German bourse and the New York Stock Exchange, it is interesting that this creates the largest derivative clearinghouse in the world, and the profits of both bourses, when you are looking at derivatives traded, come, primarily, from trading and derivatives, and not the underlying products.  In other words, if you are looking at the volume of stocks traded on the New York Stock Exchange, it now is trivial, by comparison, to the profits generated from hybrid products.

Kevin: That don’t really even exist, to be honest with you, David.  They are not real.

David: They are loosely connected to those real companies.  So, Kevin, it is just bizarre when you think about some of the best companies in the world, whether it is a Nestles, whether it is a Proctor and Gamble, whether it is an Intel, the derivative products and investment themes that surround it actually are more important today in the financial world than that product, itself.  That is a clear distortion of where Wall Street has gone, and where the financial markets have gone, but it also speaks to how dangerous these markets are, and he suggests that at the tail end of our interview today, wherein you have a collapse in the derivative market, because it truly is the greatest fiction we are living with today.

Kevin: It reminds me of smaller fictions that we have been through in the past, David.  In the late 1990s we started to see this tech stock boom get to the point where companies that did not produce a profit or a single product, were worth more than United Airlines, because they had dot.com behind their name.  That was false.  That collapsed.

And talking about derivatives, remember, just a couple of years ago, when we were having the show when we saw that the derivatives market, combined with the commodities, and currencies, and equities, passed a quadrillion dollars.  That was unfathomable.  Then, of course, we had the collapse.

David: You stack that number against the roughly 1 trillion dollars that is available, at any price, in the gold market, and you can realize that when things come unglued, and that includes the derivatives market, as well, just financial securities, the real stuff in the financial securities markets, stocks and bonds, is over 200 trillion, but again, relative to such a small, minute space.

I think one of the things that he mentioned today is a critical reminder that gold and silver are more and more being traded as currency, rather than a commodity, and that takes place, particularly in those countries that are experiencing currency crises, to some degree.  He mentions India, China, and Vietnam, experiencing inflation rates of between 8 and 12%, and our inflation rate in the U.S. being somewhere between 5 and 8%!  Is it any wonder, Kevin, that people look at their options and say, “This just doesn’t smell right.  This just doesn’t smell right.  I think I am opting for a currency alternative.”

Kevin: The other thing that is amazing is, look at how few people, still, are actually saying that.  We have talked about this over the last couple of weeks, how few people are actually participating in the only market that is protecting them from this inflation.

David: He mentions, in his most recent report of the Gloom, Boom, and Doom Report, that he has spoken to a group of hedge fund managers in Singapore, a group of private investors in South Korea, over 1000 people, and then very man-in-the-street type investors in Switzerland…

Kevin: Even Switzerland.

David: Even Switzerland, and in each instance, in a roomful of over 1000 people, only 3-5 people would raise their hands when asked the question, “Do you have any allocation to precious metals today?”  It is surprising, Kevin.  These crosscurrents of, “Is gold and silver in a bubble?”  Who is participating in driving it higher?

The classic reality, Kevin, when you are dealing with a bull market and its bubble dynamics, is that the bull market ends when the last person who has capital, and interest, can actually come into the market.  The reality is, we are so far from that, when you look at the stock of capital that exists in the world today.  The theme today:  Money-printing impacting all financial markets, in disproportionate ways.  There is a lot of money, and a lot of people who haven’t even once considered the precious metals market.  But I think that we are on the cusp of that changing.

Kevin: That makes gold, still, the best kept secret in the world.