February 27, 2013; Markets at Inflection Point

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: Last Thursday, as you had promised, you had a 3½ hour, answer-all-the-questions conference call. Unfortunately, you couldn’t answer all the questions, because we had close to 1,000 people on the line, but you did answer, I think, 29 or 30 questions.

David: Well, we promised 45 minutes, and it just kept going and going and going. The questions were fantastic, the quality of the questions, and the sincerity of those asking, trying to figure out what is happening, why, and what they should be doing in light of it.

Kevin: I have to say, I’m very humbled when I hear the people who listen to this commentary, the people who do business with us, the questions that they were asking. And this was in the face of gold dropping severely a couple of days before that occurred. I thought I would hear panic in their voices. I didn’t hear panic in their voices. I heard maturity. And the questions that they were asking were long-range questions about if we are doing the right thing, and should we be doing more of it.

Gold, specifically. Let’s talk about the years that your family has been in business, and there have been a number of times when you could purchase too high.

David: A part of what we reflected on in the conference call was the fundamentals that have been driving the gold market during this period of time. There were periods of technical weakness, as well, and in the last 12 years of a bull market, there were opportunities to have paid the highest price yet paid. So you bought high when you paid $330 an ounce, and then subsequently had to wait 12-16 months for the next up-move.

And you bought high when you paid $430 an ounce, and again, you had to wait between 12-16 months for a breakout. And then you paid an incredibly high price when you bought gold at $730 an ounce, and waited, again, 12-16 months through a consolidation, ultimately, a period that was exhausted on the downside, and then an uptrend again 12-16 months later.

Kevin: The detractors said, “Oh, it will never break $1,000. You’re going to be paying too high.” Yeah, well, you bought high when it broke $1,000, at $1,030, right?

David: And that was a high price to pay, and you waited again another 12-16 months before you had an up-trend re-assert itself. And imagine the psychological damage, particularly having paid, in nominal terms, a higher price than ever recorded in U.S. dollar history. So at $1,030 you rung the bell, and you probably had to explain to your wife (or maybe you didn’t, maybe you didn’t say a word about it) that you had bought gold at over $1,000 an ounce and now it was trading closer to $750-800 an ounce.

But again, that consolidation opened up, and again, you bought high when you paid $1920 an ounce, and now we have waited 16 months, maybe we wait 18, maybe we wait 20 months for a renewed breakout. But what we have seen is that we have held support at the lower $1500s, we’ve stayed above $1500-1530, and we can assume that we are closer to an upside move with every passing day.

Again, a move below $1500 will require some reappraisal, but holding that $1500-1535 level, we see a growing probability of 2013 setting new highs. We’ll battle through $1800, we’ll move well above $2,000 an ounce, and the longer this consolidation takes, the more likely we are to not only put in new highs, but surprise everyone on the upside for this year.

Ian McAvity, who has been a guest on our program before, recently asked the question, “By the end of 2013 does anyone seriously fear any risk of a sudden outbreak of fiscal or monetary integrity by the central banks of the U.S., Europe, Japan, or the U.K.?”

Kevin: So what are the chances of integrity actually re-entering the system this year? That’s what he is saying.

David: And frankly, even this week we have the congressional hearings, with Ben Bernanke going before them and saying, “Hey, listen, contrary to what the minutes said last week in terms of our internal discussion, we’re very comfortable with our policies, and we see that there is some downside, but we see far more benefits from the asset purchases that we are making, the billions in mortgage-backed securities, and the billions in the Treasury market. We are seeing traction in the economy. We see the economy growing as a result of what we are doing.”

Honestly, I have a very different appraisal of the economic benefits, and I also have a very different appraisal of whether or not we are seeing traction gained, as we speak. Quite the opposite, I think as we move toward the March FOMC meeting, as we get some numbers on month-end for February, I think we’ll see further deterioration.

I could be wrong on that, but it looks that way to us, in terms of housing, in terms of industrial demand, both in Europe and in the United States, we see some major headwinds following what was an incredible period of stimulation the last part of 2012 and the first part of 2013. Why do we say the first part of 2013? You know, there was an extra 41 billion dollars that got captured in terms of income, coming into that 4th quarter. It was an extraordinary 41 billion, because that was extra dividends paid, extraordinary one-time dividends, that companies wanted to get to their shareholders before the change in tax code at the beginning of 2013.

So, again, we’ll see some filtering through in the first quarter. Our main concerns are, when we get to the second half of this year, what exactly is driving growth, other than central bank printing presses?

Kevin: Talking about Fed policies, when they are satisfied with what they are doing, what we are talking about is printing of money – the Fed balance sheet has increased. In fact, how much money was erased in the stock market crash period of 2007-2009?

David: The numbers everyone knows, but there is an interesting reflection, again from Ian McAvity here recently, when he points out that between 2007 and 2009 there was 9.2 trillion dollars in U.S. equity market cap.

Kevin: But that has been restored.

David: Stock market valuation that was erased. And you are right, that has been restored, but at what cost? That is where we have seen gross federal debt since that time grow by 7 trillion, and we’ve seen the Federal Reserve balance sheet expand by over 2 trillion, so 7 plus 2…

Kevin: That’s 9. That’s what we lost. We’ve restored it, but we’ve restored it through debt.

David: Exactly. With the recovery in equities, this is really just a bailout for today’s investors, with a bill for “services rendered” being added to the intergenerational tab. Again, it took 9 trillion dollars in debt to replace value from the equity washout. Of course, our primary concern is another dip in the equity market, with the bailout capacity already stretched thin.

Again, you have this idea of socialization of risk. Another socialization of risk could well be the precipitating event for a bond market rout, and a complete reappraisal of paper assets in terms of their value and risk imputed in them, by the general public, and our sense is, we are quite close to the last hurrah for the equity markets.

Kevin: David, you have pointed out in the past, if we look at who is bailed out and how the bubble is moved, we have the tech stock bubble back in the late 1990s. That crashed, but that bubble was moved by Greenspan – by lowering rates and printing money – over into the real estate market – easy loans.

David: But the beneficiary also became the bust. The beneficiary represented the bubble, and ultimately, the bust. Then you had the real estate bust, and who was on the hook? The banks were on the hook, and the beneficiaries of this bailout, and arguably, this bubble, are related to banks. Not just banks, but the whole credit system.

Kevin: But we’re out of bailout people. We went to the source. Now the government has socialized everything and the next bubble popping, you have pointed this out before, there is no one to bail them out.

David: Except that they have tools that they can employ that will offer them time to try to solve the problem. What are those tools? These are the tools that we see in motion today that Ben Bernanke has said, “Listen, we are quite comfortable with them. We will continue to monetize. We don’t see a connection between monetization and inflation.” As he says, from cue card #72, “Inflation expectations are well anchored.”

So again, from his ivory tower, he sees no inflation, which doesn’t really explain the base level frustration that you have from people on the street, dealing with rising fuel prices, dealing with rising grocery costs, dealing with the basics of life on the increase, even while interest income and income in general, is flat. So that is the struggle.

When we look at the markets, as long as we have a Dow theory nonconfirmation, and an apparent topping formation in the S&P, we feel that the risks are lop-sided for stockholders, and the real surprise for most market participants this year, 2013, may well be gold putting in new highs, and the equity market selling off 10-25%, a reversal of what we saw last year. Even though gold finished the year strong with a 6% gain, it was nothing compared to what it could have been, and again, equity markets outperform.

So the great reversal in expectations with the underperformance in equities, and outperformance to whatever degree, in the gold and silver space. Will we see that in 2013? We think the world’s central bankers are pushing a lot into the pipeline and focusing us in that one particular direction.

Kevin: It is interesting, too, David, that with the election year over, there is nothing to prove now, from at least the political side of things, for a couple of years. Usually, when we have the first half of a presidential cycle, when the president is not trying to get re-elected, or get another of their party elected, that is usually when the stock market suffers, isn’t it?

David: That’s right. And again, if you are looking at presidential cycles, it is the first half which has the most vulnerability. 65% of all down years in stock market history, at least going back 100 years, recorded by the S&P, were in the first half of the term. So we look at the spending, the extraordinary measures in place. We look at a lack of organic growth in the economy.

Kevin: New taxes. We have new taxes coming.

David: New taxes, all of those things. You have 77% of households experiencing an increase in taxes via the payroll tax increase, and you can see a picture taking shape, again, with the consumer on hold.

Kevin: David, if they are on hold, is it possible that we are going to actually test, and fail, the 2000 and 2007 levels that we have had before?

David: Exactly. The equity market peaked in 2000, it recovered, and hit new highs, or equivalent highs in 2007, and we are back at those levels. Will we break through it? We think no, not on this go-round. Would that bring us quickly into bear mode? What won’t go up, in our view, must come down, and we’ve come up this far, we didn’t make any ground in 2007 to speak of, and to us it looks a like that 1966 to 1982 bear market period.

Remember that each successive market intervention the Fed has put in motion over the last 5-6 years increased equity values, so it did accomplish one particular goal, but it did less and less of that, so there was a diminished return with each expansion of the Fed balance sheet and creation of credit into the system.

Kevin: So the more they put in, the less impact it has, even though it is a positive impact, short-term, it is reducing its value.

David: Less bang for the buck, and now you have dissenting Fed voices which are acknowledging this. Bernanke is, of course, immovable from his position of accommodation. Immovable, because you saw even in this week’s interview, Congress got to ask lots of questions, and in a very … well, I won’t say smug … but in a very confident and immovable way, said, “We like what we are doing, we are going to continue doing it. We don’t see any negative impact from it.” Again, we would probably ask him to check into the real world occasionally to see what the implications are of the kind of accommodation he has put in place.

And frankly, he has reset the standard. All world central banks today – I exaggerate, maybe 50 of the main central banks, which are most of the world central banks – have done the same thing. They have lowered rates to the zero bound, and you have a low-to-negative interest rate environment globally, so the frustration that investors have is, “How do I pay my bills, how do I make ends meet, how do I keep my rate of return sufficient to meet my retirement objectives?”

And this is where you begin to see investors take on more and more risk. They are taking on more and more risk because they have to, and what does that really mean? The Fed policy, and the central bank policies which mimic the Fed’s policies, are creating more system risk than we have ever had in the market before.

Look at 2007 as a period that was fraught with market risk, and you could argue that given now a 5-year period of low-to-negative interest rates, we have created stimulus on a scale never seen before in world history and central bank history, and can we assume anything less, in terms of the creation of bubbles? We will see bubbles, and unfortunately, we will see them burst, as well. Where will investors be, how do they protect themselves? Those are different questions. That’s a separate conversation.

Kevin: David, after listening to Ben Bernanke, there is almost a smugness that comes across that these things are working, but it is reminiscent of a central banker in history. The 1920s is what I am thinking about.

David: Right, when Havenstein was doing what he was doing, as the wunderkind in Germany…

Kevin: He was the genius.

David: He was. And there was a very simple problem to solve. Prices were on the increase and therefore to meet the need of people who had to pay higher prices, he made more money. And so there was more money in the system and people had more money and they paid more for those same goods and services, and lo and behold, the prices continued to rise. This is what, in essence, we are doing today, just with credit instead of printing presses.

Oftentimes we talk about the “printing presses” and what we are really talking about is an expansion of credit, because we don’t have to do something as arcane and antique as printing dollars. We get to create credit with the keys on our keyboard. With the click of a mouse, we can instantly create trillions. This is the beauty of the modern era. We can go from zero inflation to hyperinflation, not even with a 2-4 month time lag, as the printing presses get revved up, but we can do it instantaneously, because it is a digital phenomenon.

Kevin: David, sometimes we talk about collapses and think that they are a one-day event. The stock market just goes down thousands of points, there is blood in the streets, and everybody says, “Oh, well, these guys were right, there’s a bear market.” But I think of some of the bear markets that were inflation-ridden, when actually the market didn’t do a whole lot for years and years and years, but the inflation just ruined the buying power of those stocks.

David: Right, and that’s where we see the 1966-1982 bear market as most similar to what we are in today in equities, which was basically a sideways movement, range-bound, and the problem was that when stocks are not going up, if inflation is low then you have no problem, and if inflation begins to creep up, then your real rate of return goes from being flat to being negative.

And it was that last 5-7 years of the 1966-1982 period which wrecked real returns and left people very despondent, very discouraged, and you started to see in newsprint that basically this was the death of equities. Nobody wanted to be in equities. Nobody wanted to be an equity investor. Why? Well, again, you go with zero return for a long period of time, almost 20 years, and then on top of that start sucking out 5% a year, 7% a year, 12% a year, 13% a year, on top of the inflation that got sucked out the year before, and now you are looking at your total return for that time span, and yes, you have given away a fortune.

It is a way that government increases taxes surreptitiously. Increase the inflation rate and it does help their project considerably. We are now moving toward the same circumstance. Higher levels of inflation, again, with many central bankers targeting 2%. We have Japan and the  DOJ suggesting that 3% might be a better target to break the back of deflation.

But again, this is in the context of a low-yield world. The inflation story is one that is massively discounted today, and I say this because in the category of unhedged risks, everyone is aware of deflation. They look at our credit markets, they look at the growth of credit over the years, and they know, and they think, that there should be some sort of a credit unwind. What are the consequences from a deflationary standpoint?

So the deflationary tail risk, frankly, is already insured against. The system has tried to cover that bet thoroughly. It’s not going to come as a surprise. A black swan event is something that is unexpected, out of the blue, and no one saw coming. Basically, everyone on Wall Street is focused on one tail of the Gaussian curve and saying, “That. Over there. That is our concern. We can’t let that happen.”

And guess what? They are ignoring the other end of the curve. No one expects to see inflation, let alone hyperinflation.

Kevin: Let me interrupt you here, though. There is somebody who expects hyperinflation, and we have had him on as a guest a number of times – John Williams. He is sticking to his guns. John knows how to analyze the numbers. He knows history, and he understands what occurs when you printed too much worthless money.

David: It is interesting because our Ph.D. money mandarins are too smart for that to occur. That’s what they consider. Even listening to Ben Bernanke this week, he basically said, “Listen, we’ve got it under control, inflation is not an issue. We will implement our exit strategy as, and when, it is needed.”

And this is the thing. Each of the crises we’ve seen over the last 15-20 years, let alone the last decade, were unexpected, with those same money mandarins saying, “Listen, no we didn’t see it see it coming, but we can tell you we will see the end of it coming, and we’ll be able to adjust monetary policy just in time.”

How is that just-in-time thinking working heading into this? Why should we place confidence in their ability to undo the massive credit that has been created and put into the system over the last 5-10 years, and this, again, is where we think it is a pipe dream. We think it is a pipe dream, and frankly, if it is a pipe dream, and the Ph.D. money mandarins are too smart for it to occur, well then maybe John Williams is ringing the bell and saying, “Yes, hyperinflation is not a pipe dream, but is in the pipeline.”

We don’t know, so we remain convinced that higher levels of inflation are a part of a designed method to reduce debt over a longer period of time. The Fed is playing for time, because inflation is their friend, and if they can run a 4% rate of inflation, but report a 2%, that is chipping away, and we are paying back our creditors with cheaper and cheaper dollars every year that goes by.

The real inflationary concern is only going to kick into gear for them when they lose control, and that, frankly, is with a snap in the bond market, as investors and central banks move to the exits on a re-appraisal of risk. Is that this year? No, I don’t think that that’s a 2013 event, but for the U.S. bond market that could very well be a 2014 to 2016 event. In that time frame, all of a sudden you go from 0-60, “We have no inflationary concerns,” to, “Boys, we’d better be able to reign this in because it’s getting out of control. Again, it’s one of those things where if you don’t anticipate, you don’t get to buy the cheaper insurance for it. The bond market is obviously a concern here.

Kevin: And you, know, it is interesting, that strategy seems to work when you are the only guy in the ring. If you are the only guy in the ring, you can create inflation and say, “You know what? It’s our reserve currency, it’s your reserve currency. We can devalue it.” But like you said…

David: Our dollar is your problem.

Kevin: There are 40-50 central banks worldwide that are saying, “Wait, this works. We’re going to go ahead and have zero interest rates, we’re going to print money.” So, the currency wars that we have been hearing about are in full gear.

David: They’re heating up, and they are divided, as Michael Pettis has recently said, into two camps – those that overtly participate, and those that covertly participate, and undermine their trade competition. The yen is now leading the pack, and of course, there is going to be a jockeying for position, who is leading on the downside. But the yen, compared to the euro, and this is mind-boggling, is now down 35% compared to the euro in just a few months. Imagine what the executives at Toyota and at Lexus are thinking right now.

Kevin: Oh, they don’t mind a bit.

David: Imagine if you are a firm in Japan, and now, all of a sudden, you have amazing trade competition. Do BMW and Mercedes and VW feel the same way? No, actually, this is very frustrating to them. This is why, in a G20 meeting, most recently, they are talking about currency wars, they are talking about competitive currency devaluation, and the fact that if the Japanese are going to do that, then they either need to cease and desist, and if they don’t cease and desist, then the euro may have to be devalued, as well.

Now, they haven’t gone that far in the conversation, but as sure as night follows day, if the world enters into a period of devaluation, everyone participates. Again, Michael Pettis’s comment, it’s whether or not you are doing it overtly, on an announced basis, or covertly, and pretending that you are not doing it at all, and you just complaining about others doing the same.

Kevin: And there is a cost to currency wars. The more money you print, as we talked about before, with inflation, that inflation can creep in, but countries cannot keep interest rates down forever, so what does this mean for the bond market after they’ve played with fire, when we start to actually have a consequence?

David: Well, isn’t it fascinating that FINRA, two weeks ago, started warning on duration risk in the bond market? So FINRA is a body that polices, so to say, the financial industry. They are not in the business of consumer protection, per se, certainly not consumer investment advice. And here is where they are going beyond anything they have ever done before. FINRA is announcing that, yes, if you have an increase in interest rates, that is the same thing as a major sell-off in bonds. You will lose value. Watch out for duration risk. Don’t own long-term bonds. Be careful what you own if it is a long-term bond. This is FINRA, this is absolutely unprecedented.

If we just take the other side of this, if you do see a sell-off in equities here in the next several months, you will see a return to bond-buying for “safety” and you have the 10-year Treasury, which today is in the 1.8, 1.9 range, which will, slip to 1.7. We may even see it test the lows of 1.43, which we put in last summer. This is our opinion.

This would be a period of time, again, where interest rates are contracting on the basis of panic in the stock market, all theoretical, but run through the scenario in your mind. If stock markets begin to sell off, you will see a migration into bonds, rates will come down, the value of bonds will go up, and this is probably the last hurrah for the bond market, a great time to be broadly divesting from bonds of questionable quality, and of intermediate and long duration. So, of course, if you hold short-term Treasuries, or very high-quality corporates, these would be exceptions to the rule. We wouldn’t have a problem with those, and obviously, if cash flow requires that exposure, maintain it.

But what you are really talking about is intermediate to long-term bonds, and anything of a questionable quality has been priced to perfection, and we know we don’t live in a perfect world. In fact, we live in a very frail financial world.

Kevin: David, just recently you said that the Federal Reserve oftentimes talks about the stimulus as a past event, and they are looking back in the rear-view mirror saying, “Well, by golly, that worked. I’m sure glad we had Ben Bernanke there.” But we have a trillion dollars in stimulus on the docket for 2013.

David: And if there is something the Fed knows that they are not letting us in on, we would appreciate some sort of a news flash, because, again, you don’t talk about the fact that you are in recovery, and try to argue that it is just degrees of recovery. Do you want a robust recovery, or do you want a tepid recovery? But we do have recovery. Why do you even use the language of recovery when you have the patient – the economy, that is – on life support?

A trillion dollars worth of stimulus, plus 6¼ to 6.7% deficit spending compared to GDP, these are measures that are intended to stimulate growth, but, in fact, we haven’t actually gotten past the dependence level on those inputs. Again, we love the ER example. If someone is on life support, you can’t really describe them as being in recovery.

Kevin: No, but you know what recovery is? Recovery is the new word like the old “tastes just like chicken.” Go ahead and eat it, because it tastes just like chicken. Go ahead and do that, because we are in a recovery.

David: A frog may taste like a chicken. Rattlesnakes taste just like chicken. What doesn’t taste just like chicken? Well, yes, returning to our recovery versus stabilization discussion, it would seem that record low rates, and monetization of assets, pressing the trillion-dollar threshold, that is not exhibit A, that is not exhibit B, for an economy that has returned to stride and is growing – in essence, has recovered.

Kevin: And not just here in America. Look at the equity markets worldwide. When you see stimulus from the central banks in those countries, you see the equity markets rising.

David: Right, so look at the charts of any of the world equity markets. Look at Europe. Look at Asia. Look right here in the U.S., and you have to wonder what the catalyst is for taking stocks beyond peak levels, and we happen to be at those peak levels now, similar to 2007, and similar to 2000. Interesting to note that all of the world equity markets were at their own version of peak numbers at the same time, 2007 and 2000. Wow. So when credit flows, all boats rise. When the tide is rising, all boats rise with it.

Kevin: And that was just before the crashes.

David: Of course. Now, the catalyst may be the money-printing and monetization by global central bankers, but without this, without this extraordinary ingredient, the risks lie on the downside. It’s not just an economic argument, but if you look at the groups who are now buying and selling in the marketplace, we have pointed this out throughout this last year. Throughout the second half of last year, we noted the rapid increase in insider selling.

Right, the CEOs of those companies were selling their shares. That trend continues. Now you have fresh meat in the market – being the hopeful retail investor just recently back in the game after several years of sitting on the sidelines, nursing wounds from the beating they took in 2008 and 2009. Just back in time to grab the bag from insiders that are more and more concerned with what? Number one, nonresolution in Europe.

Kevin: Look at Italy.

David: Exactly.

Kevin: Nonresolution in Europe, I mean, it just continues.

David: Isn’t it interesting? Only in Italy can someone be on trial for tax fraud, carrying a 4-year prison penalty and you say, “Let’s put this and the appeal process on hold until after my election bid.”

Kevin: “I have an election to win.”

David: Yeah, “So can you postpone?” And they say, “Oh sure, we’ll just wait on that until we figure out if you are going to be the heir.”

This is the issue. No, we don’t have resolution in Europe, there are fiscal issues, and there is nonresolution in the United States, or Italy’s resolution, which includes fleece the rich and redistribute assets to the less fortunate. What’s the problem with that? It’s the removal of incentive from the market-based system dependent on that key ingredient. You take incentive out of the equation and what happens? It’s like going back to the period that we saw in the 1940s, during the wartime period where our economy was a complete command-control economy.

What happened to private capital, what happened to business investment? It all dried up. Why? Well, if there is no incentive, if the government captures the upside, but we capture the downside, why would individuals and corporations take risk? They don’t. They say, “Listen, we’ve got an infinite timeframe. Your election is going to be in 2-4 years. You don’t have an infinite timeframe. You will be either re-elected, or thrown out. We will last. We will survive. We will disappear. We will go into some sort of hibernation for a certain period of time.” Capital can get very, very quiet until a new regime that is more comfortable with the incentive program in the market environment comes into play.

Kevin: Dave, you’ve talked about removing incentives. Of course, that’s a problem for the equities market, the European nonresolution. But actually, we’ve been sold a bill of goods, too. We’ve been told that even if none of this works out in the West, the emerging markets are going to pull this out, but that’s fading.

David: Right. So again, you have the insiders who are handing the bag to the man-on-the-street, and yes, they see fading prospects of a global recovery fueled by underdeveloped countries. That leaves us with the old debt-driven growth model, the model that certainly carried us for 30-40 years, but is now our only default choice?

Kevin: It’s tired.

David: Well, it is tired. So we look at the FTSE, we look at the London market, we look at the DAX, we look at the German market, we look at the S&P, and even the underperformers have recovered some of their losses from the 2008 debacle, but new ground has yet to be traveled. This is really the issue, though, because even if we did cover a little bit of new territory, let’s say the Dow did break out. We talked about the Dow theory nonconfirmation a few minutes ago. That is, in essence, when the transports have moved to new highs and, according to Dow theory, the industrial average should also reach new highs, confirming that the market is in a bull trend.

Kevin: And that hasn’t happened yet.

David: If the industrials don’t make new highs after the transports have, then the argument is, you are not really standing on two legs, you are in a very weak environment, and it may not happen at all. The challenge is, we have seen confirmations in the past, a break to new highs, and then terrible losses on the other side of that. I am thinking of 1974 when the Dow finally reached into new territory. It broke above 1000, went to about 1050, a good 5% move, and arguably, anyone who is looking at technical confirmations of upside would say, “Hey, we may be moving into a new bull market, except that we were on our way to a 45% loss immediately thereafter.”

Kevin: So it lost half of its value.

David: Yes, we went to less than 600 on the Dow immediately thereafter. A move of that magnitude would take us to about 7500 on the Dow. That may sound a bit scary, but we’ve been there before, we were there in 2008. Actually, that is not as bad a number as we saw in 2008. Have we dealt with the issues that need to be dealt with of a structural nature? No. Have we simply papered over them with central bank largesse. Largely, yes.

Where do we go from here? Ultimately, there has to be a purging, and maybe this is just too much Austrian thinking at one sitting, but ultimately there has to be some sort of a purge, the bad debts go, and you start over. You start out with something of a blank slate.

Kevin: So, David, if we really did see the Dow drop to 7500, 8000, related to an ounce of gold, which we have tried to teach the listeners to start doing, what would that Dow-gold ratio look like at that point?

David: Take the price of the Dow at that point, let’s say 8000 for easy math. Assume a $4000 gold price and it is a 2-to-1 ratio. We are at about a 9-to-1 ratio now. That implies an increase of purchasing power of seven times. Seven times purchasing power between the 9-to-1 current, and the 2-to-1 prospective. That’s interesting.

That may be, in fact, the limit on the Dow-gold ratio, in terms of purchasing power, but a very compelling story. Where are we now, where are we going? I don’t think we’ll see 7500 this year, by any stretch. We could see 11,500 on the Dow, maybe even 10,500 on the downside, as a low point. But I think what really would take the Dow lower is movement in the bond market, and that bubble beginning to burst, and all of a sudden equities circle the drain with bonds at the same time.

Kevin: I think of Bernanke. Let’s pretend he is sitting here with us, and let’s pretend he is honest, and he says, “You know, Dave? You’re right. Okay, the equities, you can take that. I realize that the equities came up because we printed money and we stimulated. And this recovery, yeah, maybe it’s not really a recovery, but we stimulated, so at least we showed positive GDP growth. But one thing you can’t take away from me (I think of the song, They Can’t Take That Away from Me) is real estate. Real estate was bottoming. It’s starting to rise. Come on, give me that.”

David: Yeah, we’ll give him that. And it is the success story of the Fed. Low rates are stimulating activity in the sector, and arguably, that’s why they are going to keep on buying 40-45 billion dollar’s worth of mortgage-backed securities and just to support that effort, an extra 45 billion. So, 40 on the one hand, 45 billion in Treasuries.

There is an interesting thing, though, and I made mention of this on Bloomberg last week, that it is private equity, and it is institutional capital, that is responsible for reducing inventories. Basically, they have turned vacant and foreclosed homes into a rental pool. They have stepped in with billions of dollars, and admittedly, this is positive in terms of reducing the overhang of product on the market.

But you don’t have families purchasing first-time homes. That has not returned. That’s not the case. You don’t have people saying, “Listen, we’ve got some job security, we’re not as concerned about pink slips anymore, and I think we should go ahead and take the plunge, buy the house.” That’s not the case. What has put a floor under real estate is investors, and particularly, private equity institutional capital.

Kevin: So, it’s not your moms and pops that are going out and buying houses, necessarily, yet. Interest rates have been so attractive, it’s a hard thing to determine. If you are buying a house, and we’ve talked about zero interest rate policy not working forever. Most people do understand that, they see interest rates rising. So there is this tough question. Is real estate going to fall further? We had a market break in 2006. How long should we expect this real estate slump to last?

David: This is an issue. You could argue that you are bottoming out right now. In other words, we could have 5% downside, 15% downside, but we are a lot closer to the bottom than we are to the record peaks, and now the question is, what stimulates growth in that space? And this is where when you look at bull markets, periods of growth, and bear markets, periods of contraction, usually the bear market lasts half the duration of the preceding bull market.

We had a good 25-30 years of growth in the real estate market. Again, we’re talking about secular trends, not the little cyclical trends. “Oh, well, it dropped back 1% last year.” In that 30-year period, you went from interest rates being 17-18% to being 3%, and that was jet fuel for pricing in retail housing, and it was, too, for commercial space and everything else. What you are likely to see here is just a dead cat bounce, in terms of, yes, we’ve seen prices improve, they’ve picked themselves off the floor, but is this really re-entry into a growth phase.

We would argue that your best prospects for growth in real estate are around 2020, unless you are buying deeply discounted real estate in Detroit, which if you buy a single-family home for $5,000, and can sell it for $10,000, you’ve made decent money. But we are talking about a different kind of purchase.

Kevin: So, if a person is buying their residence, this might be a good time to buy, if they are not trying to invest the money and make money. But for the person who actually got used to turning real estate every few months…

David: Don’t look for quick turns. This is not an investor’s market, in the sense that you can expect buoyant moves of 5-8% per year in the real estate space. Beyond this recovery of 2012, first half of 2103, which again, is driven by private equity money and institutional capital, who is next? Who is coming in next, and why? Again, we think that we have some headwinds before that happens.

Kevin: One of the sad commentaries of what we are talking about is that you can’t make money in stocks without huge risk. The low interest rates have forced older people and people who are income-starved into…

David: Into bonds, high-yield bonds.

Kevin: And speculating in the stock market. But it sounds to me like the same thing is happening over on the real estate side, that you have speculators coming in. This is not necessarily the first-time buyer. This is the speculation that is pulling off this inventory at this point.

David: That’s right, and I think to have too sanguine a view on real estate at this point ignores the cost of capital, and as, and when, you see an increase in interest rates, you have to see a decrease in the value of real estate, the real estate that you are financing. So, as a second leg down in the real estate market, you can look at the cost of capital and say, that is a part of what is still at risk.

Now, the activity in the real estate market today, again, if you are looking at residential mortgage-backed securities, commercial mortgage-backed securities, commercial real estate, residential real estate, you have people moving there because they are income-starved. This is investment pools seeking yield literally anywhere they can find it. Again, who is responsible for this? This is a direct consequence of Fed activity. And frankly, it’s not the kind of activity that the Fed was supposed to stimulate.

They are stimulating speculation, and again, this is just a pool of investors who say, “I have to have some form of income. Find something for me. Package together, bundle up a thousand homes, try to rent them out. If we can collect the rents and have a 5-6% cap rate, you manage it, take 2%, and I’m happy with 5-6%, because look at the paltry returns I have elsewhere. In fact, I’m really happy with 5-6%, and if you need to leverage that fund in order to do it, great. I don’t care. Just get me some yield.”

I guess what I’m really saying is that the Fed is embedding a tremendous amount of speculation, and a tremendous amount of systemic risk, a tremendous amount of re-leveraging, even about 2008 and the beginning of what many thought would be a great unleveraging, or de-leveraging. It is the exact opposite of what is happening now, and risk in the market has, frankly, never been greater.

We assume that there will be normal washout in the commercial real estate market, a normal washout in the residential real estate market. But just like 2 + 2 = 4, as interest rates increase, you will see a hit in those real estate markets. That hasn’t happened yet. When is it going to happen? Again, we look forward on the horizon to events in the bond market which change the nature of equities, which change the nature of bond investment, which change the nature of the real estate markets, and this is still a 2014-2016 timeframe.

We aren’t saying that there is going to be a massive collapse in any of these markets tomorrow. There could be, on the basis of some unforeseen precipitating event, but barring that, it is baked into the cake on a longer-term basis, in that 2014 to 2016 event. How the Fed responds will determine whether or not we have tame, mild inflation, or even hyperinflation.

So, this may be a conversation to return to with John Williams. Do we see hyperinflation coming tomorrow? No, but on a longer-term timeframe, it will be very curious to see the Fed in a classic liquidity trap, trying to figure a way out of what is really a dead-end position.

Kevin: So, if I’m hearing you right, Dave, we’ve talked about the stock market, we’ve talked about bonds, we’ve talked about real estate, and not a lot looks good. The gold market does look good, but what I think I’m hearing you say is, don’t go out and speculate right now. Don’t try to create dollars that may be not really there, and stay the course, maybe preserve assets through this period of time.

David: I think this was the bottom line of our 3½-hour conversation, question-and-answer, and for anyone who hasn’t listened, it might be worth sampling through it, some great questions asked, and I think will add some clarity. The fundamentals haven’t changed in the precious metals market. Supply and demand is fairly healthy now and looking like it will be for 2013 and 2014 as well.

So what really is driving the markets today? A lot of unrealities. So again, if you want to go long the equity market, fine. But you are betting on an unreality. You are betting on fiat currency being printed, ad infinitum, as a cure-all, but lo and behold it was a part of the problem to begin with. So, we remain skeptics, and is that frustrating? Well, it’s frustrating to see the Dow at 14,000, so we revert back to that primary theme and objective of asset preservation.

On a relative basis, I think gold has continued to do a wonderful job, over the last 10-12 years, of preserving value. You’ve increased your purchasing power over 7 times, almost 8 times, compared to the Dow and S&P, even with nominal values increasing in the Dow and S&P, you’ve still considerably improved your footprint in the marketplace by being exposed to gold, and that will continue.

Again, is it a Dow-gold 2-to-1 ratio? Is it a 3-to-1 ratio? Is it a 1-to-1 ratio? I think 3-to-1 is a given, 2-to-1 is a high probability, 1-to-1 we may not see. But it is important to remember that it is not the prices that matter, it is these relative relationships that matter, and ultimately, preserving value for you and your family means thinking in that way, a little bit outside of the box.