The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
This is the time when you say, with a very sane mind, “I see what’s on the horizon and I don’t like it. These changes put me at a disadvantage, and quite frankly, I’d like to put my family at an advantage, and that’s one of the reasons why, quite frankly, price volatility is meaningless to me in terms of gold and silver. When I look at the changing structure of finance over the next few years, I don’t want to be treated like a patsy.”
– David McAlvany
Kevin: David, our guest last week, Jim Grant, was great, and he is now pointing out something that could be very, very scary. Rarely ever do you see 100% consensus in the markets. We have talked about this before. When 100% of, say, money managers, are thinking the same thing, that’s usually a signal for danger, not a signal that they are right.
David: Again, you are talking about near-consensus, or a majority vote. Close to 100% of analysts recently surveyed agreed that interest rates would rise. It is a very difficult lesson for most people to grasp, and this is sort of thinking about group thinking and crowd psychology – How can so many intelligent people be wrong at once? In our household, I was raised with the adage that the majority is always wrong. (laughs) Always may be strong, but almost always might be the right approach there, and I guess I’ve always been, on that basis, suspicious of a consensus view. In this case, we are talking about professional money managers. There are new studies, and whether it is juristics, or social behavior, you can get a very concise and clear explanation of this kind of group dynamic. But the easiest way to approach this, suffice it to say, you make decisions when you are investing, and the easy ones are the ones that are supported by your peers.
Kevin: Well, that’s just human nature, Dave. Most people are a little worried when they think they’re the only ones operating a certain way. I’ll give you an example: When you’re looking for a line at the theater, or if I go into a sushi restaurant and I’m the only one there, I don’t eat there.
David: (laughs) Sometimes we forget that peer pressure in professional circles is far greater than what you would even find on the playground or in high school. Think about it. If you are unpopular in your teenage years, you are unpopular, but you don’t have hanging over you the threat of being fired.
Kevin: Whereas a money manager might, if he’s not doing the right thing.
David: Exactly. Job insecurity if you are out of step with the rest of the industry. And so, everyone decides a market is going one direction, and no one, then, is left to actually come in and move the market that direction. That is the danger of consensus in any investment theme. It’s a little like everyone loading onto one side of the boat. You are increasing the risk of something that gets out of hand, and call it a tipping point, if you will, but that’s the issue, when everyone moves to one side of the boat, it’s a naturally dangerous place.
Kevin: I’ll give you an example of that that is Durango-centric, Dave. We have the Durango-Silverton narrow-gauge railway, and as you know, it has beautiful views. There is that one view, though, that everyone has seen on the post card, in which the train is on the cliff, and you look down about 300 feet down to the riverbed, and what is interesting is that the view is so fascinating and so wonderful that everybody runs to the same side of the car, and I’ve always wondered, are we going to have this thing just flip right over the cliff?
Going back to what you were talking about, though, and this is kind of counter-intuitive, you would think that if 100% of the people who are managing money think a market is going to go that direction that it would continue to push. But what the problem is, you have everyone invested and you run out of buyers, and there is a reversal. All it takes is just the snap of the fingers for a few people to create a panic to the other side.
David: And this is what you are talking about. Momentum trends do work for a time. You are building unanimity, then an apex is reached, and usually that is an inflection point at the same time. So you have people who are, basically, taking the Fed at their word. The poll reveals a certain amount of certainty amongst market practitioners.
Kevin: You’ve been talking about certainty over the last few months. Certainty in the market – what is your certainty?
David: Certainty the rates will rise. Certainly that a rise in rates is a sign and symptom of economic recovery. Certainty that the Fed will do as they have said they would do, and raise rates.
Kevin: Well, unemployment. We’re actually looking at the unemployment numbers, and they said when it hit a certain number, they were going to start raising rates. Now, how come that is not happening?
David: Well, this is the interesting thing. Everyone has based their certainly on the Fed’s commitment to raise rates; it’s just a question of now or later. But the Fed committed to raise rates as soon as the employment rate hit 6.5%.
Kevin: But they say we’re below that now, David.
David: We’ve inverted the numbers. The rate has magically gotten to 5.6%, and we still have the divergence of opinion among Fed hawks and doves on when to raise rates. They already committed to do it. They should have done it last year, mid-year; and yet they haven’t.
Kevin: So, are they worried about something? What is it that they are seeing that worries them?
David: That is definitely in the back of my mind, because taken at their word, 6.5% was the number which was to trigger Fed action. That number is now long in the rear-view mirror. What does the Fed see on the road ahead? What is keeping them from following through? This is, I think, worthy of consideration. In the absence of follow-through, what is the consensus view of inevitably rising rates? What is that based on? So, I guess we will take the other side of the argument, both for the sake of argument, and because we think there is a legitimate case to be made for it. In this way, we do agree with the likes of Jim Grant, that rates will go lower before we see the heights of a bond market panic. Do we think that rates will ultimately go considerably higher? Yes. Tomorrow? No. In the interim, we have a number of reasons to believe that they may, in fact, go lower.
Kevin: Last night, Dave, I was reading the Economist magazine, which isn’t necessarily the bastion of conservative economics, it is more of the management type of economics that they analyze.
Kevin: It is. But the article that I was reading talked about how we are in a unique situation at this point. We have incredibly bloated worldwide debt because of the crisis from 2008 on, we have lowered interest rates to almost zero, and we’re really not getting recovery. Granted, the United States is trying to make it look like there is a recovery. But now we have a situation that we didn’t have before. We bloated the debt, we lowered the interest rate. Now, to raise the interest rates, what are you going to do? Slow down an already slow economy? And it’s a critical juncture, I think.
David: Well, that’s right. If GDP growth numbers for 2015 are expected to stall at all, then the Fed is in a real pickle. How do you exit? How do you tighten, as you say, by raising rates in an environment where we don’t have robust economic growth, but we might, in fact, see a decline in GDP growth? So, the argument for lower rates rests on, I think, at least four issues that you have in play. Number one, you have emerging market bonds. They have been under pressure, under the gun. You have prices dropping, which, of course, is sending yields higher, and U.S. treasuries represent a safer pool for the global fixed-income investor, with a greater assurance of liquidity and a relatively high yield. If we look at U.S. treasuries, it’s a decent yield relative to some of the peers that you have out there in the marketplace.
Kevin: And the stock markets for the emerging markets haven’t been stellar performers, either.
David: No, that would be point number two. That is another issue in play because emerging market equities have moved in lockstep with the general commodities indices. They have lost value pretty considerably over the last 6-12 months. Of select commodities, oil is the big one, nearly 50% down in that time frame, with dollar assets seeing a rotation, and this is on the basis of perceived risk status and a reappraisal. Do they want to be in risk assets, or do they want to be in lower risk assets? And lo and behold, U.S. fixed income has gotten something of a boost there, as well.
Kevin: Then I think I should point out, Dave, as you are going through these different points, that interest rates drop when demand increases on treasuries. I know the listener may know that, but it is important to think about why interest rates do go down, because actually, we are going to see interest rates, at some point, rise, and probably pretty dramatically, and it is important to understand that when that occurs, that is when bonds are dropping. It is like a teeter-totter or a see-saw. Bonds go up when interest rates go down, bonds go down when interest rates rise.
David: Well, it was Keynes who described the market as like a beauty contest where people are voting on who they consider to be the most beautiful “person,” in this case asset class, to be invested in. You vote, and the reality may be very different, but we have conceptions of beauty which are temporally dependent. This particular time slice today, you could say, “Well, to be beautiful, according to Vogue magazine, is to look like a heroin addict, is to look like” – you fill in the gaps – and just realize that 20 years ago you might have needed to be voluptuous and curvy, and the concept of beauty has changed, therefore the vote has changed. So there is this sort of disconnect with reality. Beauty is what it is, and the votes that are spelled out in the marketplace are what they are, and they don’t necessarily have to match up. So for instance, this last year we saw Greek debt winning the beauty contest. You had ten-year Greek debt trade as low, if you are looking at the yield, as 5.85%. That would indicate very little concern, in terms of the inherent risk. We would still consider the inherent risks…
Kevin: Using your analogy, that would mean a beautiful pick, basically.
Kevin: And no offense to Greek women, but Greek bonds are a little uglier.
David: The market was deeming them to, in fact, be beautiful.
Kevin: But they were just made up by the central banks, let’s face it.
David: Now, we’re facing a very different reality. You’ve had interest rates go from 5.85% to over 10.5% just since August 1.
Kevin: So, they’ve got rain on their mascara.
David: This is the point. Sometimes, as the beauty contest unfolds, and people are taking their votes, they’re just wrong. They’re wrong. And so I would grant you that, although people are moving to treasuries on the basis of perception of strength, and of security, and of liquidity, market practitioners can be wrong in that appraisal, too. They may have a justification for their vote in the marketplace, but they can, in fact, be wrong, and I think, ultimately will be proved wrong. I don’t think treasuries are the greatest place to be on a 3-5 year timeframe.
Kevin: And I look back at the shows, Dave, just from this last fall, the weekly commentaries, where you brought up, over and over, your concern about unusually low rates in these emerging markets, and in these BRIC countries. Greece was one of them. Spain is another one. These are countries that are under huge distress, and using your analogy, are actually very, very ugly under the mascara, and yet they’re getting beauty ratings of 9s and 10s.
David: Prettying up the PIIGS, as they say. So, with recent stock market volatility, I would say this is the third element arguing for lower rates in the U.S. treasury market in the short run – not the long run, but in the short run. You have U.S. stock market volatility. We lose 600-800 points, and then you’ve got an Evans, or a Lockhart, or any of the cast of characters from the Fed, who verbally intervene. We had it October, we had it again in the last ten days, where if the market sells off 800 points, all of a sudden somebody says, “Hey listen, this whole raising rates thing…” All they do is interject themselves, and a strong opinion, into the marketplace, to underscore the availability of credit and easy money to the marketplace. In other words, they want those who are partying like it’s 1999 to continue to party, and they don’t want everyone to pack up and go home quite yet.
And I think this is one of the things that confuses the notion of Fed independence. The Fed should care less about asset prices, and yet they really do care quite a bit about asset prices, and it really is outside of their original mandate. They should be the ones who are the sober, adult-like actors who are saying, “Hey, listen. I think you’ve gotten ahead of yourself. There is a little too much froth in the marketplace. In fact, asset prices should probably go down.” They can’t bring themselves to adult-like behavior in this environment, and I think that is one of the things that is deplorable, and frankly, will be in the history books in terms of the Fed’s record of behavior from the Greenspan era through Janet Yellen. They haven’t had the backbone to say, “Enough is enough.”
Kevin: If you think about the mandates that the Fed started with, and then have added, the original mandate of the Federal Reserve was stability of money. The second mandate was added in the 1970s, we have talked about it, and that is, the stability of employment, basically, seeing that employment is maximized. But now what you see is a third mandate. The first two, we have talked about before, could never be matched correctly in the first place, but you add a third body to this, and there is a reason I use the word “body.” In physics there is a problem called the two-body, or the three-body, problem. You can calculate gravitational orbits of two bodies, basically, but you add a third one and it starts to bring in things that disturb that original orbit. If you look at the Federal Reserve, it’s like having a bunch of kids in the car, and everyone wants to eat at a different restaurant.
David: It’s a little chaotic.
Kevin: And you’re supposed to satisfy everybody? It is a little chaotic.
David: In this case, the third body, in the orbital spheres you are describing, is asset price stability. And they have an operative theory which is…
Kevin: The stock market.
David: Exactly. If you have a wealth effect, there will be a boost to economic activity on the basis of the wealth effect, ergo, we support asset prices, and that is what they have done through the various liquidity measures, Quantitative Easing 1, 2, 3 – whatever they offer for us in the future in terms of price stabilization. But here is what you have – again, my point being that we have had some stock market volatility. At the start of 2015, think about the gyrations already witnessed in the U.S. equity market, and bonds are seeing an increased inflow of funds seeking a safe haven. Gold, by the way, has seen some of those inflows on the same basis, given volatility in the stock market, but we haven’t begun to see rates drop in lockstep with, say, a panic sell-off in the U.S. equity markets, say, a sell-off of 10% or 20%. That materializes and gets ahead of the Fed’s ability to control and manipulate asset prices, and you will end up seeing interest rates go from their miniscule levels today, to microscopic levels tomorrow.
Kevin: Do you think, Dave, that one of the points for why people would be buying bonds right now is just that the talk is deflation? You don’t hear inflation anywhere, and deflation – what they teach you in the textbooks is that when you have deflation, or you have low inflation, bonds are one of the better places to be.
David: Yes, I think that is a reality. People are factoring the official rates of inflation and saying, basically, we have no inflationary concerns. Your average fixed-income investor is saying, “If there is no inflation, then I don’t need compensation for inflation in my equation of income on the principle I have invested.”
Kevin: But is that an illusion?
David: To some degree, that is an illusion, but deflation remains in the air. You have the inflationary concerns today. Among the investment community they are nowhere to be found. Now, we do think that people are not looking far enough down the road to see the inflationary dynamics building. But look at, as we have described, the deflationary canaries in the coal mine.
Kevin: Like Dr. Copper.
David: Dr. Copper broke $3 a pound last year, and has remained below that level. Now, for the international markets, less interest on a per pound price, they have looked at $6,000 as a key technical support level, that is, $6,000 per metric ton in the copper market. We broke that this week, and have remained below $6,000 a metric ton. You have oil cratering. You have the Aussie and Canadian dollar, their trends have been very weak, with prices fast falling. All of this argues for investors buying what seems a better bet in a deflationary context, because, as you mention, the textbooks say that bonds are what you want in a deflationary scenario. Relatively speaking, this may be the case. Certainly, last year, the 30-year treasury proved to outpace even stock market performance. Is anyone aware of that? Is anyone aware that the 30-year bond outperformed the U.S. stock market?
Kevin: That is hard to believe. It is supposed to be the bastion of safety.
David: When in fact – now think about this, this is how skewed the fixed income markets are, 100-year Mexican paper outperformed the S&P 500 last year.
David: So before we get all excited about moving lock, stock, and barrel into the bond market, in the beauty contest last year, if you were just sponsoring the U.S. S&P 500 next to 100-year Mexican bonds, 100-year Mexican paper won the day. They were voted “Prettiest Girl.” (laughs) So you tell me, with a history of inflationary episodes in Mexico, that’s where you want to be?
Kevin: Well, if you’re eating your spinach, and you’re doing your yoga, you might actually make that 100th year where you can go and pull that bond out at maturity.
David: (laughs) What are we suggesting? We are suggesting that the ten-year treasury yield moves down to about 1.5%, the 30-year treasury dips to 2% or less, which would, in all likelihood, mark a generational low. This is what is particularly interesting to me. You may think, well, interest rates and a discussion of them is really kind of like watching paint dry. Things like this only happen once in a generation, so reaching a generational low, it has taken 3-5 years to get to these points, and it has taken, frankly, longer than we expected, admittedly, a far longer process than we expected. Of course, there has been more direct market intervention in the form of orchestrated manipulated rates than we probably anticipated, as well, but this is where we are at. Reaching a low point in interest rates does define a business environment for the next 20-25 years. When we can establish what a generational low is in interest rates, you know what your headwind is to economic growth in terms of a rising trend in borrowing costs from that point forward.
So, I think it is very significant, and we are at that cusp of marking the final stages of a bond bull market, and the early stages of a bond bear market. Keep in mind how significant that is for the average investor who, today, takes on not only a passive approach to investing, instead of actively managed approaches, but also looks at the bond market and says, “I want a bit of safety versus the volatility on offer in the emerging markets, or ultimately, the U.S. equity markets.” Guess what happens? You are moving from the frying pan into the fire, from the volatility of the stock market to a generational whipping for the fixed income investor.
Again, I am not suggesting that that defines 2015 or 2016, but most investors aren’t trading their fixed income portfolios. They buy them to have and to hold until death do they part. It is sort of, “Ignore the volatility, clip the coupon as you go.” And that kind of a mindset is going to separate the average investor from quite a bit of money, the average retiree from quite a bit of money, as they make a very poor choice in terms of moving to what they perceive to be low volatility and high safety in the fixed income market.
Kevin: And you have said so many times that interest rates are interesting because they are a measure of risk. And if you look at history, there are things that you can do to say, “All right, this is a pretty accurate rendering of history, because there is a thread that runs through it. Interest rates are the thread that runs through history, yet what we see, Dave, at this point, if you go back and look at the chart for the last three years – it is just flat-lining. It is that pure manipulated rate flat-line. Even Switzerland – they’re negative at this point. People pay money to have their money in the back.
David: There are actually about six or eight countries around the world that have officially negative rates. We have been running negative rates, in terms of real terms, when you factor in inflation, for some time, but our official rate is still above water. You actually have a stated negative rate in a number of countries, which is remarkable. And we think that these low yields insanely under-represent the risk inherent to the U.S. treasury market, and a lot of your European debt markets, as well, and that risk has been neglected and ignored for the last 6, 12, 18 months because of the promises of Mario Draghi at the European Central Bank, because of the buying habits of the Japanese, and the easy money policies being put in place by Abe-nomics.
Because of the continued asset purchases and manipulation of price and yield from the Fed, in terms of their expansion of balance sheet up through the end of 2014, we are now in a very interesting stretch of time, and it’s not a stretch for us to imagine lower rates when you consider the chaos of the global equity and bond markets set alongside what is likely to be, this year, a lackluster profile in the U.S. stock market. Now, that has yet to materialize, but that is something that we can certainly envision – low to no growth – and in that context, U.S. fixed income, relatively speaking, catches the attention of investors that have counted on a very different recovery outcome; that is, buy stocks, sit back, let the market grow, as it always does. If that conception of investing is overturned and upset, if those expectations are not met, then again, you have a reason for U.S. treasuries to go higher in price and yields to get squeezed. Now, here’s the thing. Energy may hold the key to disappointing economic growth in 2015.
Kevin: I don’t know that anybody expected oil to drop by over half, Dave, over the last few months. We talked about oil, back in the spring, when Putin went into Ukraine. We talked about how, in the past, the United States has used oil prices to break the bank of the Soviet Union, but I will be honest with you, I had no expectation that we would see oil drop the way it did. Did you?
David: Well, it is interesting, the pundits will often look at some of these indicators when they are favorable to their argument. Let me give you an example. CNBC will say, “Price of copper moving higher certainly indicates robust global demand for the commodity and growth economically, not only in China, but we’re seeing home ownership increase, we are seeing demand for homes and the use for industrial purposes on the rise.” So, the rise in copper is always a good thing, but then when we have a decline in copper prices, you just quit talking about it, because it is not a bad thing. It can be a good thing when the price is rising, but it is never a bad thing when the price is dropping. And oil is the same way. Listen, there is robust demand for oil in Asia. You have the tiger by the tail, so to say, as we see growth expanding, and growth rates in China off the charts, certainly beating the developed world by multiple factors, and this, along with an increase in cars on the streets in China, so the story goes; you get the point. The point is, you have a positive spin to higher oil prices, and yet, then when oil prices drop, there is also a positive spin, and that positive spin is that consumers around the world are going to get the equivalent of a tax break, they have more money in their pockets, and that’s how the story goes.
But here’s the thing. Consumers, although they are a significant part of the U.S. economy, are not turning those saved dollars into consuming dollars. The most recent numbers I’ve seen from, say, the third quarter to the end of the fourth quarter, daily consumption in the U.S., the average person spends $96 a day filling a tank of gas, buying groceries, buying books on Amazon (if you’re me), whatever it is you spend money on – it all adds up to about $96 a day. Well, with the cut in oil prices, now they are spending $98 a day. I’m not trying to belittle the difference of two bucks, but it is really not that big of a deal, particularly, when you consider what is being destroyed on the other side of the equation.
Kevin: Well, isn’t that right? This miracle that we have supposedly seen here in the United States, and it has been impressive – our energy dependence has turned into energy independence. The high-paying jobs, Dave, are in a couple of states. They are in the energy-producing states right now.
David: Right. You have the high-paying jobs which have been created over the last five years, primarily, in the energy sector. One of the guys we work with here in this office, his son was heading off to college and looking at college programs, and one of the big arguments by the Colorado School of Mines was, their petroleum engineering students are graduating and getting six-figure jobs, every single one of them, $150,000/year jobs straight out of college. That was petroleum engineering 12-24 months ago. You are going to see that tighten up considerably. Again, capital spending in the U.S. – this is corporations with large budgets to expand their future income – how are they going to expand their future income? What do those investment dollars look like today? Capital spending in the U.S. has been very dependent on the oil patch. Estimates are that oil and other ancillary spending associated with the energy space is at 30%. Now, 45% is probably a more realistic number when you include the spending which is one step removed, but arguably related.
Kevin: So, almost half of the capital spending of the United States has been related to this energy sector.
David: Right. So, now you have cutting in CAPEX. Quite frankly, I don’t think government spending is going to fill the gap. Consumer spending, sorry, you may have an up-tick in consumer credit, but that’s not going to come close to what happens with corporate conservatism and budget cutbacks in the oil patch. You have already got rig count idling which is happening, really, just beginning in earnest, with the implicit personnel idling. So, you could expect to see Texas, Oklahoma, the Dakotas, Louisiana, and a few others, begin to feel that pinch in 2015. This is where you have been seeing most of your jobs, and if you are sort of looking at earnings growth, which, in the last jobs number was not nice, keep in mind, there have been these states which have helped you average up because of the high salaries and high hourly wages, again, relating to energy and oil.
Kevin: So, what you are talking about—rig idling – they are not closing down the rigs, they are just putting them on idle so those jobs are no longer necessary.
David: Right, so the folks who are actually drilling, they are not drilling as aggressively, so they are basically taking the ability to expand future capacity and saying, “Wait, wait, wait, wait. We’re going to have to just kind of digest what we have already done.” Now, the problem is, we talked about energy independence just a minute ago. It is a little bit of a farce, because energy independence implies that all of the production we have brought online has a long production profile, a long life, and that’s not true. The reason why it is “drill, baby, drill” in all these places, is because the production profile drops dramatically at the end of 24 months, in some instances, the end of 12 months, so you are getting your best well production, in terms of barrels per oil, in the first 12-24 months, and then it drops by 80-90%. So, the fact that they are idling their rigs right now means that there is going to be, moving out on the timeframe, a lot less cash flowing into those companies 12-24 months from now, and the energy nightmare has really, in that respect, just and only begun, because if they don’t have the cash flow 12-24 months from now to make good on the loans which have allowed them to drill as much as they have, you are talking about vast insolvency in the space.
Kevin: And we are talking about a sector that employs a lot of people. But let’s just look at the overall nation at this point, Dave. The employment numbers, as you mentioned this earlier, are really strangely puzzling.
David: It’s positive! It is great news that it is at 5.6%, down off of over 10%.
Kevin: Are those believable numbers, though?
David: (laughs) Well, yes and no. 5.6% is with the upward revisions from the last two months, and so you could say, as the dust is settling, it is an improving picture. I’m puzzled. I am just flat puzzled, because you still have the difference between the actual jobs created and the statistical smoothing that occurs along the way. For instance, this most recent number, last week we were told that the non-farm payrolls number was positive by 252,000 jobs. Okay, 252,000 jobs; that beat expectations. Everyone says, “Okay that’s great, now the U3 number is at 5.6%.” Granted, labor participation fell to a new low for 40 years, but just set that aside. This is a very positive number. It is not consistent with the household survey numbers, which were actually disappointing, and in fact, when you look at the non-farm payroll number of 252,000 jobs added, it was actually negative 65,000 jobs before the seasonal adjustment.
Kevin: And a seasonal adjustment is just somebody, an accountant somewhere, with a pencil, isn’t it?
David: So, this is why I’m puzzled, because yes, it’s good news, and yes, business owners are going to make decisions on the basis of employment numbers improving, but I’m sorry, is the number negative 65,000, or is that seasonal adjustment of 317,000 jobs relevant, as we, the investment public, are crunching our own numbers and saying, “Good news, bad news, indifferent, how do we suss this out? How do we determine how we feel about the number?” Well, the actual number was negative 65.
Kevin: But not with the addition.
David: Not with the addition of seasonal adjustments, 317,000 as a seasonal adjustment, and you have birth/death modeling, which actually was a good number by 20,000 jobs. But let the dust settle and how many jobs were actually created? Your guess is as good as mine. What we do know is that the statistical games delivered a shot in the arm for the average Joe investor, and sentiment is stronger than it has been in the past. I am just still questioning the evidence. And I’m questioning whether the reasons why people are positive about the U.S. economy are as legitimate as we are told. The question will linger, I suppose.
Kevin: And not to belabor the point, but pun intended, you talked about labor participation. I think this is critical in this discussion, Dave. It has dropped to 62.7%. What that means is, about 63 people out of 100 in the United States actually have a job, so how can we even trust any employment number when you are only talking about a little more than half of the people in the United States working?
David: I think, more than anything, official statistics just underscore our dependence on officialdom, in the sense that we are so confused by the statistics and what they mean, that ultimately, if you are a relatively positive person, you would say, “Well, you know, we are told that things are improving, so they must be.”
Kevin: I think about how we measure things, Dave. What if we had a yardstick where every time we picked it up it was a little shorter, or a little longer, and we continued to make decisions, build houses, whatever, but we have a continually moving target as far as what we are measuring against? I am going to switch to gold here, because a lot of our listeners are looking at gold for 2014 and they are saying, “Well, it was another down year. You know, 2012, 2013, 2014.” But, just in dollars, every other currency, gold outperformed every currency in the world, Dave.
David: It did, and I think what you look at when you are looking at the precious metals space, silver was the one that suffered more, probably because of its industrial components and that is consistent with a lot of your industrial demand. It is also consistent with just being a smaller market. And when you get a little bit of volatility in one, you get a lot of volatility in the other. It helps you on the upside, hurts you on the downside. Silver was the real negative for 2014. Gold was positive in every currency but one. In every currency but one, and that’s the U.S. dollar. So, as people are sort of checking the stats for 2014, the global community says, “Actually, gold is a winner this year.” And silver wasn’t as bad, but in U.S. dollar terms, both were in the red.
Now, gold outperformed, again, all global currencies but one, and it actually outperformed all global equity markets with the exception of the U.S. and Canada. And that, in itself, is also, I think, a remarkable showing in the context where the dollar – if you look at how far and fast the dollar moved in 2014, it really had zero effect on the gold market. And everyone has said, and in fact, we had a recent Barclay’s report saying, “Dollar strength and improvement, or an increase in interest rates, is going to be the death knell of the gold market.” Balderdash! Look at what just happened. The strongest dollar move in a decade or more, and gold basically finished the year where it began, in U.S. dollar terms. It actually did quite well in foreign currency terms.
And I think, a part of the reason we have seen something of a floor in the gold market, is that China and India continue to consume. They are clipping along, 2014 consumption numbers were not bad at all. Have we had better years? Yes. Will be have better years in the future? Sure. But 3,000 tons taken off the market by those two countries alone – bear in mind, only 3,100 tons came from new mine supply in 2014.
Kevin: So, if we were to look at just what is coming out of the ground new, China and India consumed just about all of it.
David: They basically took 98%. So, physical gold and silver continue to become unavailable as countries like China and India continue to crank out the tonnage, both producing, and then consuming it, and yet prices have dropped, and people really do assume that, in the context of a price drop, there must be ample supplies. No, actually the supply and demand dynamics are still pretty tight and pretty positive. I think that when a price uptrend resumes, the pace of increase will be faster than what we’ve witnessed over the last 10-15 years, which was really defined by incremental, slow and ordered, measured process in the gold and silver market. Those were the past tense descriptives, because the dynamics in the physical markets, frankly, have changed over the last 3-4 years. Supply and demand dynamics have gotten tighter, and tighter, and tighter.
As and when we see, let’s say, an increase by 5% in terms of demand, supply is inelastic and the price will move exponentially. Is that this year? Could be. Is it a stretch to 2016? The dynamics are set for a very positive move in gold, and it has nothing to do with the dollar being the death knell for the gold market. Look at the evidence! The best dollar performance in over a decade, and it hardly dents, it hardly takes away, the luster of gold for the year. I think that is pretty compelling. On top of that, you have uncertainty, and again, a re-emergent concern in Europe, with Greece being back in the headlines.
Kevin: Yes, Christmas in Greece was very, very different. I know the withdrawals in Greece were 220 million euros back in November. Boy did that accelerate. Around Christmastime 3 billion euros were taken out of the Greek banks, an amazing increase in withdrawals. Now, that had to do with a lack of elected leadership, but do you think there is going to be a bank run in Greece, or do you think the euro is going to finally let Greece go?
David: I think for the intelligent investor, you have to look at the currents and tides that are changing, for all investors around the world. You can say, “Look, we’ve got another crisis, perhaps like Cyprus, in the Greek banking system, where maybe they capture some of those Greek depositors’ assets and hold them, and turn them from deposits into shares.
Kevin: A bail-in.
David: Yeah, a bail-in. But I think the bigger concern is not really with Greece. We mentioned this a month or so ago. The G20 meeting in Brisbane was a game-changer, where implicitly, these countries participating have agreed to change the quality and the character of what a depositor is in a liquidation process.
Kevin: The very nature of a deposit turns into an investment, does it not?
David: This is what the agreement was. It still has to be implemented, but these are the tidal changes, the tidal shifts, that people need to be sensitive to. Why do I own gold? In part, because I want money out of the financial system. I want a financial asset that is outside of the banking system. Why? Because the G20 is figuring out every way they possibly can to steal from depositors. Basically, the banking system is being restructured, and the average depositor doesn’t know that they will, over the next few years, stand behind a series of creditors, and that their deposits aren’t just a plain vanilla deposit. But again, they are in the lower pecking order, in terms of priority, in the case of liquidation for a bank.
This is disturbing. If I was a Greek depositor, would I have pulled funds? Sure. If I was a U.S. depositor, would I pull funds? Listen, we’re not at a moment of crisis. This is the time that you do pull funds. This is the time when you say, with a very sane mind, “I see what’s on the horizon, and I don’t like it. These changes put me at a disadvantage, and quite frankly, I’d like to put my family at an advantage, and it is one of the reasons why, quite frankly, price volatility is meaningless to me in terms of gold and silver. When I look at the changing structure of finance over the next few years, I don’t want to be treated like a patsy.
Kevin: Dave, one of my clients was talking to his church board and he just looked at all of them and said, “We’ve got all of our money sitting in the bank. We are earning virtually no interest. Can you explain to me why we have all of our money in the bank?” The thing is, we all have habits. You and I were raised putting money in the bank. When we get paid, we put money in the bank. But actually, the banks are paying us right now for the risk of the loss of our deposit. The world is facing something like this. For the Greeks, actually, it is right on their front windshield, and that’s why 3 billion euros came out. Half of that came out in one day, did it not?
David: The big changes, I think, are for 2015 and 2016, and we are going to end with just a slight reference to the Summers-Barsky thesis. Lawrence Summers wrote a paper, in the late 1980s or early 1990s, in which he describes the relationship between gold and other assets, and he looked at gold doing well in a period of low-to-no rates of return. And in the fixed income space we have that. In the last few years we have had a positive rate of return in equities. Lo and behold, there has been a sentiment shift, which is negative, directionally, for gold, and positive for stocks. You have been able to get a positive rate of return in the U.S. equities market, and that puts gold at something of a disadvantage.
But, according to the Summers-Barsky thesis, you take away the carrot of positive returns, whether it is in the equity market, or in the banks, or in a fixed income or bond investment, and guess what you end up with? People asking the question that that church board did. “ Why are we doing this? Why do we have all of our eggs in a nonproductive basket?” And in that moment, people say, “I would prefer to have a part of my assets in gold.” That was the determination, that was the calculus, if you will, that was concluded in the Summers-Barsky thesis. In a low real-rate environment, people move to gold. Take away the competitive nature of U.S. equities, and I think we are smack dab in the middle of a raging bull market in precious metals.
That could begin tomorrow. We’ll have to see how 2015 gets sussed out, how it plays out, but certainly, we have the dynamics in play. Cyclically adjusted price earnings multiples for the S&P 500 are the third-highest in U.S. financial market history. The only two times that stocks have been more expensive? 2000, and 1929. You tell me if this is a bargain basement price. You tell me if stocks sell off by 1,000 points, if you are coming in and buying a value. I’m going to have to cry balderdash on that. I don’t think so, I don’t see it, and I think we are looking at a major trend change for 2015, one that has been positively oriented to equities, and U.S. bonds, and ultimately, one that transitions, initially, positive toward U.S. bonds, negative U.S. equities, and ultimately, positive for the gold and silver market. Remains to be seen.
Last year was not a glorious year, but it certainly was not an embarrassing year, either. And I think this one might actually be a glorious year for the gold investor. Let’s wait and see.