January 20, 2011; Perceptions Are Not Reality: U.S. Investors Are Being Duped More than Most

The McAlvany Weekly Commentary

With David McAlvany and Kevin Orrick

January 20, 2011

 

Perceptions Are Not Reality:

U.S. Investors Are Being Duped More than Most

 

Kevin: David, a preview of coming attractions:  There are a couple of guys that you have been wanting to talk to.  George Friedman is a New York Times best-selling author of books that we have recommended in the past, he has one coming out in a week-and-a-half or two weeks, and I know you wanted to talk to him.

David: Kevin, for us, many of the things that we consider important are context-related.  What is the context that we are in?  What is the context that we are going to be in, as things unfold, next week, next month, and next year.

Kevin: Be it economic, financial, or in George Friedman’s case, political, and geopolitical.

David: And a part of understanding or appreciating risk is not necessarily predicting what a certain outcome will be, but understanding what may occur, and if it were to occur, then what the consequences would be.  Certainly, that is where Friedman shines, in saying, not necessarily, “This is how the world will be in the next ten years,” but “Here are some considerations for you.”

That is just fantastic for our kind of dialogue, because we do not know what is going to happen six months from now, or six years from now, but we can certainly look at risk variables and say, “If these things fall into place, then we have a better idea of what the consequences will be.”

We want to include him in the conversation again.  He is shrinking the picture back a little bit.  His New York Times best-selling book a few years ago, I think 2008 was the release, was titled, The Next 100 Years, and then we will be looking at his newest release at the end of the month, The Next Ten Years.

Kevin: What I love about reading George Friedman is, it is like reading a chess strategy book.  He seems to understand the relationship of the pieces.  In this case, the pieces would be every country in the world.  You cannot name a country to George Friedman without him giving you insight as to the relationships and the consequences, and the unintended consequences, of various strategies and policies with those countries.  Really, I would imagine he brings that kind of strategy to think tanks across the nation.

David: What is interesting about this book is that he centers his analysis on Machiavelli’s The Prince. He gives you a view of statecraft, which is, at the same time, effective, but very uncomfortable.  As you read it, as you consider it, there is something that makes you want to shiver.  You just say, “Are there people like this around?”  In point of fact, there are, and have been, for hundreds, if not thousands, of years.

Kevin: Unfortunately, of politics, when really looked at through a fine glass, it can be said, “You know, that is a dirty, dirty reality.”

David: It is.

Kevin: Now, with Friedman coming on, that covers the political and the geopolitical.  I know that there is a prognosticator and technician who has just been excellent for three, maybe four decades:  Ian McAvity.  That is next week for the gold look.

David: As a family, we have been reading his deliberations for at least 3-4 decades.  He is one of the few, like my father, who has been in and around the precious metals area, as a specialist, but also as a technician, almost since the beginning of time.  We want to ask him some questions, and it will be interesting to get his perspective on the present state of the markets, and perhaps he will prognosticate as to where we go from here.

Both of these men I have a great deal of respect for, and it is with great anticipation that next week with Ian, and the following week with George, that we carry on a deeper conversation.

Kevin: I would encourage the listeners to definitely not miss the next couple of weeks.  David, shifting to the stock market, people just feel pretty darn bullish right now.  In fact, aren’t we starting to see the numbers topping out and hitting some high numbers that we have not seen in quite a while, as far as sentiment goes?

David: When we bring things back from what we were suggesting with Friedman and our conversation in the next few weeks, when we bring those back into the investment arena, this is where it becomes particularly interesting.

Every week this year the chorus of bullish sentiment has gotten louder and louder, and the primary conversations among Wall Street analysts and talking heads are about whether or not GDP growth will be 2½% this year or 3%, whether it be 3½%, or perhaps 4%.  What is surprising to me is that they are neglecting the fiscal prop of deficit spending, which is equal to roughly 10% of GDP.

Kevin: In other words, the GDP that they are talking about is not based on growth of business right now.  Really, if you look behind the curtain, it is based on how much money the government is pumping into the system right now.

David: What is fascinating is that if you took away government spending as a component of GDP, and essentially, I am talking about deficit spending, not total government spending, just the deficit portion, instead of talking about positive figures of 2½%, 3%, 3½%, or 4%, what you are quibbling over is:  How negative are we?  Are we negative 6?  Are we negative 8?  Are we negative 5?  But we are in a situation where, just as Richard Duncan reminded us last year, if you take away government spending from the equation, the contraction in GDP is depressionary, it is not recessionary.

Kevin: What you are talking about is, rather than quibbling about positive GDP growth, we are talking about shrinkage, and we are talking about a contraction.  With that being said, is that not the definition of depression?  Shouldn’t we be looking at how much we are shrinking right now, and actually treating this as a real case, instead of something that is just being masked?

David: I think what we want to hit on in several different areas today, is the things that are being masked, the things that are considered to be true and perfect realities, a reflection of health and strength, when in fact, we have something far less than that.  It is interesting because the market is not taking that into account.

So with that Friedman style of risk analysis, one of the things that can hurt you that you are not thinking about today, and I am not suggesting that this will come as a surprise to our listeners, but these are the things, these are the elements, as we discussed today, Kevin, that will impact the market negatively with an upset of expectation, with a change in course that came from out of the blue, seemingly, when in fact, there was nothing of an element of surprise there to begin with.

Kevin: Speaking of not having an element of surprise, the debt is really what is fueling this “Positive growth.”  Are they going to raise the debt ceiling, or are we going to actually start seeing some austerity?

David: I want to start by looking both at the fiscal and monetary side of things.  The debt ceiling will have to be raised, as we run up otherwise unpayable bills, to the tune of now 100 billion dollars per month.

Kevin: What’s a hundred billion here and there?

David: I want to start by looking at the fiscal and monetary side of things, because, of course, the debt ceiling will have to be raised.  We are running up bills that are otherwise unpayable, to the tune of 100 billion dollars per month.

Kevin: A hundred billion a month that we cannot pay, but hey, let’s do it next month, or the next month after that.

David: We can finance it.

Kevin: Sure.

David: At this rate, this is what the Congressional Budget Office has estimated is our trillion dollars a year.  That turns out to be, actually, quite conservative, because our current run rate is 20% higher than that.  We will be at 1.2 trillion without skipping a beat, and again, we are already pressing the recently raised cap on debt, which was 14.3 trillion.

Kevin: That blows my mind, because it just feels like yesterday, and it really was almost yesterday, that we were talking about a 9 trillion dollar debt, and we were appalled.

David: Right.  The republicans, with the new reshuffle in Washington, were promising 100 billion in spending cuts in past weeks.

Kevin: Did they do it?

David: No, they have already backed the number down to 60 billion.  So, with the realistic numbers coming in, I think, and you think, and again, what we would consider realistic, is probably much lower than that.  What are the cuts going to be?  Is it 100?  No.  Will the cuts be 60?  No.  Will the cuts maybe be 40 or 50?  Okay, well, they can feel good about thinking in round numbers – call it 50 billion dollars.

Kevin: David, what does Doug Noland have to say about this?

David: It is interesting.  He says, “The U.S. government debt is being mispriced, over-issued, and misdirected, ensuring only deeper economic maladjustment and financial vulnerability.”  He points out that in just over 27 months, the federal government has increased its, or you might consider it our, liabilities, by 4 trillion dollars.

Kevin: Well, at least they found something that they are good at.  They can spend money.

David: They can spend it.  I know a lot of people who are good at that, actually.  The problem is, most people have a piper to pay, and in this case, we are just passing it off to the next generation.  We are living today on tomorrow’s dime, and that is a problem, Kevin.  27 months to rack up an extra 4 trillion dollars.  It is not like that number is going away, and we are aggressively cutting.  In fact, we are adding a hundred billion dollars a month to that debt.  The question is:  Is there any debate about whether or not we will raise the limit of our debt ceiling?  Of course it is going to go higher.  It has to.

Kevin: The crazy thing, Dave, and we talked about this on last week’s program, is that you can do this federally, because they print money, but the municipal bond market continues to show signs of life.  This is a market that was really never intended to be a market, was it?

David: We see, exactly as you say, Kevin, similar issues in the municipal market, which is a much more constrained market.

Kevin: And they cannot print money to get themselves out of trouble if they overspend.

David: They cannot print money, and it is a market that was never intended to be a two-way market, where you can both buy the product, and if you choose to, at some point, change your mind about what asset you want to own, go to the market, and sell it.

Kevin: So, unlike a stock, which was designed to buy and sell freely, municipal bonds were purchased to be held to maturity.

David: They really were, and the dynamics in that market end up coming unglued when you have mass liquidations.  It is not as big as the treasury market.  Obvious there is only about 2.7 trillion dollars in the market.

Kevin: Only 2.7 trillion, that is 2.7 million million.

David: It is long-term paper.  As we mentioned, it is intended to be long-term paper – distribution only, not return.  You should never sell it back.   This weekend I was studying over the individual securities that were making new highs and new lows in the markets, and I could not help but notice that at least 40% of the securities which were moving to lower lows were municipal bond-related.

Kevin: So somebody is seeing this, because if 40% of the lower lows are municipal-related, then it is not just you who is seeing it.

David: And I would just remind listeners that our conversation at the end of last summer and early fall, was that we were seeing record purchases of municipal bonds, and it made no sense to us.  We said at the time, “They are mispriced.  This is absolutely asinine.  How can you have things falling apart in Europe, and an assessment of unpayable bills, revenues that do not match expenses?”

Kevin: That is right, taxes are not keeping up with last year, or the year before, so how in the world can municipal bonds pay?

David: And the commentary at that point was, this is an example of how inefficient the market is, not how efficient it is, because according to the efficient market hypothesis, these should be pricing in – these securities and all securities should be pricing in – all known realities, and yet you had the masses going into municipal bonds on the basis that we were going to see a change in tax rules at the end of the year, and it does not matter what the stability of those municipalities would be, we want to save an extra 3%, 5%, 7%, 10%, in total tax burden by buying something that is tax-free in nature.

Kevin: I was talking to a client yesterday who had referred someone to us who really still thinks very much like Wall Street, which has not really gotten its head around the fact that this is a recovery that is not really a recovery.  The Goldman Sachs guys had flown in to actually give him advice for what the money is going to do, and it was almost all municipal-related.  They are putting him into municipal bonds right now, many millions of dollars, because of the tax advantage that they say he is getting.

Address the tax advantage versus the principle danger, and I am talking about the principle danger in this case.

David: You have just hit the nail on the head, Kevin.  It does not matter if you save yourself 3% in taxes, if you walk away from 10% in capital losses.  You are only proud of the capital gains or the income efficiency of a municipal bond…

Kevin: Look, Ma, I’m not paying any taxes.

David: Right!  Look, Ma, I don’t have anything in my account, either.   There is that issue, which has to be addressed, in terms of potential defaults.  Are we talking about hundreds of municipal defaults?  I would say dozens.  But the problem is, the fear factor in that market will ultimately precipitate … and this is why it goes in the context of our fiscal discussion today.  It goes into the context of what will be assumed by the taxpayer as a long-term liability.

Kevin: Well, then let’s shift to the Treasury bill for just a moment, because the Treasury bills are produced by the Federal Reserve and the federal government.  One of the main buyers of U.S. Treasuries has been our banking system.  They have been given the money for bailout, and then they turn right around the buy Treasuries.  It has been sort of a marriage made in heaven, even though it keeps them from giving loans to people like you and me.

David: Before we move to that, because that is a critical point, we did see a move this last week by the legislature in Illinois, moving the state income tax up from 3% to 5%, and even doing that only solves a small part of the problem, because the biggest issue with these states and municipalities is the long-term liabilities.

You have a current cash-flow issue, which is real, today.  They have to get caught up on vendor bills that have been unpaid for months now, but the longer-term issue is that they have these legacy liabilities which will be with them, and have not been solved.  Nothing has been changed in terms of the pension liabilities, in terms of the health care liabilities, in terms of the things that they have promised out.  They have assumed strong economic growth would be buttressing those payouts, and in fact, we are in an environment where that just is not the case.

Kevin: If revenues have been dropping, it is because people are making less money in their businesses.  To raise taxes does not necessarily mean they are going to make more money in their businesses, they are just going to take more of what a person is making less of.

David: That is right.  You are not really solving the problem.  You will generate a few more dollars in income, but it is not a structural change, and it is not that sound in terms of solving the larger issues.

As you mentioned, Kevin, with the Treasury market, there have been a number of things which have been changing over the last 24-36 months, which are uncomfortable and inconvenient.  One of them is that you have 70% of the debt which has to be rolled over, over the next 24-36 months.  That, in itself, is a major issue – the rollover issue.

Kevin: This is debt that already existed, it does not help us a bit, it just has to roll over.  This is nothing as far as the new debt that needs to be taken out.

David: And those new funding requirements were what we were speaking of just a moment ago, roughly 100 billion dollars per month – if you annualize it, between 1 and 1.2 trillion dollars in new funding requirements.  Then you have what we mentioned a few weeks ago, Kevin, the Chinese demand, or lack thereof, in the Treasury market, as a consequence of them changing their requirements for repatriation of capital.

Kevin: Yes, but we still have the banks.  Aren’t the banks buying Treasuries?

David: And that is the point.  Now you have bank liquidations which are piling up, as well, on top of the Treasury market…

Kevin: So the banks are selling Treasuries.

David: Because they have bought, hook, line and sinker, that we are in recovery.  The recovery story has been bought by the bank heads, which on the one hand, will be effective in terms of getting them to loosen the purse strings and begin to lend, so there is a very positive element there.

Kevin: Yes, but what about speculation?  At one time, after the Great Depression, of course, laws were put into place to keep banks from speculating in markets.  Is speculating coming back, or have we gotten regulations to keep that from occurring again?

David: I do not know that they are speculating in that regard, but I do think that they are increasing their risk profile and moving to securities that have more income to generate, so if they can still borrow from the Treasury at ridiculously low rates, and invest at slightly higher rates and leverage that up, they can increase their rate of return from 12-15%, to maybe a 16%, 17%, or 18% return, when all is said and done and the leverage is working for them.

Kevin: If the Chinese demand for Treasuries is dropping, and bank demand for Treasuries is dropping, what happens when we cannot sell Treasuries as a country?

David: This is what forces the monetization issue to a very uncomfortable and dangerous level, and we will talk about this in a little bit, but monetization is becoming commonplace.  It is something that was on the tips of our tongues two years ago as a theoretical possibility, and now is taken for granted as normal functioning in the marketplace, and therein is the danger.  We are reconsidering, we are recreating, the context for investments, and all of us are considering what is, today, normal, as normal, and it simply is not.

Kevin: An analogy for monetization, for the new listener, or for someone who does not really understand it:  It is the production of Treasury bills, offering them to the market, and the people who produce them buying them back themselves.  That reminds me of when my kids would have certain fund-raising campaigns, and instead of going door-to-door, oftentimes the parents ended up just buying all the stuff and you had the house full of this stuff.

David: Chocolate bars, or whatever.

Kevin: Exactly, so not only was it not a fund-raiser, but it was a fund-depleter.

David: I think that was a part of the gig – they knew there was a captive audience.  And in this case, also, there certainly is a captive audience.  At the Fed, as we get into the monetary side of this equation, we can expect to see their balances shift  significantly.

Kevin: If we are buying all this back, what happens to our credit rating worldwide?

David: This is a big deal.  We have the S&P and Moody’s agencies both warning on our credit ratings, and they are looking at the next two years, the next 24 months, as very critical, for either a real turnaround, or a negative watch or downgrade.  That is echoing our concerns over the U.S. deficits and what is compounding when you bring in the municipals, when you bring in the rollovers of current debt.

The issues that we have been talking about – it is not that S&P and Moody’s are unaware, it is just that it takes them a long time to do anything about it.  This is the week that they just moved Greek debt to junk status.  Now, how long has it been junk?  It has been junk for some time, but it took them a very long time to acknowledge it.

Kevin: And they are talking about the United States – lowering their credit rating.

David: Again, it is something that will take some time, but it is certainly on their radar.

Kevin: If something does happen so that the dollar is downgraded, would that not be a very large paradigm shift?  There are some major things that have occurred in the last century, but the U.S. dollar is the reserve currency of the world.  If it is downgraded, what are the effects?

David: Yes, it is very similar to the Berlin Wall falling, in terms of its recalibration of relationships and importance thereof.  If you look at Europe, if you look at the balance of power in Europe, in the Middle East, many things changed at the end of the Cold War, as the Berlin Wall came down and Communism ended shortly thereafter.  It was that kind of change, that recalibration, that I think we can expect should the dollar lose its reserve currency status.  It is of massive, monumental significance.

Kevin: Even if we keep the reserve currency status, there is a certain relative value of the dollar versus other currencies.  I think it is running close to about 78 right now on the index.  What is your thought on the future of that index, or that price level?

David: Looking at the dollar, we watch the 78 level as a very significant price.  It needs to hold up, or short-term pressure is going to take over, and we could see the currency back up toward about 72, potentially lower.  The dollar is, unfortunately, weaker than expected, and we would have expected, with all the things happening in Europe, and the decline in the euro off of 140 – it has lost a significant amount in a very short period of time, with the resurgence of concern with the European debt crisis – that is something that we would have expected to see show up more dramatically in the dollar, as an opt-out vehicle.  In fact, it has not been that impressive.

Kevin: How about the Chinese currency?  They are taking a little bit of heat for our own problems, aren’t they?

David: That is something that is certainly present, center-stage, now.  The Chinese are getting very vocal about the dollar-based international monetary system, and the point that has been made publicly in the last week or two, is that that system is a thing of the past, not of the future.  A part of that, I think you can assume, is a verbal jousting.  It puts the U.S. on a different footing in terms of the relations that we have and the negotiations that we are continually in with the Chinese, because we take the other side of the argument, not you and I, but the U.S. position, officially, is that most of the global instability which has been caused over the last 2-5 years is because of the trade imbalance with China, and specifically, the Chinese currency being undervalued.

Kevin: Isn’t this one of the reason why you wanted to talk to Dr. Friedman in the next couple of weeks?  He takes the view that the United States, with all of its troubles, is still going to probably be the hegemon of, at least, the next decade.

David: He does.  He looks at the next decade, and frankly, the next 100 years, and argues that the dominant position of the U.S. is not in question.  From a political standpoint, geopolitical standpoint, even an economic standpoint, considering the gap between us and China, they would have to see an explosion of growth continuing at the level that it has been at, 10%, 12%, 15% GDP growth per year, for another 30 years to begin to match us, before they could even raise us one.

Kevin: Whether we agree, necessarily, or not, with the authors that we talk to, it is to show the other side, because there are very valid points in Dr. Friedman’s book, just as there were valid points with Stephen Roach, talking about the rise of China over time, if they do the right things.

David, I am going to shift gears here a little bit.  The Federal Reserve runs a balance, and their balance is growing at this point.  It is in the trillions, is it not?

David: Sure, if we are transitioning to the monetary side of things and away from the fiscal, you have the Fed balance sheet, which is now at 2.47 trillion, and that is after last week’s increase of 32 billion.  The direction of that balance sheet is decidedly higher, and that is a given between now and June, because of Quantitative Easing II, which has already been announced, promised, etc.

Kevin: So, their balance sheet increases in size as they purchase these off of the open market?

David: Yes, and the question is, whether or not it will explode higher after June, with a Quantitative Easing III, or whether or not there will be some sort of a plateau and it will stay flat.  Really, the only thing that will keep Quantitative Easing III in check is the bond market beginning to revolt in earnest.

Kevin: Is that something you expect?  At this point, can you make that call early enough in the year?  Would you expect QE-III at this point, or sometime in the middle of the year?

David: It is difficult to say.  We suggested this months ago, that it is very possible that treasuries could begin to trade in black pools and there could be a hidden component in the Fed balance sheet, where we do not know what is being bought, or where it is going, so that it looks like there is relative stability on the Fed balance sheet.  Meanwhile, it is expanding exponentially, to the chagrin of our creditors, who would like to know what is happening, but they are having to connect dots that do not exist, because we have just removed them from the equation.

Kevin: Is this a little bit like what happened with Portugal?  Last week you pointed out the danger in Portugal, and then all of a sudden, it seems to have been swept away, and there does not seem to be a problem.

David: I guess this is one of the things that concerns me, as a contextual issue: When we look at monetization, here in the U.S. it has been largely a cleanup operation.  We are just picking up the remaining pieces from each treasury auction, that which represents excess, and it just gets shuffled away onto the Fed balance sheet.  It is no big deal, it is a few billion here, a few billion there.  Given the size of our economy, it is really not that big of a deal.  Given the size of our monetary supply outstanding, it is really no big deal.  Nothing fundamentally is changing as long as we are just picking up scraps.

But the point is, we are taking it for granted, and I think this is one of the things that disturbed me last week, and Nomura Securities was good at pointing out the extent of European Central Bank participation in the bond market last week, and in weeks previous, but with Portugal, they had a much smaller bond issuance than we would have here in the United States, but again, it is just a difference in the size of the economy and their funding needs.  They offered roughly 1 to 1¼ billion euros worth of bonds to the market, and it was a successful treasury auction, everything was taken, and Bloomberg just kind of moved forward.  There was no comment, no issue – obviously, the European bond market was stable.

The issue is this:  Nomura Securities pointed out that a billion euros of the participation came from the ECB.  We are not talking about cleaning up scraps here, Kevin.  We are not talking about a cleanup operation like we have in the U.S.  We are talking about an 80% purchase, in rough terms, of the Portuguese debt, going straight to the ECB, the European Central Bank.

Kevin: I wouldn’t call that a successful auction.

David: That is not a successful auction!

Kevin: No.

David: That is a failed auction, and the point is, nobody even batted an eye at it.  Everyone was saying, “The European bond market is as stable as they come.”

Kevin: Must be a recovery.  We must be fine.

David: Now, there has actually been a change in the last few days as yields have begun to creep up.  The better evidence is not in the pricing of bonds, which can be manipulated in this manner – through monetization, you have an utter mispricing of sovereign debt on a global basis.  But what is not mispriced, and what is not lost on sophisticated investors, is the cost to insure against default on any of those bonds.  A much better picture of the instability in the sovereign debt market is in the CDS market, the credit default swap market.

Kevin: You mentioned that last week, that the prices were just sky-rocketing.

David: Right, even while you have relative stability in the price of bonds, as a result of this monetization feature, if you will.  It is a new feature, it is an enhanced feature of the bond market, and it is one that, according to the powers that be, we should all be very excited about.  It represents a new form of stabilization – a new form of not just stabilization, because that has a negative ring to it, but of stability.

This is the point.  The market, whether it is the bond market or the stock market, is assuming relative stability, and we are now moving into an era of peace and calm.  This era can end in two seconds.

Kevin: That peace and calm is being manufactured by governments going further into debt.  This is not people actually going out and saying, “Hey, honey, let’s go buy some Portuguese debt.  That sounds good to me.”

David: All these things depend on how you want to read them, how you are inclined to read them.  Granted, maybe we are pessimists and like to call ourselves realists, but the reality is, if you are an optimist in this environment, you have far more to lose than to gain, because the fundamentals do not support you.

Let me just give you one example, Kevin, with Intel:  Blockbuster results.  They did a year-on-year comparison, showing that from last year to this year they are up 47% in their earnings.  The problem is, they took a one-time charge last year, over a billion dollars (laughter), which lowered their number, which makes the relative comparison that much more significant.  Not only that, they played with their tax numbers.  In addition, they had 1.5 billion dollars which should have shown up as revenue on the income statement, and it was not expensed.  Why?  Because it went out the door as stock options.  You have play in these earnings figures of roughly 3 billion dollars, which takes a 47% earnings gain and shrinks it to about 7% when all is said and done.

Trust me, Kevin, this was not lost on a handful of sophisticated investors on Wall Street.  The company was not rewarded for those blockbuster numbers.  How did the stock perform in the days that followed the announcement?  1%.  2%.  There was no news.  Why was there no news?  Because enough people know how to read the numbers and see what was going on there.  However, that did not prevent the media from manipulating popular sentiment and suggesting that there was a massive recovery in tech.

Kevin: You just spoke about sophisticated investors seeing through this.  There is a generational issue here.  A lot of the people who are making the decisions, the people that we see on T.V., the people who are actually buying, and writing, and  this whole organization of the financial markets, they are really of the middle-aged generation.  You have a few old-timers who are concerned.  It reminds me of the movie, Wall Street, the first one, with Michael Douglas.  They came out with a second one this last year, but in the first one there was an old-timer in the office, and he was warning, continually, saying, “No, no, no, you don’t want to do this, you don’t understand, I have been here before.”

One of the guys we have talked to many times, David, is Alan Abelson.  You have had him on the show in the past, and hopefully, maybe we will have him on the show again.  He is an old-timer.  He has written for Barron’s for about 50 years.

David: 56, almost 60 years – a long time.

Kevin: He is saying, “Don’t get fooled by this one.”

David: Kevin, that leads us to an important issue, which is, there are a certain number of people who are feeling better about the markets, and this is true of frankly too many people all at once.  I think that is what Alan Abelson was getting at in his recent Barron’s article.  You mentioned he has been a guest on our program.  He looks at a couple of different figures:  The AAII index of individual investors is registering about 52.3% bullish on the market, with about 23% bearish, and, as Alan says, the remainder are either comatose or on the fence – they are just not paying attention, they do not get it, they do not understand, they will never make a decision.

The point is, those numbers are getting high compared to past market peaks.  More worrying is the investment advisors, polled by a group known as Investor’s Intelligence, which is the name of the organization, it is not an appraisal or a measure of the actual intelligence investors are employing at this point.  The poll puts the bullish sentiment at around 57.3%.  Again, for perspective, the peak in October of 2007 just before the radical decline in the market was 62%.

Kevin: 62% of the people who were polled at that time were bullish on the stock market, and that was the very top?

David: And we are at 57.3% currently.  We are within spitting distance of there being the near-unanimous vote for all the bulls being in, and there being no one left to buy.  That is the point.  Everyone who was looking for a reason to buy, has bought.  What is the next set of reasons to buy?  Is it Quantitative Easing III?

Actually we are all bought up on the basis of Quantitative Easing II, and there certainly were powerful expectations of economic growth as a consequence of Quantitative Easing I – sorry, market, it did not materialize as expected – and that is certainly being factored into the price of stocks today, with the advent of Quantitative Easing II.  We have yet to see if there is real impact to economic figures as a result of the liquidity created and put into the system.

Kevin: That is quite a spread between bullish and bearish sentiment right now.

David: And the spread between bulls and bears is at 38%, with the danger area, according to the guys at Investor’s Intelligence, being anything north of 35%.  So if you are comparing the bulls to bears, and looking at that difference, and if the difference is higher than 35% – “Danger, Will Robinson!  Danger!”  The red lights are flashing, and investors should be aware of it.

The problem is, this is about the time that no investors care, and that is the point.  We look at the VIX, the volatility index, and it is at lows – it is between 15 and 16.  This is the point where the market usually turns, and the volatility index spikes.  Why?  Because people have been buying calls, and not puts.  They have been going long the market, speculating that things are going to be going up, ad infinitum.  Again, the last bull to purchase is what precipitates the decline, because there is no one else to push the market any higher.

Kevin: It reminds me, David, when you want to pick a good restaurant, or pick something to do, oftentimes you want to follow where the long line is, because that is a good indicator that it is a good service that you are going to get.  It is the opposite with the markets.  If you see a long line at the markets – I remember the tech stock long line back in the 1990s, and the real estate long line back in the mid 2000s.  That is not the line you want to get in, is it?

David: No it is not, Kevin, and just for the record, we are not contrarian for contrarian’s sake.  Frankly, it is a term that has lost most of its meaning.  But we are suspicious of structural recovery when structural issues have been neglected, they have not been addressed at all, so for the argument to be made that we are entering into structural recovery, we think there are some things that are significantly wrong with that.

Again, we are not trying to be dilettantes, and just take the opposite side of any particular trade, it is just that we do not see it adding up.  In fact, the risk far outweighs the reward in this environment.  Classic:  Richard Russell says this in several reports in the last week or two.  He said:  “Why would I buy the stock market today, with the average dividend yield at 1.86%?”  Charles Dow, the father – literally – the father of Dow theory, and of the Dow Jones Industrial Average, would not touch it with a ten-foot pole, anytime – anytime – the dividend yield slips below 3%.

Kevin: And it is about half that now.

David: Yes, plus or minus a little bit.  This is an era where buying guarantees losses over the next 10 years.  There are a number of different analysts out there who have projected that over the next 10 years the maximum growth will be about 3.3% per annum.  That includes dividends, that includes everything, and those are nominal figures.  That is not a real rate of return.  When you suck out inflation and your taxes on that basis, you are upside down.

Kevin: That brings up an excellent point.  So far, we have talked about the economy, we talked a little bit about the coming talk on politics and geopolitics, but there is something that sucks the life out of any rising market, and that is inflation.  We have not really seen huge signs of inflation in the grocery stores yet, but is it coming?

David: The December numbers for both PPI and CPIU and CPIW were unexpectedly higher.  That, I think, needs to be paid attention to.  There is also anecdotal evidence, in the developing world, of food and fuel prices, increasing tensions.  Again, these are political and social tensions, as a result of not being able to fill bellies.

Kevin: Tensions may be an understatement.  There are riots and deaths at this point.

David: True enough.  While there is criticism of local politicians not doing enough to contain food prices, and provide ample supplies to the general public, there is the new dot which is being connected, which is, these prices would not be rising if it were not for crazy monetary policy in the United States.  If they were not running the printing presses, we would not be paying the price.

The issue for us is this:  As Americans we have the luxury, having had an above-average annual income compared to the rest of the world, of being only inconvenienced by this.  It is no big deal for food costs or fuel costs to rise by 5%, 10%, or 15%.  It does not destroy our social fabric.

Kevin: We still eat, we may just eat a little differently, whereas in a third world country, they may not eat at all.

David: Exactly, and that is the point.  There is an immediate something that has to be fixed.  For us, we have credit cards we can put our added expenses on, or we can cut back on part of our budget and reallocate to another.  For much of the world, this is a question of going home tonight and not having anything to put on the table for your children.

Kevin: Our system has been based on conspicuous consumption.  In fact, if you think about when President Bush said we need to spend money to pull this economy out, we have been encouraged that that actually is how we do the world some good – to consume.

David: It is these marginal increases in basic foodstuffs that are financially putting a number of people around the world to the wall, and it is, as you mention, creating riots, protests, a heightened awareness of the divide between rich and poor.  So you are right to raise the issue of conspicuous consumption, because in the context where you have those who are not able to put food on the table, with those who can afford two, three, or four new Louis Vuitton bags for their luxury travel collection – guess what?  What you have is two versions of vulnerability.  One version of vulnerability is those who just cannot feed themselves, and the other is the vulnerable nature of the haves being put against the wall by the have-nots.

Kevin: Which we have seen many times throughout history.  You can just look at France, for example.

David: It is not to say that the judgment of the crowd is accurate or reasonable.  It is just to say that it is a dangerous component, and when you have a crowd that is angry and upset, they are generally looking for a scapegoat.  How do they prove their point?  How do they express their anxiety, frustration, anger, etc.?

That is what we are concerned with, coming into this year.  We stated a few weeks ago, and we also stated in 2010, that social tensions are something that we need to be very, very deeply aware of, certainly in the Third World, because it reconfigures geopolitical alignments, but also here, even in the United States.

While we are talking about the developing world, it is important to note that these consumption trends, in some regards, are constrained by what people have to buy to put food in their bellies, but there are some other trends that are important to recognize, too.  The World Gold Council pointed out for 2010 a radical increase in importation of gold.  That does not usually happen – and this is the main point – it does not usually happen when the price of gold is increasing, because the primary demand in India for precious metals is for the purpose of jewelry.  But 2010 redefined the gold market in India.  We went from 557 tons imported into India in 2009, to 800 tons in 2010, and the two components were investment demand rising by 73%, a component which is pretty rare, and not that popular in India.

Kevin: Theirs is jewelry demand, is it not?

David: And normally, there are less consumers of jewelry as the price goes higher, and yet, even reaching record prices in the gold price, there was a 62% increase in jewelry demand in India.  So there is a recalibration of thought, and a lot of this does have to do with an inflationary trend.  People are feeling it, people are looking at it, and I think we need to look at the leading edge of those decisions, and an awareness of inflation.

What I am saying is, I would look at this as a leading indicator, if you will, for an inflationary awareness, on a global basis, and you need to look where it is exacerbated and more dramatic – the impacts of inflation, people’s awareness of it, people looking at the man on the street and saying, “I can see that he is angry and frustrated, and I know why, and it does not bother me, but I am going to do something to protect myself all the same, because the awareness of inflation is here, it is now.”  Again, we are not that aware here in the United States.

Kevin: It is Asia, and to a small degree, Europe, but it is mainly Asia and the Middle East.

David: And a part of the reason why we are not aware, is because of that same issue we have been talking about all day today, which is that context is being redefined all around us, in such a way to put us at ease.  The CPI says there is no inflation, while there is inflation.  The consumer sentiment numbers say that everyone is happy, when I know people are not.

As that reality is being redefined, and being obscured for us here in America, we need to look at what others are doing, and why they are doing it.  As we suggested a few weeks ago, considering something as dramatic as redenominating, if it is important for the Indians to redenominate as a consequence of inflation, and they are at the leading edge as an inflation indicator, where they are seeing the consequences of our inflation here, just as the Chinese are seeing the consequences of our inflation there, the demand for gold as it rises globally, unfortunately, we will be the last ones to have an awareness of inflation because our reality has been redefined.

I think it really is important for our listeners to grasp the idea of denomination, denomination, denomination.  What are you investing in and why?  What is it denominated in?  Just like real estate, the critical variable being location, location, location, in 2011, 2012, and 2013, your economic stability and viability will be defined by denomination, denomination, denomination.  That is one of the things we will look at with Ian McAvity this next week as we look at the precious metals market, specifically, from a technical perspective, with a specialist who has been doing this for 50+ years.