The McAlvany Weekly Commentary
With David McAlvany and Kevin Orrick
January 26, 2011
Kevin: David, with what is going on in the gold market right now, there are a lot of questions as to how far it can correct, how far it can go up. There are a few experts who have been in this industry for decades. Probably one of the most well-known, as far as his technical analysis, is Ian McAvity, today’s guest.
David: Our conversation with Ian today, Kevin, is of incalculable value to our listeners and clients. He sees things with a clarity that I think many analysts lack. His observations unpack the themes depicted in charts and graphs, all of which tell a story, and beg for meaningful exposition, which is exactly what he does, month-in, month-out, with his newsletter, and I hope today we have the same experience.
Kevin: Let’s go to that conversation right now.
David: Perspective is something that many in the investing public lack, often through no fault of their own. Our guest today has described most investors as confused as a herd of goats on Astroturf. Perspective and insight are what we seek to bring with the many guests on our program, through the ideas we entertain and discuss each week, whether it is Otmar Issing, Alan Abelson, Marc Faber, or Stephen Roach. Each guest brings a certain nuance or insight that comes from both an in-depth study, as well as broad professional experience, so we have invited Ian McAvity today to join us to discuss the markets.
Of course, on the program we look selectively at bonds, the equity market, housing, precious metals, and today we have the opportunity to discuss all of these in depth with a veteran of the markets. Ian also shares an interest in gold and silver that goes back decades. He launched his newsletter, Deliberations, in 1972, the same year, in fact, that we entered the precious metals market as a company, providing wholesale supplies to the major wirehouse firms and individual investors.
Ian’s newsletter is in a class of its own, and it sits amongst a small peer group, whether it be Richard Russell, Jim Grant, Jim Dines, or Harry Schultz. There are a very few people who have been thoughtfully writing and investing in these markets for decades. It is one that I consider to be an invaluable resource. You can look at the link and go to his website if you are interested in a sample subscription, or a long-term subscription to the newsletter, which I would encourage you to do.
Oftentimes it helps to begin with general observations and get specific. We want to look both at secular trends today, things that are currently in motion, and then perhaps sharpen our focus onto more cyclical trends.
Starting with credit, Ian, there are some things that have been driving the markets, whether it is the bull market in equities of the last few decades, or frankly, the bull market in bonds for the last few decades, and some of it comes back to credit. The period from 1982 to 2006 witnessed a collapse in the savings rate, an explosion in debt relative to GDP, and it seems that some of those trends may be in transition. What do you think?
Ian: Absolutely. We have a generation of American consumers that basically ate their homes one brick at a time, and subsequently, you have seen the credit markets explode, and in essence, they have lost value on their homes, but the debt is still there and they are not going to be coming back spending any time soon.
To me, America really has been living beyond its means, essentially, since about the 1968-1971 period. It started with Lyndon Johnson’s Great Society and the idea that you could have a Great Society, and fight a war, and not pay for it. In essence, the debt-to-GDP ratio just exploded until the credit markets finally blew up in 2007, and I think we are heading into what I would call the second half of that crisis, because the government bailed out the banking system after the collapse of Lehman Brothers, Bear Stearns, and the others.
Now we are at the stage where the guys that did the bailout are coming under the microscope. It seems to me that it has gone beyond sort of a domestic bailout situation to questioning the credibility of the global currency system, and in many respects, the transition that has occurred over the past decade has seen China, Brazil, Russia, India, Korea, and Japan, end up with all of the international foreign exchange reserves, and yet Europe and America are basically destroying the values of their currencies by trying to borrow their way out of debt.
It seems to me that we are at an extraordinary period of time, in which I have been saying for some months now that I think we are headed into what I would call the second half of the 2007 crisis.
David: The thesis that we are in recovery, and in fact, the recession ended some time ago, would imply that there will be, very quickly, a recovery in housing and that the financial sector will be coming back to a vision of prosperity, perhaps, that is reminiscent of the 2006 and previous period. As you mention, 2007 is when the credit markets blew up, but it seems like the administration currently in Washington is putting together policies which would bring us back to that pre-2006 vision of prosperity. Do you see that coming together in housing in the financial sector, the way that they would imply?
Ian: No, not at all, because among other things, just prior to the blow-up in 2007, the U.S. economy literally was creating about eight dollars of new credit market debt to add one dollar to GDP. Again, I keep coming back to the phrase, “How do you borrow your way out of debt?” The consumer is not going to be able to come back, because the mortgage-backed securities and the asset-backed securities market, at that time, were throwing something on the order of 110-130 billion dollars a month into the system. Those markets now are generating maybe 10 billion a month and the Fed is largely the buyer.
The problem that we have is that, in essence, the Fed is trying to replace that flow of money under the QE-II program in which they are throwing about 110 billion dollars a month into the system, trying to create another stock market bubble to somehow get the consumer feeling better and go back onto a borrowing rampage. But the credit market facilities are not there to enable that credit to flow down the chain to the people, so, in essence, all they have really done is bail out the banking system.
Statistically, it is always amusing to me to hear them say that the recovery is under way and that the economy has turned, when you have the long-term unemployment rate still up somewhere in the vicinity of 16%. As far as I am concerned, there has been no turn at all. Statistically, they created one, but as I always say about any of the data coming out of Washington, there is more fudge in that data than there is an in a Hershey’s chocolate plant.
David: So, if the consumer is not coming back, then it is, I think, healthy to state that GDP growth is going to continue to be propped up by government intervention and direct operation through QE-II, QE-III, or what have you. That does not bode well for the U.S. dollar. Of course, the dollar is not alone. Along with other fiats, we live in a post-1971 currency world, in which they are all floating, or as you have described, maybe we have not a floating exchange system, but a sinking exchange system. Tell us about that.
Ian: That is exactly what it has been. If you look at the gold price as the mirror reflecting the value of the four dominant currencies in the world – the pound, the yen, the deutschmark previously, but now the euro and the dollar – they have all been falling since 1946 when the Bretton Woods agreement was put in place to re-establish a monetary system post-World War II. Nixon closed the gold window in 1971, and that is when they started using that, what I would say is, a rather infamous phrase, that we were going onto a “floating exchange rate system.”
By way of floating, what we have managed to see is the dollar value of gold sink from $35 to $850, then up to $1430. An ounce of gold is still an ounce of gold, it is just how many pieces of paper you have to spend to persuade someone to give it to you.
The problem we have is the extraordinary growth that has occurred in the so-called BRIC countries – China, Russia, Brazil, India, Saudi Arabia, Korea – they are the ones that now hold the bulk of foreign exchange liquidity. They are sitting there looking at holding this 5.3 to 5.4 trillion dollars of paper, and they look at the track record of that paper and say, “Why should I own it?” It is losing about 4-5% per annum on a compound growth rate over a couple of decades, so they are basically growing their domestic markets, where, in essence, China is having an industrial revolution in one generation.
At the moment, they still are the second or third largest holder of U.S. dollar paper, but they are spending those dollars are quickly as they can, and they are not going to be there to continue to fund the deficits that the Obama administration seems to project out into the hereafter.
This is where you are going to have a major problem in the U.S., in the dependence on foreign lenders to finance the U.S. deficit. The dollar has already lost a lot of status in terms of the makeup or the share of international foreign exchange reserves, and I think it is going to continue to go down. In essence, that is going to come back to reducing the overall standard of living in the United States.
David: As some prognosticate the end of the dollar reserve currency status or even inflation moving from what it is to an advanced stage of double-digit annual, perhaps even more aggressive, inflation, I guess one of the questions we would have is, how low can the dollar go, and, as we have discussed, who would bail out the dollar? Maybe this is not like the 1978 period where there were others who could lend a hand because, as you mentioned, it is the British pound, it is the yen, it is the euro, which face the same travails that we do, both in terms of depreciation and inflation. What are the resources that could be gathered to have that sort of coordinated dollar bailout à la 1978?
Ian: I think probably the most significant event, and it has not received a great deal of attention in the U.S. media, is that there is no question that the euro is undergoing a huge problem right now because of the Portugal, Greece, India, Spain, Italy debt problems right now, which are in the spotlight. The U.S. debt problems are sort of in the shadows at the moment. But the most material thing that has come along in the last couple of months is China taking a lot of its currency reserves and going to Europe to help prop up and support and sustain the existence of the euro. The thing that strikes me is, and it is really quite amazing, I speak at a lot of different conferences in the states, the complacency with which Americans say, “We are okay, because Europe has a worse problem.”
The way I often describe it is, right now the dollar and the euro are in a contest to see who can be the best-looking horse in the glue factory. Both of them have comparable problems, though slightly different. In Europe, you have Greece, Ireland, Italy, Spain, etc., but in the United States, you have California, Illinois, New York, and a couple of other states that are just about as bankrupt as the European countries are. But right now the focus is in Europe, and to me the significant thing is China stepping up to join Germany in sustaining the euro, because that is the other liquid currency, and they want that currency to survive, and I think that they will make it survive.
There seems to be an American attitude that the euro is destined to fail. I do not think it will fail. I think it will garner international support and will be propped up, because no other country wants their currency to become the international medium of exchange, so the dollar is not going to zero. The dollar is not going to go away, it is important for trade, it just does not preserve purchasing power over time.
The euro will be propped up to keep it alive, but at the same time, I think we will see all of those cash-rich countries, or Forex-rich countries, increasingly build up their gold reserves at the same time. We will never go back to a gold standard, because, in essence, gold is just too small, relative to the mountains of paper that have been created.
But much the same way as the U.S. and Germany are two of the major holders of gold, as that final reserve, Russia is clearly doing it. They have published numbers every month showing that they continually build up their gold reserves. If you think of it, China has emerged as the largest gold mining country in the world, and yet they are still the biggest importers of gold in the world. They only show changes in their official gold reserves very periodically. My suspicion is that we are going to get a surprise sometime in the next year, in which we are going to learn that China has more than doubled their gold reserves again. In essence, at the end of the day, gold is, in its historic form, the ultimate form of money – defining money as the medium of exchange and store of value.
David: The dollar is thought by many to be correlated to the movements in the gold price. You point to a different set of facts in the last gold market. Perhaps you could share that historical insight with our listeners.
Ian: When people talk about the dollar and gold as if the rest of the world and the other currencies do not exist, the most material periods of time are when gold is rising against all of the major currencies, and the run-up from 1978 to 1980 is, to me, the best example. The dollar had an extreme bout of weakness that drove the German mark almost through the roof in October 1978, to a degree that it precipitated an international crisis where all of the major central banks intervened to stop the decline of the dollar and put a ceiling on the German mark. That caused about a 40-dollar sell-off in the gold price, when the intervention occurred the first week in November 1978. From November 1978 right out until 1981, in essence, the dollar was bottoming, and the dollar was not declining.
That was the period in which the gold price ran from $200 to $850, so the great gold rush that peaked in 1980 actually occurred against a bottoming dollar, not a falling dollar. In a sense, you could almost say that, at that stage, gold was in catch-up mode to what had gone on before.
In many respects, I think we are in a comparable stage today, if we were to replicate what actually occurred in the 1970s. When I hear people talk about a bubble, I burst out laughing and I say, “To replicate the 1970s, the gold price would have to be about $5500 an ounce today,” and I quickly add, “Be careful what you wish for, you would not like the circumstances if that is where we get to.”
David: That period of 1978 to 1980, just to recap: You are saying that we saw the dollar reach its lows, but it essentially moved sideways for two years as it bottomed out.
David: And that was the period in time that gold went from $160 or $200, to $850 an ounce, in that same period, so that the dollar crisis and the intervention that ensued did very little to derail gold as it moved higher. In retrospect, this is clear, as you describe it, but what most people expect is an utter collapse in the dollar for gold to move to new highs, and you are saying, that is not necessarily the case.
Ian: I would put it this way: I think a great deal of the dollar collapse in purchasing power has already occurred, and in essence, I think that by seeing the Chinese intervene to try to help stabilize the European situation, it is sort of amusing at this point, the Japanese have also got the problem where their yen is way too strong, and you now have Bernanke with QE-II quite blatantly trying to devalue the dollar.
It is sort of amusing that Geithner and Bernanke are pursuing a policy that they call a policy of lowering the purchasing power of the dollar, while they accuse China of manipulating their currency. I am not sure that I see the difference between China’s policy of tying their currency to that of their major customer, which is called manipulation, but when it is the other way around, it is called policy. China has actually handled this period remarkably well, when you look back on it. I sort of cringe every time I hear Washington talk about the Chinese manipulating their currency, because that is exactly what Bernanke has tried to do and the Chinese have essentially check-mated him.
David: Perhaps they have just done a better job.
The confusion over the real nature of this gold bull market is that it is, more accurately, a fiat currency bear market. You have a currency devaluation amongst our leading industrial nations, as you mentioned earlier, the pound, the yen, the euro, and the dollar, and frankly, given the levels of debt carried by the developed world, perhaps this should be no surprise.
You have developing countries and sovereign debt-holders who would be wise to recognize that what is actually occurring in front of them, or to them, as holders of treasuries or other sovereign paper, is, essentially, a strategic default. What do you think the road forward is for these holders of sovereign paper? Do they stand by and continue to watch their paper assets, those Forex reserves, devalued intentionally through, as you mentioned, Bernanke’s policy of lowering the purchasing power?
Ian: I think that the Chinese, the Brazilians, and the Koreans have already started to take steps to preclude the further buildup of their dollar holdings. On the one hand, yes, they are trying to invest those dollar holdings by converting paper into tangible assets around the world, but you are seeing, increasingly, capital flow constraints and taxes and penalties to try to keep the hot money from flowing into those economies that are growing.
And increasingly, you are also getting bilateral arrangements. For example, the one that really caught my eye last year was Brazil and China, essentially agreeing to settle their trade balances with each other in their own currencies. In essence, yes, they will trade copper in dollar prices because that is how the global copper market works, but at the end of the year, whichever one of them has a balance of trade surplus, that surplus is settled either in Brazilian real or RMB or Chinese yuan. What they are doing by that is stopping the buildup of the major currency reserves.
You have the same thing more recently announced between China and Russia. China and Russia have never exactly had what you would call great relations, but they are now trading with each other on a bilateral basis, and increasingly, they are looking for ways to settle trade outside of the three major currencies.
On the global stage, last year we had the G7 meetings and the G20 meetings. The G7 is the old boys club that thought they were telling the world how to operate, and it has become increasingly clear that the G20 is now the dominant group because they are the guys that have the money. There has been a huge political shift on that global stage. The bilateral settlements, the rich countries dealing with each other to preclude the buildup of more foreign paper, are a very material step.
In the meantime, the Chinese are never going to call up Goldman Sachs and say, “Sell 2 trillion or 4 trillion dollars worth of U.S. bonds,” because they know that will immediately prompt a protectionist response, or a penalizing response from Congress. Nobody wants the dollar to blow up. It is an important element for international trade. But at the same time they are sick and tired of having Geithner and the Fed trying to tell them what to do when it is quite clear that, to use the old familiar phrase, “physician heal thyself first.” The U.S. is in a mess, and yet they are trying to tell the rest of the world how to get into the same kind of mess, and the rest of the world has had enough.
David: It seems like the dynamics, then, that support the bull market in gold, as we mentioned, are not necessarily dollar-related at all, but when you look at the global issues in foreign currency, and the reserve issues that each of these central banks are having to make critical decisions on, they are making the same decisions that many investors are today, and it is looking at their cash reserves and saying, “Denomination, denomination, denomination. What is our reference currency?” Perhaps a fiat denomination is not what they want. To a certain degree, and at this point, to a very small degree, the metal is beginning to take a greater role.
Ian: Exactly, and you are seeing it in the newly industrialized countries. You are seeing it where a great deal of the run-up is in things like copper, platinum, iron ore, consumable metals, as well, and consumable minerals. You have people converting paper into tangibles. Dennis Gartman always uses the wonderful phrase, “If you drop it on your foot, and it hurts, it is something you want to own.” In other words, the tangible stuff.
In essence, we are seeing all of the commodity spectrum begin to reflect the purchasing power of the currencies in which the trade is denominated. Again, it comes back to gold, number 1, silver, number 2, trading on its monetary history, as well as its industrial demand, and then out to the other metals.
I am sort of amused when I hear talk about how they are going to launch several large copper ETFs in which they are going to store the copper in warehouses to get around the forward market transaction cost. When you look at the actual specific gravity density of copper, I do not know what kind of vaults they are going to store it in, but it is going to cost about a 100 times more than it costs to store silver, which is a lot more expensive than storing gold.
To me, there is an awful lot of paper product being created by Wall Street to try to participate in this trend that probably is not going to work all that well. Many of your readers are probably familiar with Central Fund of Canada, the CEF?
Ian: I was one of the founders of converting Central Fund into a stock exchange tradable bullion proxy. It is essentially a Canadian entity, holding nothing but physical gold and physical silver in Canada, and I always used to say, because Americans are afraid that Franklin Roosevelt might get re-elected. Gold and silver have the monetary history, they have great value per ounce in that sense. It makes sense to store them, but the best way to own gold and silver, still, in my opinion, is in your hot little hand. In Central Fund, we tried to create what I often call the second best way to own gold and silver.
David: What expectations do you have of the gold-silver ratio over the next several years? We are currently at 48 on the high side, we have seen 80-100 on the low side. We have seen, perhaps, a market anomaly at 15-17 during the Hunt brother days, an average of more like 30-40. Where do you see it going in this environment with poor man’s gold taking on perhaps some appeal simply because the price of gold is getting up there in terms of its access by the man-on-the-street?
Ian: I think a very long-term median argument could be made for something like 35-to-1. When you talk about the 15-to-1 anomaly of the Hunt brothers, in point of fact, geologists will talk about the occurrence of gold and silver in the ground being at about a 15-to-1 ratio, although the problem, of course, is that silver has much higher mining costs.
But on a very long-term basis, we have had a range, as you cite, roughly 40-to-80-to-1, vaguely, since the mid 1980s. Prior to that, the range was more in the area of 50-to-1 to 15-to-1. I conservatively expect to see something on the order of 35-to-1. I think if we were going to replicate the inflation-adjusted gold price of 1980, today that would be approaching $2500 sometime in the next year or so. I would expect to see that $2500 gold price able to convert into about 35 ounces of silver, i.e., that silver still would have further to go.
But for the last couple of months of 2010, coming into 2011, there is no question that this last rally that took silver beyond the breakout of 21 up to over 30, that got a little frothy, got ahead of itself, and quite frankly, I would like to see it come back down into the low 20s, somewhere in the 22-23 area. I would be a lot more bullish about it than I would trying to buy every little dip under 30.
In the same vein, I keep seeing these marvelous articles about gold being in a bubble, and I regularly try to point out to people that the venerable Financial Times of London has managed to produce a bubble-top article on the gold price at virtually every $100-dollar increment since it crossed $400. I find the bubble articles amusing, rather than illuminating.
In the recent period we have had the gold price run from $700 to $850, up to $1400, and come back $100 or so, everybody seems to get mesmerized by big numbers, but I like to try to point out to people that if you have a stock that ran from $8.50 to $14, do you get all antsy because it came back to $13.50 or $13.25, or maybe $12.50? If you think of it in those terms, we have been building a very orderly, almost linear trend, going back a whole decade. This thing has been literally a linear trend. We have not even seen a possible parabolic curve on it, and you really do not have much in the way of great speculation until you get into that parabolic curve. I think that still lies ahead of us over the next 2-3 years, and the problem is it could come sooner.
David: Transitioning to bonds and interest rates, because certainly I would agree with you, the manic dynamics have yet to emerge in the gold market, perhaps about $1500, somewhere in the range of $1500 to $2500, you could begin to argue that there are more people in the general public with an interest in gold, but today there are more people selling than buying, even if it is gold trinkets and gold jewelry, liquidating what they have to pay bills.
As you mention, The Financial Times, and CNBC, are right in there. They would disagree, I think, with us both, that the bull market has, in fact, ended, we are in a present decline, as evidenced by the last $20 move down (laughter), and you are wise to point out that in percentage terms, these are insignificant moves. In fact, right in line with what we have seen for the past decade, an orderly two steps forward, and one step back.
One of the things that you do so well is technical analysis. I look at trends in the interest rate market, which have covered long stretches of time, and remember Alan Shaw and Louise Yamada at Salomon Smith Barney. They did a study in 2004 incorporating 200 years of various bond yields or interest rates, and what they showed was that trends in the interest rate environment lasted from 22-36 years, with an average of about 28 years in duration, specifically U.S. interest rates.
That is one direction or the other, either up, down, sideways, which leads me to ask: Now that we have shifted debt from private entities to the public, this transition and the bursting of the credit bubble, circa 2007 to present, and clearly we have socialized the risks taken by individuals and individual firms – where do rates go from here, in your opinion? Looking at it technically, and if you want to support that with fundamental arguments, but technically, where do you think we go from here?
Ian: I think, technically, that interest rates have seen their lows. In essence, you have had, in recent times, these spikes down, in the long rates, typically, coincident with panic in the stock market. When the stock market panics, people still flee to bonds. CNBC calls it a flight to safety. I often refer to it as a flight to liquidity. Also, when people are worried about their margin accounts, they get more margin on their bond holdings than they do on their stock holdings.
But, in essence, I think we have seen the lows in interest rates, and perhaps the most interesting observation of all is that since Bernanke’s Jackson Hole speech in August and the commencement, when he announced that he was going to do QE-II and then has subsequently done the QE-II or Quantitative Easing II, of basically buying 90 billion dollars a month of treasury bonds. It has been sort of amusing that with this tremendous buyer in the market, interest rates have gone up, not down, and in essence, the market is looking right through them and saying, “We can see exactly what you are trying to do, and, have-on-ya.”
What is interesting to me is the QE-II is, in fact, such a blatant form of money printing that the bond market has started to reflect it. I did a web cast for a fund group back in November in which I talked about, if the long bond futures contract broke 129, that would really confirm that a significant trend was changing. That contract broke about two weeks later, and it is now down to about 20.
What is interesting is that all of the bonds that Bernanke’s traders are buying are basically now reflecting a loss for the Fed’s balance sheet, and, of particular interest this past week, the Fed has announced that they are going to change their accounting rules so that they do not mark their holdings to market. In the private sector, we call it fraud, but unfortunately, fraud is not a crime in the public sector.
It is extraordinary what is going on, and in my view, the credibility of the treasury market is increasingly going to face scrutiny internationally, which is going to encourage the international participation to continue to shrink. Again, if you have escalating deficits, I do not how prices do anything but go down, when you need more and more money and you are running into increasingly reluctant buyers, if bond prices are going down because interest rates are going up. I think it is the international vigilantes in the bond market that are going to drive U.S. interest rates up in spite of Bernanke’s intervention.
David: It seems they may be the only ones with the gumption to look at what you just suggested, a change in accounting rules, as significantly important to the bond market. Just as the change in FASB requirements for the banking industry have allowed them to keep garbage paper on their books without having to mark it to market, now you are saying the Fed gets to do the same thing.
The U.S. investment public, I think, could care less. They do listen to CNBC, they do read The Financial Times on occasion, certainly the Wall Street Journal, and USA Today is probably the biggest American read next to People Magazine, but what we do have is a crystallizing in the sovereign debt market of real risk, and real risk of default, if it is not outright default, the kinds of default that we have seen in the 1980s in Latin America and other parts of the world, certainly through inflation, a more subtle form of default.
This is the frustrating thing, and perhaps you can comment on this: When does the market realize that the pricing in treasuries does not reflect that risk? The direct intervention of the Fed and the quantitative easing which is occurring is distorting prices, and actually keeping them somewhat healthy.
From September to present we have moved from 3.5% on the 30-year to 4.6%. That is a pretty strong move from September to the present, and yet, I think we would see even more volatility in the price and yield if it were not for the government in there actually monetizing debt. Of course, the efficient market hypothesis is out the window, but when does the market realize, domestic or international, that the pricing in treasuries is totally skewed?
Ian: It is going to come along. I think, in a sense, it is already under way in the muni market. There is, increasingly, focus on the municipal market. The most interesting thing is, watching Governor Moonbeam come back into power in California. There is no real mechanism for a state, by itself, to go bankrupt, within the U.S. bankruptcy code.
I saw one article in the past week that was talking about the City of Vallejo, in California, trying to settle its debt for 5 to 20 cents on the dollar. I think that is the second time they have done that, that I can recall, and people are going to start looking at the concept of credit ratings. What do the credit ratings mean? As far as I am concerned, the credit raters of the past decade should be sharing a cell with Bernie Madoff.
The credibility of the credit markets is increasingly going to come into play.
This is where I think we are seeing this return of a buildup of savings, that as the money is being injected into the system by the economy, those that are in a position to save are saving it. They are not buying treasury bonds, they are not buying municipal bonds, and in many respects, they are being sucked into buying some common stocks. But I think increasingly, you are going to see them reducing debt.
That is the problem that the economy faces going forward. The credibility of the U.S. credit markets is increasingly sliding. But bear in mind, I think that probably the ultimate line was something James Dines said some years ago: “The last person to learn about the bubble is the guy that is living inside it.”
In many respects, the American investing public is living inside the bubble, and they believe that somehow or other Bernanke has this magic switch with which he can make everybody feel better. In the history of money and credit, I like to point out that Bernanke calls himself a student of the Great Depression. I assume that he is a great expert on the Great Depression, but I also assume he failed all of his courses in the history of money and credit, because he does not seem to understand that at the end of the day, that money and credit is going to implode.
David: One last question on interest rates, and then perhaps we can look at the stock market in brief. Wall Street believes that higher rates are gold-negative. This is a familiar refrain, whenever someone lifts rates, even a quarter of a point. Maybe you can take us back to the late 1970s and early 1980s. At what level was gold affected by higher interest rates?
Ian: Only when the real return on paper, i.e., the nominal interest rate minus the inflation rate, got high, then that began to impact the gold price. On the run-up to $850, treasury bills and longer-term rates were all above 8%. I sort of chuckle when I hear people talk about a 50 basis point rise over the next two years and the Fed funds rate would kill the gold market.
I think if you got the Fed funds rate up to 6% and the inflation rate to 5%, though I do not see that happening, at that point there would be a positive real return on paper. That would put some pressure on the gold market. We have Bernanke making blanket statements that that is not going to be allowed to happen. Real returns on paper are what would impact the gold price, and we are so far from that, I would not even contemplate trying to put a number on it.
David: In reality, Bernanke is not open to raising rates. The market would have to do that at the long end of the curve because with the debt that we carry, we are looking at moving the ceiling up again from 14.3 trillion, to even higher. The issue is, the interest portion on the national debt, at 5% to 6%, is a massive percentage of GDP, and it is not something that they can even entertain.
That may be a slightly different position than the 1970s, when Volker could step in and run rates to the moon in order to crush inflation, because even though we had more debt than in previous generations, it still was nothing on the scale that we have today. Well, that is helpful – 8% is kind of the number from the 1970s, something like 6% with an inflation rate of 5% might be in line, you think, today.
Global stocks, if you look at equities, both domestic and international: Are we in the eye of the storm? Certainly, sentiment is as positive as it can get, and what is awkward is that while sentiment is positive on Main Street, on Wall Street, and with corporate executives, we have had, over the last three months, record liquidations of their own shares. So, are we in the eye of the storm?
Ian: I think we are in the presence of a very significant top, and in my annual forecast newsletter, I have made the point that I think that 2011 is probably going to turn out to be the first negative year for the S&P that coincides with the so-called pre-election year of the presidential election cycle. We have not had a down year in the pre-election year since World War II.
But, given the mid-term year, 2010 was supposed to be the bad year, and it turned out to be an inflated year, thanks to Bernanke. I do not think he can repeat that magic for 2011. We have come into 2011 with the most extraordinary complacency and enthusiasm that somehow all the problems have gone away, and I am extremely nervous about this market, because I think that, in essence, it is flying on fumes at this point, and we are starting to see the various divergences in a variety of sectors.
I think I could quite correctly point out that insider selling is going on at an extraordinary rate. I just saw one report where it was the first time in which there was one time-frame in which there was absolutely zero insider buying. Think of an Excel spread sheet with a div by zeroes. How do you calculate a purchase-to-sales ratio if there is no buying? I think 2011 is coming in with sentiment extraordinarily high and I suspect that we will see the opposite extreme before the year is out.
David: So with areas of divergence and a significant top potentially forming in 2011, we certainly would agree with that, but we do question how far quantitative easing can take you. We have added a significant amount since the announcement of Quantitative Easing I and II. Is there now a conflict between Quantitative Easing II and III, and what the bond market might vote, and will the bond market hold quantitative easing in check? That is one question that lingers in our minds.
The other that I would love for you to comment on is that it seems that this is a period reminiscent of 1966-1982 where the stock market really did not go anywhere for a long period of time. There was no catalyst – if anything, a catalyst to the downside. Not only a lost decade, even a little bit more than a decade.
Ian: In many respects, I have been suggesting since the technology top from the stock market in 2000, that we are into one of those great, long, sideways periods, where the top at 2000 and the bottom at the 2002 crash, might define the range for a period of 15-20 years. In a sense, that is what we are doing. We went a little bit higher in 2007, we went a little bit lower in the 2009 range.
It is not dissimilar to what occurred from 1966 to 1982, but in that period, if you take inflation out of the stock market, the constant dollar decline of the stock market from 1966 to 1982 was really quite extraordinary. I think what Bernanke is trying to accomplish, without saying so, is to pull off a replica of that period.
The problem is that when you look back over a 100 years or more of history, the other alternative would be to go back into the period of 1929 to 1949, and in that case the wheels did fall off. That period started off with the great crash, and then you went into the sideways period from 1933 to 1949. I think that we are in one of those periods right now, so when I see some of the small stock components, for example, threatening their highs, or making new highs, relative to the 2007 peak and all this bullish sentiment, I would point out to people that we are probably in the range, and we are much more likely, at this point, to be probing the lows that we saw in March of 2009, than we are to seeing the massive stocks going above the highs that they had in 2007.
If we are lucky, we stay within that range. If there are any material accidents along the way, systemic-type accidents that may be precipitated globally, I would say that the greater risks are on the downside. To me, the risk/reward of the current stock market is just all risk, and very little remaining potential reward. I would not touch the stock market with Obama’s money, let alone my own.
David: Many discussions with one of our guests, Russell Napier, through the years, have pointed to 2014 to 2016 as a period where equities are likely to be cheap, specifically, following a collapse in sovereign debt and a rise in interest rates. The period of 1980 to 1982 was significant for many investors entering the bond and equity markets, and we have mentioned a couple of time frames here, as well. 1949 was one of those periods of time where it made sense to be looking at equities, coming out of a long period of consolidation. Those were intense periods. Certainly, sentiment was as negative as it could be, and yet, that was when value emerged. How does the period 2014 to 2016 sit with you?
Ian: On a time-frame basis, 2015, 2016, maybe out to 2018, if we are lucky that we do not have a systemic accident prior to then. Probably the best really, true, long-term measure of relative value of the stock market would be to come right back down to dividend yields. Historically, Edson Gould, back in the 1950s and 1960s, used to publish the fact that whenever the stock market yielded less than 3%, using the broad index, the market was high and overvalued, and when the yield was in excess of 6%, and it has been as high as 9% yield on dividends, at that point the stock market is truly under-valued.
We have not been at 3%, the over-valued level – that high in dividend yields – since Greenspan started flooding the system with liquidity in the 1990s. Since that period, whenever people got scared, they went into treasury paper. If treasury paper is going to come under increasing suspicion, it is entirely possible that the money flow in markets will, in fact, go back to seeking dividend payments.
I would say that when you get the S&P yield over 6%, rather than the 2% it is right now, at that point you can begin to argue common stocks as being significantly valued, and attractively priced for future investment. I think we will see 6% yields on common stocks at some point in the next several years. It is certainly not going to happen tomorrow, because we would have to have almost a reverse split of the S&P to get yield down to that level, at this point.
David: What does the journey look like, moving from the present Dow-gold ratio of almost 9-to-1, to 3-to-1, or even 2-to-1? A double dose of volatility, or do you think it would be more one-sided, favoring an up-move in the gold market, or a down-move in equities?
Ian: Bear in mind that we have seen a 1-to-1 ratio twice over the last 120 years. I know that James Dines and Richard Russell, and others, have pointed to the anticipation that we will see a 1-to-1 ratio again, or maybe it will be only 2-to-1. But, for example, if it is a 1-to-1 ratio, does that occur at 5000 Dow/$5000 gold, 10,000 Dow/$5000 gold? It is almost impossible to try to pick a number where that could occur.
What it really tells you is that gold, relative to the Dow, is sort of a financial versus tangible ratio. It has traveled from an extreme back in 1999 of 44-to-1, down to less than 10-to-1, and I have seen some people publish that ratio on an arithmetic scale chart, saying all the easy money has been made, so the game is over.
But you have to put a ratio onto a semi-log chart, and when you put it onto a semi-logarithmic scale, we are about halfway there. What that trend really says is that for several years yet to come, the gold price is going to perform better than the Dow. What the magic number will be that would create a 2-to-1 ratio, or a 1-to-1 ratio, I have not got any clue at all. I just know that the trend of that ratio tells me I sleep a lot better at night owning gold than I do owning the Dow.
David: And it seems that the journey between here and there includes a significant sub-story, which is that an investor who is willing to own metals today, and consider a transition tomorrow with a part of their metals assets, is looking at an 8 times purchasing power on the other side, coming from an 8.75, and if we should see a 1-to-1 ratio. As you mentioned, this is an exponential growth in terms of purchasing power, which is pretty interesting, if you are thinking about intergenerational wealth.
Ian: David, I could add to that, be careful what you wish for, because, believe me, nobody is going to enjoy the circumstances that create a 1-to-1, or even a 2-to-1 ratio, but in terms of intergenerational wealth preservation, gold will stand, and has stood, the test of time. I have charts showing that, for example, for British citizens, going back a couple of centuries.
But the biggest problem, I think, is that way too many people look at the gold market, and we are going to see increasing volatility, and they start thinking like short-term traders, and the nature of short-term trading, if you started off as an investor, I can almost guarantee you will be out of the market at the wrong time almost every time. Gold is something to hold for the major trend. Do not try to trade the short-term swings.
David: That is well-advised, and we appreciate it. The last note on deliberations: What is the website you would like for our listeners to go to if they are interested in looking at a copy, either a sample copy or a subscription, to the newsletter? I strongly recommend it. Your technical analysis is second to none.
Ian: Ironically, I do not even operate my own website. My primary chart provider has a website up there that has all the subscription information. It is here, or if they do a Google search for deliberations and Ian McAvity, that will lead them, probably, to that page.
David: And we will include that link on our website so people can just click right through.
Ian: I would be happy to send them a free sample copy of the newsletter so they can see the work that I actually do.
David: You would be crazy not to take Ian up on that, certainly look at it and consider a long-term subscription.
Ian, I enjoyed seeing you in New Orleans, I look forward to seeing you again when we can, if our paths should cross soon. We appreciate you joining our conversation. Our clients and listeners have benefited greatly by it.
Ian: Thank you very much.