January 5, 2011; 2011: A Look at Risk and Uncertainty

January 5, 2011

2011: A Look at Risk and Uncertainty

Kevin: The year has changed, David. We have gone from 2010 to 2011. We have had a lot of questions from listeners, trying to bring clarity to what seems like a very ambiguous year that we are going into. Can you explain?

David: Kevin, I think the challenge coming into 2011 is that many of the risks from 2010 do remain. Very little has been done to correct those structural imbalances, and yet we do want to, as a group, look ahead and try to discern what 2011 might hold.

Kevin: Can you bring some accuracy to what the picture is showing on the screen right now?

David: Frankly, I can’t tell you, with any accuracy, what the political calculus will produce, and as you look at various international entities, it is almost impossible to see what they might do to enhance their own interests and enhance their overall position in the world structures of power and influence, so this is going to be, actually, a very confusing year, as we look at a new kind of capitalism, which is very much state-sponsored. Whether you look at China, whether you look at Russia, whether you look at the Arab states, you see that there is both a free market operation on the one hand, but also a strong arm of government and bureaucracy involved, as well.

The reason that is important is because what happens economically and financially will not be immune to what happens politically. We will get to some specific examples of that. Even what has happened here in the first few days of 2011, which has very significant ramifications, but it all started in the political sphere.

I cannot tell you which asset classes will outperform, or which will make you more money than another. Anyone who does, frankly, claims so to their own discredit, as we know nothing of the future.

Kevin: David, what we have tried to do, at the beginning of each year since the beginning of this program, is to look at the financial, and then look at the economic, look at the political, and then look at the geopolitical. There have been years where it has been clearer at the beginning of the year. This year does not seem to have that clarity. In fact, there seems to be reason perhaps to sit quietly in a room and do nothing and just watch, and get your ducks in a row.

David: Yes, we look ahead at 2011 and see a mixed bag of uncertainty, ambiguity, certainly volatility if you are talking about the financial markets, and also, surprise. Those would be things that we would suggest will capture 2011.

Kevin: What would be the recommendation in a period of time like that?

David: Exercise caution, and if boldness is stirred inside of you for any reason, we would suggest that you hold that in check, and that patience, at this point, is required to get through. Two to four years from now, you’ll see a very strong outcome.

Kevin: And I would say patience is in order if you feel like you are set for the storm. If you have done nothing to get set for the storm, and you are sitting in the equities markets, or you are sitting in municipal bonds or treasuries, then possibly there is action that needs to be taken immediately.

David: Yes, as you mentioned, Kevin, whether it is 2010, 2009, 2008, 2007, 2006 – there were some concrete realities and inevitable consequences to come from them. There were the issues of derivatives, which we have talked about, or mortgage-backed securities, the over-extension of the real estate market and lending in that market, over-extended bank balance sheets, the institutional collapses as a result of over-leveraged positions. These things are, kind of, 2 + 2 equals 4. If it does not add up correctly, then you know what the consequence will be on some sort of time frame.

The problem today is that we are in the political calculus. We are at the place where behind closed doors things are being negotiated. For example, here in the next few months, the Chinese will be releasing their next five-year plan. We do not know what the outcomes will be over the next five years. We will certainly have a better idea in the next 60 days, and so we will bring questions about China into the conversation this year, as an example. Certainly, we will do the same with other parts of the world, as well.

Kevin: Today seems to be very different than even last year when we were kicking off the “What’s going to happen in 2010?” program. Let’s come back to the word caution, David. Would you elaborate on that?

David: I think maybe just like a football game, there are certain strengths and weaknesses on either team, and you can try to figure out who is going to ultimately win the game. But guess what? When the ball has been kicked at kick-off time, and it is in the air, you do not know if it is going to hit the ground, and you do not know when it hits the ground which direction it is going to go. You are in suspense, and that is really where we are now, because the political ball has been kicked, and we do not know exactly where it is going to hit, we do not know if it is going to be grabbed, with a change in our legislature as of 2010-2011.

So where do we go from here? This is going to be a really important year to keep your eyes and ears open and to discuss things freely, and probably the biggest danger will be for those who state things emphatically in an utterly defined way.

Kevin: It seems to be that sometimes we get ourselves into the most trouble when, in a period of time like this, we feel the need to make a decision. I am reminded of a famous saying: “Most of the evil in the world is caused by man’s inability to sit quietly in a room and do nothing.” It reminds me of R.E. McMaster, a good friend of your father’s, who does not always trade the day.

David: He was a talented trader, and he used to say that some days are good, and others are bad, that you should not feel compelled to trade them all. This is a period of time where you do not want to be particularly aggressive. Whatever defensive postures you can have in play do make sense. I think owning metals does make sense, but I would be very cautious in the equities markets, and even more so, the currency markets, and this is what we want to begin our discussion with today.

There is an underlying presumption which we think will be challenged by all astute investors, and what we are really watching for in 2011 is a transition away from asset class distinctions, where people think in terms of stocks, bonds, real estate, and that term seeking alpha, where you may be trying to enhance returns – your total return for the year.

The idea of asset class distinction will have something else added to it, and in the value equation people will now ask, “Is the asset in question dollar-denominated? Is the asset in question euro-denominated?” Again, when you put your traditional assets – stocks, bonds, real estate – through a slightly different rubric, and say, as you would with real estate in general – location, location, location – this may be the year where it is important to ask – denomination, denomination, denomination?

Kevin: In other words, what in the world are you capturing your value in when you have taken a profit?

David: Correct. It is in the context of QE-II, potentially QE-III, that we could see significant one-off downgrades to our debt, and a significant single-day, or single-week, decline in the dollar, say 15%, 20%, 25%, and these kinds of mark-downs moot any gains that you might have in any particular asset class.

Kevin: You brought that out during the German hyperinflation back in the 1920s. The stock market did very well, nominally. The problem was that it did not do as well as it needed to keep up with the currency decline.

David: And in absolute terms, you were still down 98% in the German stock market. In that context, you are right. Nominal winners were, in absolute terms, losers.

So, to witness 2011 as a year when foundational or underlying strength or weakness comes into focus, I think again you are talking about a small group of people – this is not the majority. I listened to CNBC this morning, as I often do, and, Kevin, if I watch it much longer, frankly I am going to look like half the guys on the program, but I will not have lost my hair, I simply will have pulled it out. I just honestly cannot believe that guys who trade a $5000-account on their own are considered experts, “I am long this,” or “I am short that,” – that we actually have, in our minds and our consciousness, the ability to impute wisdom to them.

Kevin: They are there because of journalism and broadcasting degrees, and an excellent head shot.

David: Well, I would call that last part into question, I am looking at a bunch of them thinking, it must be a stressful job, because the head shot that they have today probably does not match the one when they were hired.

Kevin: So, not the bubble-headed bleach-blond that we are used to seeing up there, to quote a famous song?

David: Kevin, just to bring it back around to currencies, we think that they will be very volatile, and that is as a result of monetary authorities, specifically, central banks, collaborating with fiscal authorities, which are legislators the world over, to jam the economies of the world, and to create unique export opportunities. In specific countries – whether it is the U.S. trying to do that, whether it is Australia trying to do that, whether it is Great Britain trying to do that – you will see indications of a fiscal and monetary chaos show up in what happens to the underlying currency.

We are very close, frankly, to a break in fiscal stability. This is something that happens, not just once in a generation, but once in the life cycle of an empire, where you have such a catastrophic break that it cannot be fixed, it cannot be put back together again, so the occasional currency intervention, we think, will become much more common.

Kevin: The way they cover these fiscal problems has always been, up to this point, currency intervention, at least in the last 2-3 years. What are we going to see there?

David: I think it will become much more common because politicians are striving to both consolidate and preserve their power, and they are going to use, as they have in the last couple of years, the state apparatus to both influence and control businesses, as well as, to the degree that they can, their currencies, for whatever advantage they can gain by that.

Kevin: Which can either be the enemy to everybody else around, or it can be the enemy to their own currency, depending on how they intervene.

David: Right, so currencies are one thing to fixate on, I think, particularly.

Kevin: Let me ask you, then, about real estate – something just about everybody who listens to the program owns. What about the real estate market?

David: Particularly U.S. real estate, I think, is moving toward critical collapse, as the cost to carry real estate becomes too burdensome to maintain. We have taxes, we have physical maintenance, we have other cash outflows, which are quickly becoming unbearable, and many of the liabilities – balloon payments, and what not – that were renegotiated in the 2006, 2007, and 2008 period, are now up for renewal. We have individuals who are experiencing their own kind of rollover crisis in 2011 and 2012, as the U.S. government is, as well, and competing for the same sorts of liquidity and credit.

Kevin: There is a moral, ethical reason, to pay off the debt at what you agreed to with a piece of real estate, but the people who listen to the program – these are not people who want to purposely foreclose or let their properties be foreclosed on, but there is a point when they cannot even maintain the property at the prices, the taxes, the inflation, whatever it is, with the value being so low at this point, and dropping.

David: I am reminded of a client that I worked with many years ago up in the Washington state area. This is a man who built his fortune in real estate in the 1930s – he was very responsible, not particularly interested in the stock market. All through the 1920s he was somewhat suspicious of borrowing on margin to buy stocks, and kept his money in cash, which, if you will recall, in the 1920s, was gold. So he sat in 20-dollar gold pieces, which were as common as 20-dollar bills today, and did nothing, but began to buy property in 1932, and began to build single-family residences and was selling them for $3000, $3500, $4000 for the larger homes. He, by the end of 1937, was a multi-millionaire, not in today’s dollar terms, but in 1937 terms he was already worth several million dollars.

He went on to become the largest poultry farmer in the state of California, at one point owned well over a thousand acres in the Napa Valley. I remember, particularly, because this relates to real estate as we are describing it today, what he described about his 750 units there in the Bay area. He had a number of apartment complexes totaling 750 units right in the downtown San Francisco area. He did not own them with debt against them, he owned them outright. That was his common practice, if he owned it, he owned it.

Kevin: Dollar for dollar, paid for it.

David: Exactly. He watched his neighbors struggle through different business periods where they had debt that they had to maintain against their properties. That actually was how he consolidated much of his real estate holdings and grew them through time, because he could reduce his rent by 30%, 40%, 50%, 60%, as he described to me he did on a number of occasions, to maintain as full a stock of renters as possible. Meanwhile, the neighbor next door was leveraged, had debt against the property, and could not reduce rent sufficiently to keep his renters.

Kevin: They were frozen in stone versus that elasticity of being able to move up and down.

David: Correct. We have a whole generation of folks who have forgotten that. I remember the conversation with him, when in 2003 I asked him to tell me what his family thought about how all of this had occurred, and he said, “Frankly, they do not get it. They do not understand it. They want me to teach them how to make money in real estate. They think that I am a wizard somehow, and that the answers to their future growth and future income and everything else is tied to real estate.” He said, “Of course, I own no real estate today. I am 100% in gold.”

That was not our recommendation to him. This is a guy who had his opinions and made his decisions very clearly, and if it was to not to be in debt, it was not to have even a dollar in debt. If it was to be invested in gold, in this case, it was to be 100% invested in gold. We are talking about tens of millions of dollars invested in gold at roughly $300 an ounce. I do not have to tell you what it is worth today, to see that this man made a decision for his family, and basically, they are still asking the wrong question. They still think that a particular asset class has all the answers.

Kevin: Which brings us back to the word denomination. He chose to re-denominate his value from real estate, to gold. Now, there will be a point, possibly, when he, or his family, down the road, will re-denominate in something else with a portion of that.

David: He does not care if it is single-family homes or a turkey farm. He cares about the value that he paid for it, and the value that he is going to get for it in the future.

Kevin: Would you call this depression economics – being able to get good deals for low prices? Tell me about depression economics.

David: I think that is where levered real estate will either have to get a prop from bailout funds, or we are going to see real estate, even from these prices, sell at 50 cents on the dollar or less.

Kevin: Which is good for the buyer who stayed liquid.

David: And I am talking, specifically, about leveraged real estate, not property that has been in a family for a long period of time, and of course, there are exceptions to this, where you are looking at legacy properties that have a certain value. I am thinking of a building on Ghirardelli Circle, right in downtown San Francisco. Pretty tough to redo that. That is a space that you will not have an opportunity to buy again, and will always maintain something of a premium.

But depression economics will define real estate as an asset class, in my view, for another 5-10 years, and we will see bargains emerge, but I would suggest that people weigh those bargains against the relative attractiveness of other asset classes. It is really only the unleveraged players who will thrive over the next 5-10 years in real estate.

Kevin: So the key is being liquid.

David: Oh, absolutely. Maintaining liquidity will allow for the non-leveraged real estate buyer to participate in the consolidation, maybe even of legacy properties, as they move from weak hands to strong hands. By weak hands, I am specifically talking about a leveraged position.

In our comments this last week on our Wealth Management Site we talked about the tide of inflation raising all boats, except those boats that have holes in them. The problem is, when you have an asset that has debt against it, that is a little bit like the boat that, as the tide comes in, is unable to buoy, because it is impaired by the hole that is in the side of it.

Kevin: Let’s move to manufacturing. Our country used to be a manufacturing country, but the world, at this point, manufactures even to over-capacity. Let’s look at the last couple of years. Right now you have people who are making things that are not being purchased.

David: I think that over-capacity is something that you expect to see when you have excess credit, because you have people who can buy, and only need, one television, but with ample credit at their fingertips, will put one in every room in the house. There is this ability to go beyond what is normal, so you have manufacturing which has been built out to accommodate an excess credit environment. Excess capacity begins to be more obvious as a problem when credit contracts, and people are not buying like they used to.

Kevin: Right, because we have had a 30-year bubble of credit expansion. If ever there was a bubble, it was not in tech stocks; it was not in real estate; it was in credit – and that created the other bubbles, and that has led us to over-capacity.

David: With over-capacity comes weight on pricing power and depressed pricing results, so it is really the lowest-cost producers who will walk through the next five years. I think Asia benefits from a radically lower cost structure. It is worth noting that that is in flux, specifically in China. Starting January 1st, the minimum wage is up by 20%. They are, I think, getting ready for their next five-year transition, and it will be a very significant transition. We will explore that at length in the months ahead.

Again, Asia, in general, benefits, because of a radically lower cost structure. What that says to me is that U.S. manufacturing is in a vortex, that it will have a very difficult time getting out of, without a significant number of the population returning to the equivalent of minimum wage jobs, and that is going to be difficult. How does a family of four, used to combined salaries of $50,000, $60,000, $70,000, cope with a 60% reduction in family income?

Kevin: You are talking about people who are heavily in debt. When we were talking about real estate, we talked about how the person who was able to move, and able to own, was the person who stayed liquid. For the person who did not stay liquid, who has been up to their neck in debt, are they going to still be able to own the family home? You know, a chicken in every pot, the family home – or is there going to have to be an adjustment in thinking?

David: Here is an adjustment that I think is worth talking about. This is the theme that is not necessarily numbers-related, but it is social fabric-related. There is a severe sociological adjustment for 2011 and 2012 to be dealt with as an ownership society.

Kevin: Which we are – we feel like we own, even though we have been in debt to do it.

David: You have a vast cross-section of the middle class that has benefitted from the era of democratized credit, both under Clinton, and under Bush II, as we moved into a home for the first time. Frankly, we are just going to have to adjust to learning to love renting again.

I guess we have been instilled with the belief that the good life includes the house with the white picket fence, and a growing number of middle class families will either have to adjust their thinking of what the good life entails, or get used to what is really a not-so-good life.

What are the stresses and strains that come into family dynamics as people deal with, not only reduced incomes, but even long-term unemployment? We are at 9.8%. Let’s say the numbers get better and go to 9% by the end of this year – that is U3. Even on a positively adjusted number, maybe it is 16-17%. You are still talking about over 45 million people that are unemployed.

That would be positive – if we do not end up adding to the unemployment numbers. Those long-term unemployed are the ones who have been draining the equity from their house, if they can. They have been maintaining lifestyles and going through spending, and I think 2011 and 2012 mark a departure from the normal feelings within society, to a much more constrained and anxious set of feelings where the savings are gone. Where, no, you already had one credit card pulled, and you are not being extended an extra 5 or 10 grand on the other card, where people are just forced to recalibrate, and that recalibration is, in light of what we were just talking about in terms of over-capacity in manufacturing, where we really cannot revive our manufacturing base because of the huge cost of retrofitting.

Kevin: What you have then, is that you move from the financial, to the economic, to the political. Social tensions, when they rise – that is when the politicians are called to account.

David: Right. If you look at a bank balance sheet, as earnings recover in the areas of the financial system, those financial system components which are recovering are, specifically, the ones that captured bailout dollars.

Coming back to that social tension, there will be a groundswell of marginally employed, to unemployed, persons, suffering through an economic decline, and they will give a much louder protest, as they look at something that is the equivalent of class warfare – the haves and the have-nots. You have those who are feeding at the government trough, who are receiving bailout funds, and then there are the “rest of us.” The haves and have-nots, in this case, the economically insulated, those who have not had to experience the economic winter, and those that are just flat cold and not happy about it.

Kevin, look at 2010. Personal bankruptcies were up 9% from 2009, well over 1½ million for the year. Again, we have the long-term unemployed. That issue persists in the context of housing, which is teetering on the edge of a double dip. These are the ingredients that end up driving the political calculus, and even with the changes in Congress in 2010, 2011 looks to be like a real fight in Washington, as you have the voice of the hoi-polloi, or let me say more generously, the general public, who say, “We want a fix, and have to have one.”

Kevin: Sure. David, we were talking about extremes – the haves, and the have-nots – and I think about weather patterns. We are in Durango this week and we had 14 below, 15 below on Sunday morning. That was an extreme high-pressure system, based on the heat that we had before, and the heat that comes in afterward. You have these extreme weather changes when you have the extreme temperature differentiations. But with the social tensions, it turns to mob rule, does it not?

David: I think this is where maybe some classical education is important. If you look at Polybius, if you look at Plato, if you look at Aristotle, even Marcus Cicero had a slightly different view of this, but in terms of a sequence of events, what follows democracy, according to the ancient Greek writers, is ochlocracy. It is a mouthful, but ochlocracy is essentially mob rule. We are moving into modern times with this sort of transition.

It is not just the conservative think tanks who like to criticize democracy as mob rule, but there is an actual transition, and we have seen a transition in our own country from a constitutional republic to a democracy. There are benefits to that, and there are also drawbacks, but if you would use history as something of a guide, the oldest political thinkers, and this dialogue has been carried through Montesquieu and others, into the modern era. And guess what? It is very common to move from democracy to mob rule.

Kevin: Which is interesting, because that is not anarchy. Anarchy is not necessarily the mob ruling, it is individuals ruling themselves.

David: But I guess what we are looking at is that populace voice becoming more prominent, in the context of pain. It is an economic and a financial pain, but it moves us that much close to ochlocracy, and ultimately, closer to the strong arm of tyranny.

Kevin: It reminds me, we were just talking to somebody this morning about reading Gibbons’Rise and Fall of the Roman Empire. When empires fall, there are certain characteristics that accompany that. Is this an empire that, at this point, is starting to show signs of, not only cracks, but actually collapse?

David: If you look at the critiques that the historians write of the fall of the Roman Empire, the fall of the British Empire, the fall of this, that, or the other empire, it is the privilege of the historian to construct the tale and tell you how it occurred. But if you were living it in real-time, it does come as a surprise, and it does happen quite quickly, to those who are in the context of it.

The collapse of most great empires has been precipitated by fiscal disasters. It should almost be axiomatic that when 50% of revenues, or greater, go to interest on the national debt, your demise is imminent. That is basically where we are moving. Will revenues decline and debts increase to bring us past that threshold? Is that a 2011 event? Is that a 2012 event? I do not know, but we are speaking of revenues redirected, specifically, to interest on the national debt. When it moves from 15-25%, it can bounce to 50% within a 12 to 24-month period. Frankly, by your statesmen, your economists, Wall Street in this case, but in the past just market participants – it is generally unexpected.

Kevin: The people we should probably be watching who are seeing this from the outside, is that other great and rising empire, and it may take a long time to get there, but China seems to be seeing this, and seems to be saying, “Hey, I’m out of the dollar, I’m into gold.”

David: This is an interesting point of what we could call contention between my father and me. He looks at Asia and paints with a broad brushstroke, and frankly, I think he is spot-on, that Asia will be tomorrow’s next giant.

Kevin: It is just, “When is tomorrow?”

David: “When is tomorrow?” “When is tomorrow?” is the more minute question, because we have a major credit issue there. We have a massive percent of their GDP that has gone into construction spending and into infrastructure building, which is impressive in terms of current GDP rates, but not sustainable on a year-in, year-out basis (unless you are willing to print, print, print, as they have done over the last few years, and provide massive liquidity stimulus to the real estate markets – the general economy, if you will). There is something about China that we should be looking at; there is something about Asia that we should be looking at, but not necessarily from an investment thesis.

Kevin: Not to invest there, but to watch what they are investing in.

David: That is particularly interesting, Kevin, because I would draw all of our listeners’ attention to a Wall Street Journal article from January 3rd, which will go very unnoticed, but is absolutely worth reading through and studying. It is titled, “China Expands Easing of Capital Controls on Exporters.” Unfortunately, though, the writer does not understand what he is talking about.

Kevin: He is reporting, but he is not actually connecting the dots.

David: He is reporting, but he is not analyzing, so there are contradictions in paragraph four with the last paragraph, unimportant to the general thematic, which is this: “China eased capital controls on exporters, foreign currency earnings this weekend, a move that over time could dampen inflationary pressures and slow growth in the massive foreign exchange reserves that have made Beijing a heavyweight global investor.”

Here is what has happened, Kevin. If you were a manufacturer in China, you were forced by these capital control requirements to repatriate the proceeds from your transactions, your foreign trade, and to take them to the Central Bank, in whatever currency it was in – euros, but predominantly dollars, as we are still their largest trade partner – you would exchange those with the Central Bank for yuan, or renminbi, the home currency.

Kevin: Right. So then what would the Central Bank do with those dollars?

David: Well, that is the account balance, the trade surplus, if you will, which has been, in small years, 150 billion, in larger years, close to 300 billion dollars, which they have taken to the U.S. treasury market.

Kevin: So it has been recycled back into U.S. treasuries, thus allowing us to go further into debt.

David: That is correct. It is interesting that one stroke of a pen in China, in terms of a currency control, or a capital control requirement, changes the game, because it is not the responsibility of the Central Bank to make that decision any longer, it is the responsibility of the business owner to say, “I have hard currency in a foreign country, and I am not required to bring it home and have it recycled back into U.S. treasuries any longer. In fact, I have the ability to do with it what I wish. Will I expand my business overseas? Will I capture a greater percentage of the supply chain, and not just be the manufacturer, but become the logistics, delivery, and ultimately, the retailer?”

Kevin: So it is pro-business for the Chinese businessman.

David: It is very pro-business.

Kevin: It is negative dollar-value for the U.S. treasury-holder.

David: It is very negative for the U.S. treasury market. The issue is: What does an individual do with wealth that does not have to be repatriated? Do they buy a building overseas to expand their business? Do they fill that building with art on the walls? Because, again, you do not necessarily want to bring all of your money back home, in this case, the Chinese repatriating it to Shanghai, Beijing, or where have you. What do they do with that money? Do they fill a bank vault in Switzerland with gold bars? There are a whole host of options which they can now pursue legally, which is a significant game-changer to the treasury market.

Nothing in the article would imply that this is treasury-negative, but I would ask our listeners to read the article and consider the intersection between economics and politics, because a politician made this determination, and it has radical implications into our own debt financing here in the United States.

Kevin: This goes back to, what do you denominate your assets in when you can have a single announcement that is completely unexpected, that reduces the value of your assets, or your currency? So – denomination, denomination, denomination.

David, as promised last year in the 2010 program, we did talk quite a bit about China throughout 2010. We talked to some top experts. There are some strategic issues that I know you want to see addressed again this year that we are going to keep our eyes on.

David: Kevin, international relations are at the cross-section of political interests, specific to a particular country, and the way those political interests cross over, and either interfere or compliment someone else’s interests in another country. We are watching a chess game being played between the U.S. and China. We have had a lot of negative banter back and forth, and it has been words only.

We, in the last year, decided to move a number of aircraft carriers into the region, one, specifically, into the South China Sea, and it is not surprising that the Chinese have countered with the announcement, just in recent weeks, of a land-based missile system, designed, specifically, to eliminate aircraft carriers. This is just, sort of, you move your chess piece, and you think you are going to win, and they eliminate the value of the move that you just made.

Kevin: Sure, they move one in front, or they put another piece in check.

David: But at the same time, we learned just in the last few days about the J-20, which is a long-range stealth aircraft which is capable of very large payloads. So between a stealth fighter, if you will, and a missile system which is geared toward carriers, specifically, did the U.S. regional influence just find a match? We ask that question? And to some degree, that is the case. So just when our foreign policy and military communities think we have pressure to exert, the dynamics of the game change.

Again, whether it is chess, or also a very Machiavellian English game, Snooker, sometimes the best offense is defensive, and it precipitates a tilting of the opponents’ original plan. We have been destabilized in our Chinese calculus, if you will. By what? They just announced that they have weapons we did not know they had before, and it changes our posture politically, economically, and in many other regards.

Kevin, there are other trends that we should follow, because certainly there is a growing middle class in China, there is a growing super-rich in China. We even saw Rolls-Royce gear up for 2011, producing 800 cars which they plan on shipping to China. These are ultra-luxury vehicles upwards of a million dollars apiece. There are trend changes to watch in China, whether it is a geostrategic issue, or simply an economic issue.

Kevin: Okay, that is Rolls-Royce. But let’s go ahead and mention that they have been buying a tremendous amount of gold, as well.

David: In the last few years, and I am sure our listeners are aware of this because we have reported it, or they have read it elsewhere, but the Chinese are now the world’s largest producer of gold. They have reserves that are still a far cry from what we have here in the United States in terms of gold reserves – on the assumption that what is in Fort Knox is actually there.

Kevin: It is no longer South Africa that rules the road on gold production.

David: That is exactly right; the Chinese continue to accumulate at an aggressive pace. But, as we mentioned a few minutes ago, the game-changer is not so much an announcement that they are no longer buying treasuries, or are shifting those treasury assets to metals or some other foreign currency – they just change the rules in the middle of the game, and there is an assumed appetite of our government and treasury – we have gotten used to the fact that these guys order the same thing every time they come to the buffet.

Kevin: Isn’t that what QE-II, and maybe QE-III, all these things, were all about – the assumption that somebody is going to buy that debt?

David: Exactly, and as we know, markets are made at the margins. The problem is, we are now talking 150-300 billion dollars of assumed treasury purchases by the Chinese each year…

Kevin: …that just possibly vaporized.

David: Over the course of 12-24 months, given the opportunity to buy something else, individual business-owners will buy something else.

Kevin: David, I hate to say this, but we have gotten so relaxed about whether our treasuries are purchased, at all, by the Chinese, or anyone else, because at this point, the government just monetizes that debt and just puts it back on the back of the taxpayer. Someone who cannot do that, however, unless things change, is the state, and the municipality. Tell us about municipal bonds – things really did change this year in the muni market.

David: Sure, and I would encourage any of our listeners to go back and listen to the 60 Minutes interview with Meredith Whitney, the bank analyst, who did a very good job summing up what the municipal crisis looks like. I was very surprised by how candidly the facts were shared, and how deeply they were covered. That was a 60 Minutes interview just in the last month or two.

The municipal crisis is basically this: We have 140 billion dollars in shortfalls for 2011. Those are bills that have to be paid, which the states do not have revenues to cover. As you mentioned just a moment ago, it is the same thing we are doing at the federal level, but what we can do as a larger body politic, because we are in control of the money printing, is – what?

Kevin: We can monetize, but again, states do not print their own money.

David: No, so here is where I think we end up with a unique wrinkle in the municipal market. It ties directly into the fiscal crisis in Washington, D.C. The question is: How many Chapter 9s will there be before the bailouts begin? You cannot allow the cascade effects to occur, and the dominos begin to fall, one by one by one, without there being greater concern at the federal level, and for them to just step in and start purchasing that debt. Again, what does that equate to? It is monetization; it is further pressure on the Fed balance sheet. It makes our credit rating as a country look even more tenuous. It makes our debts, the treasury bills, bonds, and notes, much more subject to scrutiny by foreign buyers, or anyone else.

Kevin: David, last year you pointed out that Moody’s rating service said that there was absolutely nothing to worry about in the municipal bond market, and in that same year we had something to worry about in the municipal bond market. Things changed pretty dramatically.

David: Yes, eleven months later, we have the exact opposite – not only present tense, but future tense critical issues, states like Illinois and California being at the top of the list. There are two solutions: You can allow for restructuring and eliminate the debts, to some degree – long-term liabilities – you can restructure them to the greatest extent possible. Multiple Chapter 9 filings – that is what we are talking about. Or, you get the Federal Reserve to expand their balance sheet, and once again, purchase a few hundred billion in muni debt.

Kevin: Doesn’t that seem like the most likely?

David: It does. The latter option stabilizes the muni market, and what it allows them to do is focus on the worst product on the market, with the most toxic derivatives products and mortgage-backed security products. There is some real, real nastiness on the Fed balance sheet. The beauty of this is that, in terms of the Fed’s opinion and the market’s opinion, barring a Fed audit, you can take all that nastiness onto the Fed balance sheet and the general public begins to forget that there was even a municipal problem to begin with. Solvency is no longer the issue because the bad paper simply went away.

Kevin: Okay, so if we continue to move everything onto this dollar docket, where we can print dollars, monetize the debt, which will actually pay the greater price in 2011 – the treasury market, or the dollar market?

David: It is a great question, Kevin, and I do not know that we know which one is likely to buckle first – one, the other, or perhaps both simultaneously. The treasury market and the U.S. dollar market are very critically linked. This is one of the reasons why we would look at both under the microscope for 2011 and be very concerned about currencies.

Kevin: This brings up a good point, David, because you are continually beating into our minds that we do not want to price things in dollars. We do not want to think in price terms with a currency that may or may not even exist down the road, in the form that it is now. Explain what kind of frame of mind people should adopt when they are thinking about the value of their assets.

David: Kevin, you mention gold, and I think when you are pricing it in dollar terms, it becomes insignificant. When you are pricing it in euro terms, it becomes insignificant. What you should do is create some sort of relative value structure. The Dow-gold ratio is certainly one that is useful. It takes the price out of the investment equation.

Kevin: Sure, you are just valuing the price of gold versus the price of the stock market.

David: It is basically pricing it in terms of purchasing power. What can I buy with my ounce of gold? What can I buy with my ounce of silver? The price of gold, the price of silver, the price of oil, the price of real estate, the price of the Dow or the S&P – all of those are seemingly significant, yet the currency basis is critical. We would suggest that you are not going to be able to look behind the veil on what is happening in the currency markets without creating some sort of a relative value equation as you are trying to make economic or financial decisions.

Today the Dow-gold ratio is 8-to-1. If gold were to drop, or the Dow to appreciate and that ratio were to back up to 10-to-1, I have just increased my purchasing power by 200%. I am very interested in that. I am interested in owning more gold at a 10-to-1 ratio, so there is this concept where price is irrelevant. I want to know what my purchasing power is. That is what you get with the Dow-gold ratio. How much has my purchasing power improved?

Kevin: David, I was thinking about the Dow-gold average just the other day. What about the guy who does not buy it, he has not purchased an ounce of gold, he is going to be a scoffer until gold is, let’s say, $4000. If the Dow is 12,000 at the time, and gold is $4000, that is a 3-to-1 ratio. If gold continues to click up, or the Dow clicks down, however that ratio works, and we get to a 1-to-1 ratio, that guy has still tripled his money by waiting so long to get into gold. This guy may triple his money, but for the person who actually sees this, they can actually do much, much better in their values. It is weighted to the point where it is almost logarithmic.

David: Yes, it is interesting, coming back to the currency issue, because I think this is where most of the confusion lies. People will say, “Yes, but I am not comfortable buying gold at $1400, or $1200, or $1600, or whatever the price is. I would rather be in Swiss francs, or I would rather be in euros, or I would rather be in Australian dollars.”

There is a Swiss analyst/commentator who was reflecting on the strength of the Swiss franc, and then also on its inherent weakness, like all fiat currencies, and he said this, which I think was very telling: “Since 1971, the value of the U.S. dollar has gone down 97½% against real money – gold. Since Nixon abolished gold backing of the U.S. dollar in 1971, both the dollar and most other currencies have been totally destroyed by reckless government. Nixon should not have been impeached for Watergate. Instead, he should have been prosecuted and jailed for destroying the world’s currency system. Concurrently, banking developed into a fractal system whereby banks could lend massive multiples of their deposits and capital. All of this has served to drive up asset prices to totally unsustainable levels. All currencies are declining against gold, but some faster than others. The U.S. dollar, for example, is down 78% against the Swiss franc since 1972.”

Kevin, just let me insert this: Wouldn’t it have made sense to own the Swiss franc? But here is his rejoinder: “During the same period, the pound has declined a massive 85% against the Swiss franc. Both the dollar and the pound are now at all-time lows against the Swiss currency. But, the Suisse is only strong relative to weak paper currencies, because against real money – gold – the Swiss franc has declined 87% since 1972.”

A 97% de-valuation, or an 87% de-valuation. Yes, on a marginal basis, the Swiss franc has done better, but we say again, as you have mentioned before, Kevin – denomination, denomination, denomination.

We are coming into a critical period, Kevin, of fiscal crisis here in the United States, and in certain places around the world, whether it is Eastern and Southern Europe, or what have you – and guess what? Denomination, denomination, denomination, will be absolutely critical.

Kevin: Okay, David, that is currency. Let’s look at the stock market. It is raging right now. If you listen to CNBC, which I watched you doing before we started the program this morning, these guys are excited.

David: Kevin, stock investor sentiment is very strong at the end of 2010. We look at articles from USA Today, we look at the eleven Barron’s analysts, we look at Charles Schwab, as institutions that are all looking at 2011 to be exquisite for equities. The positive consensus is remarkably one-sided. The AAII Investor Sentiment Indicator is bullish, and at record levels. Next to that, you have margin borrowing, which is now above 300 billion dollars, which is also at record levels. Next to that, you have the Volatility Index, which has dipped to 15, and is now slightly higher, but 15 is a fairly reliable reversal point, and again, what the VIX as a volatility index implies is that no one is assuming anything bad can happen in the stock market.

Kevin: Everything is coming up roses.

David: All tulips and roses from here. So I guess what I would suggest as the only thing that will take the stock market beyond these levels will be excess liquidity. The problem with that is that the law of diminishing returns is in full effect, and with each Fed or treasury liquidity infusion we are getting less and less bang for the buck.

I have watched volume statistics in the last few weeks on the stock market as it has continued to rise, and they are awful. They are awful. This has been pushed up by a few small hands that are swinging a very big bat.

Kevin: And what of the guys who actually run the companies? What are they doing with their stock portfolios?

David: As we have talked about several times in 2010 – record insider selling. We are talking about the captain of the ship, who has already gotten onto the lifeboat, has said bon voyage, and is now kind of chuckling about the fact that he survived and everyone else on board is going to go down with the ship.

Kevin: Less than a month ago it was an 8000-to-1 or higher ratio.

David: And even in the last week of the year, when no one is paying attention to their equity portfolios, someone is still selling stocks. You had 34-to-1 in terms of the ratio of insider selling-to-buying, so it is kind of a lights-out maneuver as you are going to celebrate New Year’s Eve – what are you doing?

Kevin: “I think I’ll sell a few more stocks.”

David: “A few more shares” – as if I hadn’t sold enough already this year. There is something very hollow about what we see on Wall Street right now. Can it go higher? Of course. Liquidity can to anything to any market – this is John Maynard Keynes’s maxim: “The markets can stay irrational, longer than you can stay solvent.” The idea that it has to do what you think it is going to do – it does not have to do it in the time frame that you expect it to.

Kevin, just as perhaps an illustration: Sotheby’s stock. Sotheby’s and Christie’s are the two large auction houses the world over, and what you see with Sotheby’s stock hitting all-time highs, or new highs, is that it signals a return of the moneyed crowd to the art market. Why do we bring this up? This stock, Sotheby’s, is a proxy for expensive art, and it has made highs at each stock market high over the last 10-15 years.

Kevin: So it is hitting a high right now?

David: (laughter) Yes.

Kevin: And what that has signaled in the past is the high-point for the Dow, or the S&P, before it comes back down?

David: Correct. Perhaps the only piece missing from the past patterns, where a market has turned down, is that employment numbers were typically much better as the stock market has rolled over. So, is this time different? We are at 9.8; the U6 is at 17-18% – roughly 50-55 million people unemployed. Maybe the stock market reflects the flow of funds from Quantitative Easing I, the expectations of economic growth stimulated by Quantitative Easing II, but it is speculation in the stock market that has it at these levels, something that we are not particularly interested in participating in hand-over-fist.

There are so many other things to talk about as we look at 2011: Tensions in the Middle East, Lebanon and Israel, mineral rights disputes over the Leviathan find. We have a number of things which are raising the points of envy and hatred in the Middle East – Iran backing Lebanon on that particularly basis. In Turkey, of course, we have had an initial round of elections and we have a presidential election coming up this summer, so we will come back to that this year, as we look at their gradual shift toward Islamism. And again, that issue of Israel having at their fingertips now, 100 years worth of energy independence, and are there objectors to this? Yes. Does it begin with Iran and Lebanon? Certainly.

Where do we end the conversation today? Kevin, I guess what we are saying is that the world is continuing to get more and more complex. It is not getting easier to figure out, it is getting more difficult. We will entertain questions and conversations with experts the world over. We will continue to travel the world over and see if we can figure out what, why, how, and when things will occur, and do our best to make the educated guesses that have made for good years in the last few years, both in our Wealth Management Platform, and in our Asset Preservation Tools.

Kevin, the commitment is to continue to ask questions and to maintain a sense of curiosity, and to assume that this is going to be more difficult as time goes on. Coming back to where we started, the ideas of ambiguity, of uncertainty, of volatility, of surprise – that, I think, is what 2011 holds for us, and that is why we will continue to ask the questions that we do.

Kevin: So what we want to do is to hold our value in the right bucket – that is that denominationword again. Do you put that value in a bucket with hole, or do you put it in a bucket that actually is sealed?