July 17, 2013; Super Gold Bull

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: We’re just getting back, David, from a trip where we spent time with clients in Denver. You gave a presentation there and then, of course, questions and answers, consultations. It is always such an honor to meet with our clients. And then we went on to a city that we don’t necessarily go to by choice, but we went to Vegas, and we went to the Freedom Fest there, and you gave your presentation, as well.

What was really interesting to me in both places, was there is a lot of pain. Gold and silver owners are enduring a lot of pain. In Denver, almost everybody who came to the conference were our clients, several hundred people, and those were people who seemed to be very well informed as to what is going on. But when we went on to Vegas, to the Freedom Fest, those are not necessarily all our clients. It was several thousand people, all of varying degrees of understanding and gold ownership, and the questions were quite different. I would have to say they were probably more elementary, but you answered those in the presentation.

One of the things that I would like to do today, David, is for those who could not be at the Denver conference, for the clients, and for those who could not be at Freedom Fest, we kept getting requests after your presentations, for an audio presentation CD and then a lot of people asked for your overheads, or your visual presentation. I would like to go through that today and see if you would be willing to offer the video side of it, and then maybe just in an audio way go through some of the points that you made this week.

David: Yes, the slides are straightforward enough, although they may need some explanation. What I have tried to do in a few of my recent presentations is to include data that is generated by the Fed, so there is no real question as to the veracity, but some explanation is certainly needed, otherwise you are just looking at lines on a page – some go up, some go down – what is it and what does it mean?

I think that is where it gets particularly interesting. The conversation really needs to start with an acknowledgement that the Fed, the ECB, the Bank of Japan, Mark Carney at the Bank of England – these are the guys who are making the decisions which impact market prices today. And we are not just talking about interest rates and currency values, but any more, speculators are very concerned if they have the support of central banks in their speculative endeavors.

Last week was a classic case in point. You had risk on, back in the marketplace, and Bernanke had changed his tune, a dramatic change from June 19th to July 10th. But if you look at the move in the dollar during that period of time, June 19th marked the uptrend in the dollar, and that was because there was going to be no more QE and the tapering was coming fast and furious. But then we have July 10th and the comment that, “Listen, we’re going to be doing this highly accommodative monetary policy for the foreseeable future.” You can slice and dice “the foreseeable future” any way you want, but that is 6 to 12 months, at a minimum, and maybe beyond that.

I guess this is where we find ourselves. The markets are subject to the commentary from these various central bank presidents. And whatever they say will ultimately direct the markets. The irony is, of course, that they are supposed to be responsible for price stability.

Kevin: Right. That’s part of the mandate – price stability and employment.

David: But the deal is, employment is our issue here in the United States. Not all central banks take on that second mandate. Here they are influencing not only the price of the currency, itself, but asset values, and that’s where I think we are at a very sick juncture, not sick as in disgusting, but sick as in unhealthy.

Kevin: Well, you know, the markets are hanging on every word of these central bankers. The problem is, the recovery narrative has to be brought forward, but any time they start talking about recovery, you have these strange things happen in the markets where people are trying to judge. Well, does that mean they are going to raise rates? Lower rates? Print money? Not print money? It really seems to be completely driven by the Fed.

David: There is a lot that goes into assuming that we are in recovery and the July 10th comment was, I think, the best evidence that even those at the Fed know their numbers are garbage. Implied in Bernanke’s comments was that you can’t really put that much stock in the 7.6% U3 unemployment number. It’s not a full picture in terms of our employment situation. It really doesn’t adequately represent how we are doing.

Kevin: So what is the full picture? I guess that’s the question.

David: We include that in the charts that we had. We include the contrast between U3 and U6, looking at the 7.6 versus something that is far closer to 14%, and I think that comes closer to the case – 14% as an unemployment number. There is this notion that we are in recovery, and that is why the stock market is hitting all-time highs.

Just look at the market’s behavior following the June 19th comments in the sell-off in equities, the major move higher in bond yields, as prices in bonds were moving down, and the dollar strengthening. And that, of course, moves into reverse, one of the largest single-day declines in the dollar on record going back to July 10th. Again, all of a sudden he changes his tune to, we are going to be accommodative – boom! We’ve got over a 2½ point drop in the dollar in a single day.

Kevin: We hadn’t seen that since 2008.

David: Those are big moves. They are hanging on whether we are in recovery or not, and what are the consequences? If it is going to be print and QE to infinity, then the stock market knows what to do with the information and it is to infinity and beyond, as Buzz Lightyear use to say. You can tell I have kids (laughter). But that’s the same as we had with Fed policy and the stock market. There is nothing to hold these horses in check, to hold them back, to rein them in, if in fact, we are going to print, and print, and print.

Real estate being in recovery, employment being in recovery, these are the things that we were talking about in our conversations with clients, and the reality that that is nothing but a false narrative.

Kevin: I think it is important, again, I’m going to mention that this visual presentation is available on our McAlvany Weekly Commentary website, if a person wants to click on it. It’s in PDF form, and some of the things that we are going to be talking about today really need to be seen in chart form. We’ll get to the real estate in just a moment, but one of the things that I would like to talk about is the Federal Funds rate, how they are stimulating the economy right now.

We can go back to 1950 and see that the interest rates had fluctuated all the way up to between 17½ and 20%, and then they have come back down to ZIRP [zero interest rate policy], zero at this point, and they have flatlined. What does that do to the economy, and how long can we expect that to last?

David: I think it is important to realize that we are not the only central bank or country that is doing this. There are 40 banks around the world, central bankers who are at zero, or near zero, interest rates, and this represents price controls. This represents, in our view, what is really command economy characteristics. It distorts risk perceptions, and essentially you are manipulating the free market, manipulating how markets would price in risk into the interest rate environment, and very critically, interest rates inform how everyone prices risk throughout the financial milieu and that is a problem because you have folks saying, “Listen, stocks aren’t that expensive relative to bonds.”

If you have distorted the value of bonds, and now you are using it as a benchmark for risk, stocks end up being distorted, real estate ends up being distorted, mortgage-backed securities, the price of mortgage paper, the 30-year mortgage paper, 1510, whether it is fixed or variable. These things get distorted as a consequence.

That’s the problem. When you look at the Fed funds rate today, and you look at that chart, what you see is that normal is volatility. Abnormal is a controlled environment in which rates are doing the same thing for a long period of time. That is exactly what we have had since 2008 and 2009 moving forward. Here is the real sticking point. When you look at the Fed funds rate being set at 9 basis points, basically zero, what used to be called risk-free return is now, as Jim Grant likes to call it, return-free risk.

Kevin: It’s amazing. When you said that, I could just hear it in the audience. A lot of the people who were listening to these conversations over the last week, David, need income for retirement, and they are getting none right now.

David: But what they have is life support for the economy. We can be thankful for that if, as, or when, it actually stimulates recovery in the economy. It has yet to do that. And I think the perspective here, the chart goes back to the 1950s, is just to say that these are extraordinary measures. The fact that this has now flatlined from 2008 to the present, this represents life support for the economy. We would like to believe that we are in recovery; however, we don’t see it, as indicated by Fed monetary policy and an easing of very aggressive measures.

Kevin: David, wouldn’t you say that one of the reasons that we are keeping these interest rates low is to stimulate employment? Obviously unemployment became a huge issue as we went through the crisis over the last few years. It got up to close to 10%. Granted, they are telling us it is below 8 at this point, but you brought up a couple of points that were very, very important, that manufacturing jobs are just going away, and it is the part-time restaurant work and that type of thing that actually is on the increase right now.

David: Circling back around to Bernanke’s comment that the U3 statistic of 7.6 doesn’t adequately represent the employment picture, he is exactly right, but he didn’t go into the details that we often do. Labor participation continues to be a driver of lower rates, and as you see a shrinking in the total labor force, the number employed versus a shrinking labor force gives you an improved number, even if you aren’t adding jobs. Add to that, you’ve got the birth/death modeling. 132,000 jobs were added. This is a statistical aberration. Those were added in June. 205,000 jobs were added in May via the birth/death modeling. Over 193, I think 193 was the exact number, in April. This is a trend. This is data that is no good. And if we are assuming that it informs the recovery story, just understand that you are building that story on a very faulty foundation. The bright spot in the new unemployment number was that we did add 360,000 jobs. Unfortunately, they were part-time jobs, while we lost 240. We looked, also, in this presentation, at a longer-term trend, not just this employment number, but looking at the last 10 years, restaurant and bar employees, they’ve been increasing aggressively. You have been adding to those numbers aggressively.

Kevin: At 25% increase.

David: Meanwhile, manufacturing employees have been falling off the cliff. This is where, in our opinion, you build wealth through building things, not by serving drinks. If that is the basis of the new economy – how much whiskey we can drink – then this is really going back to that Cuda whisky idea, the notion that you can just introduce, as Benjamin Strong did so many years ago, a little bit of stimulus into the economy and that’s all you need. You don’t need anything actually organically growing in the economy. We would take umbrage with that idea. We don’t think that works.

Kevin: You had also mentioned that before the crisis, before 2008, we had over 60%, 63% of civilian employment by population, and now civilian employment has dropped down into the high 50s.

David: That is the real picture. The real picture is that in spite of an improved employment number, the civilian unemployment population ratio would show you that what you are looking at is balderdash in terms of statistics. The number of people employed, divided by those of working age, has been stagnant since 2010, and even though you have seen an improvement in the employment number, it should reasonably have you asking questions – am I being lied to?

Kevin: Where is that money going? And look at GDP.

David: Jobs are not being created, not the kinds of jobs which ultimately build wealth in this country.

Kevin: Just look at GDP. Look at the growth. Just the decline that we’ve had. You had a chart there that went back to 1940. If we take 1940 on, we’ve seen GDP as high a 7½ to 8%, and now our gross domestic product has dropped down, and actually, we are not even talking about how much the Fed adds in quantitative easing to this GDP, but even when you count in what they are adding, we are at less than 2½% on GDP right now.

David: In that presentation, we take the chart back to the 1950s, just to show the declining trend in gross domestic product, that we were closer to 10%. Now we’re close to zero and 2% and that trend has been in decline for decades. This is not a new issue. This is one that you experience with a maturing economy. I say maturing economy, because when you have the high growth numbers that you have in China, for instance, you go from double-digit as kind of the norm, to now high-single digit, and that is some sort of a disappointment.

Well, their 7½% just reported this week beats any number that we’ve had in over 5 decades, so their new low number is representative of our old high number for the last 50 years. You are really not looking at apples to apples, because you are looking at mature economies versus, if you want to call it, immature. There is a higher growth rate. I mean, look. When was the last time you added two inches to your height in the last 12 months? That doesn’t happen at your age. It does happen when you are in your teens. You can go on summer break and come back an unrecognizable human being, having grown 2 inches, 3 inches, 4 inches. That happens with the immature becoming mature.

And I think it needs to be understood that it is ultimately not sustainable, the kind of growth rates that you have in China. What we see is actually a lowering in expectations coming into the second quarter, where we could, in fact, once they tally the numbers, show up as less than 1% growth. The first quarter was supposed to be 2½. They revised it back to 1.8%. That’s what we show on the chart. And now the next series is going to show even lower growth than that – not particularly compelling in terms of that recovery story.

Kevin: David, one of the things holding us back, as well, we talked about the two mandates for the Federal Reserve, which is price stability and employment, but actually, the Fed takes on a third one, wouldn’t you say? And that would be trying to get growth out of the economy, trying to milk GDP out. The problem with that is, it is created by debt, and we now can say that our debt is greater than our entire GDP. It is better than 100%.

David: That’s right, the national debt at 17.15 trillion puts us at about 105% of debt-to-GDP. The compelling thing in this is when you look at mandatory programs. Take out defense, that’s not one of the mandatory programs, whether you are talking Social Security, Medicare, or Medicaid.

Kevin: The entitlement stuff.

David: Those entitlements, with a few others, represent 81% of our total tax receipts. The thing is, these are issues which are on the horizon and growing, ballooning issues, if you will – Social Security, Medicare, and Medicaid. Given the fact that we are just on the front edge of the baby boomer generation coming into dependence on these programs, they, today, represent 81% of total tax revenues. What do they represent tomorrow?

Kevin: Look at Obamacare. That is an unknown. No one knows, really, what it is going to cost, first of all, for the individual, but second of all, the government.

David: Politically savvy to punt that into 2015 for implementation and getting it past the mid-term elections, because it was going to be a disaster on implementation. In fact, I just read an open letter by three unions, basically saying, “You will crucify the middle class, and you will crucify unions, on the cross of Obamacare. You’ve got to stop this nonsense. Repeal, rewrite, amend, but understand, the implementation process is going to be very bitter. And I think what they are really communicating is that if you allow this to continue, you may, in fact, lose union support. That is not really music to any Democrat’s ears.

Kevin: David, if we were in Washington, D.C. right now, these guys would just be laughing and shaking their heads. They would be telling us that we are in a recovery. They would be putting their best face on, and actually, that’s what they are planning on. They aren’t planning on 81% of total receipts going to these mandated programs, because we are going to grow our way out of this.

David: And that’s what it is at present. Wait until tomorrow, when these are ballooning obligations, 55% decrease in deficit over 5 years is the White House’s estimation of growing economy equals an increase in tax revenue, an increase in tax revenue equals a shrinking in the deficit by that 55%. But again, it all ties back to the recovery story. What we see is a lack of recovery, as Stephen Roach pointed out a number of weeks ago, what has been characterized as an aversion to spending. And that showed up in the most recent retail sales figures this week. It was actually on the basis of this week’s retail sales figures, which were a disappointment, that you have people now lowering their estimates for the next round of GDP, or total economic growth.

What Stephen Roach was pointing out is that you have a stock adjustment where in a recession, people don’t buy big items. Their durable goods orders go down, but you have then a resurgence of buying as people loosen their belts after having previously tightened them, and you see those numbers soar to about twice what is normal – 6%, 7%, even 8% in terms of durable goods.

That’s what they call a stock adjustment, when you are basically making up for lost time, buying what you did not buy. And we haven’t seen that at all. In fact, in the context of the last five years, liquidity continues to be presented to the banking community, to the financial markets, and guess what happens? No real net benefits to the consumer. The consumer is locked in their habits of austerity, and I think for good reason. There is still an insecurity about jobs, and there is still an insecurity about an increase in income to keep up with the rise in inflation. These issues have people on hold in terms of major purchases.

Kevin: And it may be that they are just running out of money before they run out of month, Dave. We have talked about these jobs actually being part-time jobs and not nearly the quality. Debt used to actually generate some growth. You have a chart in here that talks about from 1947 to 1952 you could generate $4.61 of new growth with a dollar’s worth of debt. Of course, that has changed here recently. I think it has dropped to 8 cents of growth per dollar of debt. Is that accurate? It is hardly a trade-off at this point.

David: This is something we talked about with Chris Martenson maybe two years ago. If you look at the exponential function, there has been an overlap with there being an understanding by economists that you can have debt grow exponentially, as long as you have exponential growth in the economy, and that has been sort of the principles that they have based this radical spending, spending beyond our means, with money we don’t have. As long as the economy reflects this growth, they are comfortable with it.

The problem is, they haven’t taken their foot off the pedal. You mentioned 1947 to 1952. Those years, increasing debt by $1.00 gave you $4.61 of growth. That is a decent trade-off. If you, in fact, doubled that and said now you are getting $8 of growth for $1 debt increase, that would be an even better deal, but it is not $8 that we are getting today. In the last decade that’s 8 cents of growth in GDP compared to $1 that is still being added to our debt. And we are still adding debt exponentially. Meanwhile growth is falling off a cliff.

Kevin: Just a point on that. Back in 1947 to 1952, those debts were taken on to be paid back and they were paid back. Any debt that we take on at this point, I think everyone knows, cannot be possibly paid back.

I’m going to shift gears here, because we had a number of real estate investors, both astute and beginning real estate investors, especially at the second conference. I would like you to comment a little bit, Dave. We have had a drop in mortgage rates as part of all of this. It is very, very cheap to borrow and buy and there is a huge temptation right now to borrow and buy based on the low rates. Can you comment on where you think that is going? What do you think of real estate right now?

David: I think real estate is sort of a conundrum. It is something that you have both upside and downside. And the challenge is, real estate prices will obviously be impacted by a move in rates, higher or lower. Rates are being pegged at a lower number, given the current Fed purchases, mortgage-backed securities. The involvement in that market is immense. The mortgage-backed securities market is 100%, lock, stock, and barrel, bought by the Fed today. That’s not healthy. You don’t have a private mortgage market. And so you are seeing a high volume of transactions as long as it is a conforming loan of less than $417,000, the borrowed amount, that is, which means that with houses right at a half million or less, you are actually seeing some turnover there, and an improvement.

But here’s the issue. If you want to keep your mortgage payment constant, and you move from where we were just 8 weeks ago, 10 weeks, ago – 3½% rates on the 30-year fixed rate mortgage, if you jump from 3½ to 6½, you have to pencil in a 35-40% loss in the value of homes, if you want to keep your mortgage payment the same, which really means that for anyone who wants to buy a house, you are buying either the same house you wanted, at a 35-40% discount, or you are looking at a house that is 35-40% less than the house you really wanted to buy in that short adjustment phase from 3½ to 6½. Why do I say 6½? We spent all the 1990s and 2000s with a more normal range between 6 and 9. So just take the low end of that range. But 6-9, even going back to 1990, that’s where interest rate volatility was in the 30-year conventional mortgage. So what we can expect is lower home prices with higher mortgage rates. And that’s the result, that’s what you get, when the Fed “tapers.”

For anyone listening, this is where you have to ask yourself the question. It is one thing to acknowledge that your current activity in the marketplace is not getting you what you want, and I think the Fed is recognizing that QE is not buying them a recovery. The problem is, you have the stock market which is transfixed by this liquidity, and if you take the liquidity away, you can shave 20%, 30%, 40% off the stock market.

Make the Fed go away with their interventionist activities and you are looking at an S&P and a Dow, minimum 20% lower. Let’s just call it, conservatively, 20% lower, but it could cascade from there. Just like high-frequency trading pushes things up, it doesn’t matter. It doesn’t have a conscience, or a brain, and it is happy to drive prices down, as well.

But one more thing, you have real estate, which is just as much subject to this change in liquidity flows. The Fed steps away. It’s one thing to acknowledge that your policies are not working. It’s another to look at the unintended consequences of pulling away from those policies, which would be to gut the real estate market, to gut the equity market, the stock market, that is, and the bond market, as well. Those are the real-world consequences. I think they should go ahead and take it on the chin and get us back to some sort of normal pricing instead of what we described earlier as a controlled market.

Kevin: And you have charts in here talking about the price. There are three charts, in particular, that a person who is interested in the real estate picture needs to see, because even though prices have been on the rebound, they have only really rebounded back to where all the lows had been in the past. In other words, we are seeing a rebound, but we are starting to see, at the very high point of this rebound, just reaching the lowest points of every other recession in housing. So without going into great detail on the charts, the point is, the housing recovery may not necessarily be as boisterous as we are being told.

David: And you see this in the Fed charts, particularly on housing starts. We have seen a massive recovery off of the lows in 2010. As you mention, that just gets us to what were previous recession lows over the last six decades. We are still 67% below pre-recession peaks on housing starts. You do have one area of strength, and that is existing home sales. They are only down 49.4% from the peaks, and that is because you have had flippers, and buy and rent crowds, particularly your private equity and hedge funds come in and say, “Hey, we can’t get yield anywhere, so at least we can clip a 6% coupon. Buy a thousand homes, turn it into a rental pool, and 6% is better than no percent, because that is where real interest rates have been manipulated and fixed by the Fed. This, I think, is compelling. So that’s housing starts.

We also looked at single-family homes. These are new single-family homes, not the existing. The existing have improved. It is only down 50%. Let’s call it 50. But new single-family homes are 80.6% off of peak numbers. If you look at the last two years, what you see is tremendous growth rates off of what is a considerable low, levels that we hadn’t seen in five decades in terms of new single family homes. But if you look at it in the context of that 5-6 decades, you realize that we are just now, as you said earlier, with the other housing stat, getting to the worst case scenario in the last six years, in terms of those recessionary debacles, going back to the ’70s and the ’80s, and the lows that we saw in the ’90s. The levels we are putting in now are just getting to those recessionary lows, as you mentioned earlier.

Kevin: I’m going to shift gears here. I would like to get to gold soon, but before getting to gold, we should address money, because you get asked at these conferences, “Where do you think gold is going to go?” The real question should be, “Where do you think the dollar is going to go? Where do you think paper currency is going to go?” You have 2 or 3 charts that talk just about the monetary base, the dramatic increase from about 2008-2009, up to today, of the monetary base, and excess bank reserves, all this money that you have referred to in the past, as sitting behind a dam, like Hoover Dam, just waiting to be unleashed.

David: The Fed balance sheet started this recession at 865 billion dollars and now exceeds 3½ trillion dollars.

Kevin: That’s a four-fold increase.

David: The St. Louis adjusted monetary base gives you kind of a snapshot. It’s a close picture of the Fed balance sheet, and you see that growth rate. You see where QE 1, 2, 3 came in. It is interesting, I mention there, the correlation of the S&P being on the rise. What we don’t see is an increase in bank activity. What we don’t see is an increase in economic activity. What we don’t see is an increase in durable goods. What we don’t see is an increase in demand for copper.

Kevin: Well, how about velocity? We don’t see an increase in velocity.

David: These are all issues which tie to a growing economy. What we do see is the Fed has expanded their balance sheet and provided ample liquidity to the financial industry and we do see, on that basis, and sensitivity, again, you look at the dates – July 10th versus June 19th. What did the dollar do on those dates? What did the Dow and the S&P do on those dates? You see this unhealthy dependence on what the Fed says and what the markets do thereafter.

The dollar is no longer an indication of a growing economy, it is an indication of the Fed’s footprint. The S&P and the Dow are not an indication of economic growth and vitality, they are an indication of the Fed’s footprint. That is why we look at the Fed’s footprint here with the adjusted monetary base and say, “Okay, well, what we have today is a fairly large footprint, and what we expect tomorrow, after seeing an asset price explosion, in other words, the S&P and the Dow have continued to increase in value. This is par for the course.

I will mention an old dead guy who is an economist, or better than an economist, a market practitioner, in league with John Law in the 1700s in France, Richard Cantillon. What is now known as the Cantillon effect, when you increase the money supply, or your monetary activity, and you instantly see asset price inflation. And tell me John Law and Cantillon didn’t have some awareness or appreciation of asset price movements as a result of playing with the monetary levers.

Kevin: Right. Of course that was the hyperinflation in France in the late 1700s.

David: And the Mississippi bubble, what we saw there in terms of massive asset inflation. When you pull the monetary levers, the first thing that happens is that asset prices are the primary beneficiaries. On a lagging basis, however, you end up with consumer price inflation. Where is inflation today? That is the big question people have. And Wall Street, and Main Street, at least the Main Street Media, would say, listen, no concerns with inflation.

And with a rise in interest rates, we have a positive real rate of return, no need to own gold. The question is: How much inflation is already in the pipeline? And again, on a lagging basis, according to the Austrian business cycle theory, just a matter of time trickling out the other side. Again, in terms of that Cantillon effect, it is first asset price inflation on a lagging basis, it is consumer price inflation, game over.

Kevin: David, even though the money is being printed, and even though it is increasing in quantity, it seems like it is just backing up in the banks, that it is not really getting out in the form of loans. I mentioned velocity, but velocity is how many times a dollar bill changes hands in a year.

David: Technically it is a ratio of GDP to money supply. What you have is that money is sitting dormant, whether it is savers like you and me, or banks being unwilling to lend out and I included two charts, both the velocity of M2, and the excess reserves of depository institutions. These are all generated by the Fed from their website.

The reason we have both of these here is because, number one, velocity is the key to inflation, and it is the key to defining what is either a mild inflation or a superinflation. What takes you from 2-10? It is velocity, and velocity can pick up very quickly, so all it takes is a little bit of liquidity being multiplied. Again, you look at the amount of liquidity that is in that next chart, Excess Reserves of Depository Institutions, a little bit of liquidity, 1.8 trillion dollars.

Kevin: From zero. The excess reserves were at zero just a few years ago, 2-3 years ago. Now they are at 1.8 trillion dollars, just waiting to be unleashed into the marketplace.

David: You have this issue of the lending mechanism being broken. Banks are not willing to lend, borrowers are not willing to borrow, or are not able to. Because frankly, what does a banker want to see? A banker wants to see, not the assets or balance sheet that you have, but the income that you have, and whether or not you are going to be able to make payments on the loan. Why wouldn’t a small business owner be able to borrow today? To be quite frank, it’s because their business stinks. It’s because incomes are off relative to previous years, and it is tougher to qualify. Not only have the qualifications, the standards, been raised, but also, verification of income, and the process is also more challenging. Why? Oh, yeah, it’s that slight issue that we’re not actually in a real economic recovery. We’re in an asset price recovery on the basis of Fed stimulus.

Kevin: So in other words, do as I say, not as I do, because they are trying to tell us that we are in a recovery.

Okay, let’s go to the stock market now, because in one of the charts, and I would highly recommend our listeners go to these charts and look at them, you compare gold, over the last ten years, to the S&P 500. The S&P 500 is getting all the news right now because it has been going up to new highs, but when you really look at the chart relative to the S&P 500, gold is up about four-fold still, and the S&P 500 is just getting back to – maybe just slightly exceeding – levels we were at in 2007.

David: This is compliments of our friend, Ian McAvity, who writes a wonderful newsletter, Deliberations on World Markets. Gold and other assets, this is the title of that chart, the S&P has registered, in real terms, a negative real rate in terms of the last ten years, but if you look at this chart, it’s fascinating. Barron’s decided to print an article in October of 2009 and they said, gold is still a lousy investment. The S&P in October of 2009 was a fraction of the current price. Gold had just been blistered all through the fall of 2008.

Do you realize that the growth rates up to that point from 2008 to 2009, gold had still buried the S&P in terms of a positive rate of return. We are talking hundreds of percent more, and yet Barron’s, the best they can do in terms of a diagnostic in the market is to say, “Yeah, S&P good, gold bad.” You can look at the same thing today and all the news pundits like to say,  “Gold went into a bear market in April. Gold went into a bear market in April. Gold went into a bear market in April.”

Kevin: I think they started printing those reports in March. “Gold went into a bear market in April.”

David: You’re right, you’re right, and it was the off-the-shelf version, the kind of thing that politicians do on a regular basis. You write the legislation and pull it off the shelf when you need it. The interesting thing is, this is a little like a broken record, circling back around. They’ve said that gold was worthless and lousy, even in 2009. No wait a minute, we’re about double the price of gold off of those 2008 lows, even now, with a massive correction in the price of gold. And wait a minute, we’re still up almost 300 percent since the beginning of the decade.

How does a 300 percent gain in gold compare with a negative real return in the S&P in the same timeframe, and yet everyone is fixated with the new highs being put in the S&P 500. I don’t quite get it. What I don’t get is the blindness that people have to these larger contextual issues. We have not dealt with the structural issues that we have of a fiscal nature, and now we are compounding those on the monetary side, and yet, people are still willing to throw gold, literally, under the bus, and say stocks are where you should have your primary investments today. Right idea, wrong time. You do want an emphasis in equities. The question is, when and how? Because if you were a buyer in 1932 or 1937, you were a smart buyer. If you were a buyer of equities in 1949, you were a smart buyer. If you were a buyer, there are multiple times in the last hundred years where if you were an equity buyer…

But here is the issue. If you were a buyer of equities, let’s say 1974, 1975, 1976, you still had the tail end of the bear market to deal with, in spite of the fact that Arthur Burns looked like a genius, and it looked like there were no inflationary consequences to aggressive monetary policy, which had been in place for years, and so the sort of 1971, 1972, 1973, 1974, and 1975 period appeared to be innocent. You can print, you can monetize. Look, we’re all geniuses now. We’re all living on the Ph.D. standard and aren’t we glad we left the barbaric relic behind, and aren’t we glad that we have further proof that the bull market in gold is dead?

Kevin: Strangely, the barbaric metal ended up going up 8-fold after the bottom there in 1976.

David: This is just to show, this S&P versus COMEX gold, how blind the market is to what is a bear market in equities – has been. We have been moving sideways for ten years. That is the kind of bear market we were in from 1968 to 1982, and this is why it is so important that people pay attention to this, because the deception here is that people recalibrate and say, “Oh no, no, no. Prices have been moving up since 2008. Is that your cost basis? Is that when you were buying aggressively, in 2008? Or were you a buyer earlier in the decade, which means you’re just at break even? Marginally at break even, maybe slightly better than. Factor in inflation, and you are still upside down. The deception of the 1960s and 1970s in the equity market was that you only moved sideways, and guess what became the real killer? There were low rates of inflation in the early 1970s, so it didn’t matter that you had low growth in the equity market, but by the time you got to the late 1970s, you had low growth in the equity market, and high rates of inflation, which meant you were having your head handed to you, in terms of a real rate of return.

We are doing a replay of that almost precisely today, and I think as we move into 2015, 2016, the massive inflationary impact of the last 5 years of monetary policy will be felt, and the question is: How do you feel as an equity investor, having your lunch handed to you in that environment? And frankly, how do you feel as a gold investor when people recalibrate their inflation expectations and say to themselves, “Well, yeah, I went from 2 to 10, and I guess I should own some of that stuff to offset some of the losses. The mass scramble toward gold is going to be very interesting. Does that happen in the next 6 months? I don’t know. You are dealing with the madness of crowds. You are dealing with a perception shift, a psychological reappraisal of what is an expectation of inflation in the future.

Kevin: And that was one of the questions that we got. It is only fair to allow a person who owns an awful lot of gold to ask, “Do you think the bottom’s in? Where’s the bottom?” There’s pain in these cyclical changes. We’ve had cyclical counter-trends, and we could talk about that in a moment, but this is not unusual, what is occurring in this long-term secular bull market.

David: But whenever it happens it is still painful. So, is the bottom in? Is $1200 the low? Is $1155 the low? Is $1045 the low? Is $770 the low? I don’t know what the low is. I do know that the leveraged players are pushing this as far as they possibly can, because they can. And even since we discussed this with clients last week, the new COT reports have shown us that the short position is no longer 115,000 contracts. That is 11½ million ounces short the gold market. It is now 13 million ounces short. That’s about 1000 tons of gold that will have to be bought back.

Think about that. 1000 tons of gold will have to be bought back to cover the speculative short. Some people will ask, “Well, yeah, but what if it is governments that own it, and don’t have to require delivery in kind? What if they just want to settle that in Treasury bills or cash?” Money managers represent 80,000 of those contracts – money managers – so a large section of that. And that doesn’t include your hedge funds and individual speculators, but just the money management space accounts for 80,000 of those 130,000 contracts.

That is a massive amount. It is the largest amount short the market, I think, in recorded history. I could be wrong on that, I’ll have to go back to an almanac or two, but I think that is the highest, certainly, that we have seen in the last 30 years. David, I think the question is: Who is buying those contracts? You contrasted the difference between somebody who is actually trying to protect their business, like a gold mine, or somebody who actually has skin in the game from another perspective. And then the speculator, the guy who is really just betting on an up, or betting on a down.

David: You have the South African miners with an average production cost per ounce of about $1400. Everyone else in the world is close to an average of $1200-$1300.

Kevin: But the South Africans are losing money, right now, for every ounce that they mine.

David: Right, so you can shut down production, you can lay people off. Of course, they have a number of issues in terms of labor relations, and there is a lot of pressure in South Africa. What we see is that the producers, and that is why we are bringing this up, the producers have nothing to hedge. The reason why a producer goes out and shorts the market in the first place is because they have ounces in the ground which they are producing, that they are bringing out of the ground. There is a time lag.

Just like the farmer, you plant the seed, and you harvest in the fall. And you don’t know what is going to happen in between. You don’t know if there will be bugs, you don’t know if there will be hail, you don’t know if there will be no rain at all. And if someone is willing to pay you a fixed price today for future delivery, that’s why you go ahead and capture your gain now.

And that’s what the futures markets were all about, taking a future price and applying it to the product today. Even though the product is only going to be delivered tomorrow you are just establishing the price in the present.

Kevin: They were really designed to stabilize, not to destabilize.

David: They were, so that you didn’t have producers going bankrupt because of the vagaries of weather, rock blasts, or what have you, depending on your industry. In this case, you don’t have margins to protect. The miners are losing money in South Africa, and are very close to that same situation in the U.S. We show a chart of the commercial interests a little later on in the presentation. It’s the net commercial position, and this shows you when they are aggressively short in the market, and when they are not short at all. When they are short in the market, they are protecting their interests, they are protecting their production. We mentioned 130,000 contracts short. That’s not the makers, that’s not the producers. Those are the rank and file speculators. Those are the hedge funds, the individuals who say, “Hey, I listened on CNBC the other day, and apparently gold is going down further. It seems like an easy money play. I’ll make a few bucks as gold goes down.” There is a different level of commitment, I think everyone should appreciate that. The existential commitment that corporate executives have to maintaining job security, and maintaining their industry as a whole, versus the speculator who says, I’m in it for fun and profits and I’ll close out the position when I need to. I think what you need to really stir up the shorts is a retest of the lows. If you retest the lows around $1200, and you hold those lows, you are going to see a massive panic out of the short position. The reason why you haven’t seen any short covering to date, in fact, you have gone from 115,000 contracts to 130,000 contracts over the last month, is because shorts are still bold. They still think it is going lower. If you retest $1200 and it holds, you are going to see mass panic on the shorts, and they will attempt to cover as fast as they can.

Kevin: David, one of the things we have is short memories, and a lot of times, as dollars get greater we hear, “Oh my gosh, gold is down 200 bucks.” Well, back in the days when gold was 300 dollars, a 200-dollar decline would really hurt. But percentage-wise, we’ve had a number of declines in this long-term bull market. We lost 25% from 1999 to 2000 and then it rose pretty dramatically, and then we had other declines, 25-33% declines, but what we are experiencing now is not that unusual in a long-term secular bull market.

David: And I think that is the most important thing here, is that you are talking about a counter-trend decline, counter-trend, as in the trend is up, but you can still move down, even though the major secular long-term trend is up, and that’s par for the course. That’s par for the course.

You’re right, shortness of memory is, I think, something we all suffer from. Maybe we try to remove painful experiences out of our memory, and a 25% decline back in 2005 and 2006 certainly was unpleasant, but went away. A 34% decline in 2008, yeah, unpleasant, but it went away. How fast did it go away? It went away in a matter of months. We hit the low and recovered in about 90 days. You only get that kind of a speedy recovery when you have someone trying to get out of the way of the markets.

Why? I want to bring up again those 130,000 contracts, 13 million ounces, over 1,000 tons of gold having to be purchased to close out those positions. That is the rapid ascent that gold has in its future, and that doesn’t define the course of the bull market, it just defines a very quick recovery. If you want to sell at these numbers, be my guest. You can be at double these numbers within 12 months.

Kevin: What I would also say is that we have to look at the Chinese, the Russians, the Indians. When we were in Vegas I had someone from Malaysia come up and talk to me, and he told me, “When you Americans in the paper markets knock these markets down, every time, the queue lengthens,” and I’ll be honest with you I didn’t know the British word queue, so I said, “What’s a queue?” And he said, “A line. People are buying gold with both hands and they are paying substantial premiums for the physical metal.”

The contrast, Dave, between the physical markets and what was occurring in the physical markets – the COMEX warehouses, Scotia Mocotta, JPM – the dramatic drop in inventories before the paper manipulation of gold in April. Would you address that just a little bit? You do have some charts that show the actual numbers. We were seeing a severe inventory problem, actually beginning at the end of February, early March.

David: And it was no surprise that there in April we saw what we view as an orchestrated move lower, a pressured move lower. In a few hours, to dump 400 tons of gold on the market, it’s just not smart. You put yourself in the position of the owner of those 400 tons of gold, you want the best price possible, and you feed the market a little bit at a time, so as not to create a downward spiral in price. In this case, there was no discretion given, it was just a dumping of gold, and of course, it did cause a cascade in price. With every ounce they sold, they got a lower and lower price. That’s not someone who owns the physical metal and wants the best price. That is a paper trade, and that’s all it was, a paper trade. Specifically, by paper trade, I mean an uncovered futures contract, short in the market. That’s what we were talking about, again, 130,000 contracts of those, times 100 ounces per contract. You don’t have to have the gold. These are naked shorts. There is nothing backing them. You just say, “Hey, I want to short gold.” Great, you can short gold.

And you are right, Kevin, what we do see is Chinese demand going through the roof, Indian demand going through the roof. We show the 223.5 metric tons bought by the Chinese imported into Hong Kong there in March. That’s a single month import. We’ve had 3-4 months in a row of radically increasing imports into India, and to the point where the jewelry association is in an awkward position with the government, they’ve seen an increase in taxes from 4-6 and from 6-8 percent in terms of import duties, and they are scared.

They are scared that the industry is going to be redefined by some sort of governmental decree, so they are playing ball. It won’t surprise us at all to see June numbers down, July numbers down, maybe even August numbers down, for India. But what is happening is, the official market is slowing while the black market is picking up.

I’ll just give an example of how that has worked in Vietnam in the last year. You have a huge amount of gold that is held by the Vietnamese, 300-400 tons held by individuals in Vietnam. And as they have tried to control the flow of gold into that country, the central bank is the sole importer of gold, that was one of the changes they made in Vietnam. And then they also made the Saigon Jewelry Company the only distributor of gold bars. They tried to discourage the holding of metals.

Guess what happened? You have had a massive increase in black market smuggling. Anytime you increase the cost of doing business beyond a reasonable threshold, you go from white to black in a heartbeat. White market trade goes to black market very quickly. I think that’s what most statists don’t appreciate. You can push buyers away from their normal venues and straight into the black market.

And you see that. Vietnam is a classic case in point. It used to be all official gold imported, about 50-60 tons is legally imported into Vietnam. At least that’s what it was 2011-2012. At least 50-70 tons is now smuggled into Vietnam. You control it? Guess what? It’s just going to work right around it. So actually, we expect to see numbers decline in China, eventually. They are still interested in officially importing. It’s India that is not interested in importing more gold. Guess what’s going to happen?

Kevin: It’s just going to be underneath.

David: So all of the official numbers will show abysmal imports. Meanwhile, the smuggling is going to go off the charts. Let’s say, for instance, that you increase the premiums on ounces in India by 10%, to 18% duties. Now the black market profits on anything that they can import and deliver to you at a 16% premium or less.

Kevin: It’s a little bit like the drug argument. Why would some of these drug dealers actually want to see drugs legalized? Because the premium built into them is the black market premium. That’s what they gain.

David: Do you know what the premium is in Vietnam?

Kevin: No.

David: $235 an ounce.

Kevin: Wow!

David: One of the highest premiums per ounce. That is an immense premium, for what? A generic bullion ounce.

Kevin: But it is a real ounce, and this is something Goldman-Sachs and Merrill Lynch have no control over whatsoever, because they are selling fake ounces.

David: People the world over are still willing to pay premiums to own the real thing.

Kevin: David, we are seeing this physical accumulation, but even if we just take the price of gold as it is in the futures market, the Dow/gold ratio is something that we have talked about for decades at this point, we saw at one point, when you divide the price of the Dow Jones Industrial Average by an ounce of gold 12 years ago, it was a 41- or 42-to-1 ratio. You could get 41 or 42 ounces of gold for that one share of the Dow. Of course, we’ve seen it fall all the way down into the sixes.

We are back now over 10, and I’m wondering what your thought is on the Dow-gold ratio. It’s one of the things that we watch the closest, to see when the value time is, to actually start exiting our gold position.

David: When you look at the Dow-gold ratio today, we have a chart of that in the presentation, what you see is a counter-trend move, and what we see is sentiment being deeply, darkly bearish in gold, and as good as it can get in the Dow and the S&P. We are putting in new highs there, and unsustainable, in our opinion, on the basis of Fed money-printing. That’s how we have gotten there.

Gold, on the other hand, is at unreasonably low numbers, and we’ve gone from 6-to-1 on the Dow-gold ratio, to about 12-to-1 at present. This counter-trend move up, to us, represents another 12 times purchasing power, should we return to a 1-to-1 ratio. If it’s only a 3-to-1 ratio that we get to, still, a 400% increase in purchasing power, gold terms, buying Dow shares, if you will, in the future. Sentiment in gold is as dark as it has ever been. In fact, if you look at the Hulbert Gold Newsletter Sentiment Index, that is at a negative 50. A negative 50 is a record low.

Kevin: And for our listeners who don’t understand the contra-cycle of that…

David: These are advisors who are either long or short the gold market and they are saying, we should be buying, or we should be selling. Negative 50, in the history of this index, it has never been lower, including the bear market that we went through for 25 years, it’s never been lower. That is a stunning sentiment indicator, in terms of how low gold is, how under-appreciated it is today, and the Dow-gold ratio, you get to contrast that with extraordinary exuberance. I think this is one of your best exits from equities and entrances into the gold bull market.

What is wrong with gold today? It lacks a sentimental prop. That’s all. That’s the only thing it’s missing is positive sentiment. It has all that you need in terms of being justified.

Kevin: Yes, it lacks the sentimental prop, David, here in the West, by guys who manage paper money. It doesn’t lack the sentimental prop over in the East.

David: True enough, true enough.

Kevin: We’re seeing that happening right now.

David: We’re down 24% for the year. Silver is off more than that for the year. We’ve gotten here not on the basis of liquidations of physical metals, but on the basis of a paper trade pushing it lower. Again, I think a retest in the $1200 range. What do we get to on the lows? $1178? $1184? We touch that level again and hold? I think you are going to see a massive short covering, because there is an insecurity amongst shorts. Is it going lower? If so, we are going to make more money. If it’s not going lower, we need to close out our position, and there is a race to the exits. You don’t want to be the last person to exit a short position.

Kevin: They call that a short squeeze, and those things can be miserable.

David: If you look at how fast things improve, particularly in a space like the gold market, in 2008 the recovery was less than 90 days, and you are talking about covering more than $300 per ounce in that time frame. It wouldn’t surprise us at all to tack on $500 in a 6-month period of time.

Kevin: So the demise of the gold bull market is premature.

David: Yes, the death of the gold bull market is premature – to announce that at this point. Look through the slides, study them, appreciate the perspective we are coming from, and if you have questions, feel free to talk to anybody in our office, and figure out where you are in this process. Wealth generation, wealth transfer – we see a tremendous amount at risk in the bond market, a tremendous amount at risk in the U.S. equity market, as well as the emerging equity markets. We see a tremendous benefit to having a gold and silver exposure, and at these prices, we would consider allocating aggressively to the metals.