March 23, 2011; The Land of the Rising Yen

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: David, we talked a little bit about the Japanese crisis last week, but I have been asked several times, and when I was on the plane the other day, someone who was not even financially aware was asking, “Why in the world would the yen be rising during a period of time when Japan is at one of its greatest crises?”

David: Kevin, the Japanese crisis does not explain why the yen is appreciating, and there are certainly a lot of things in the background that we should cover for that to make sense, but if there is one news item that people should latch onto in the last ten days, it would have to be the G7 intervening in the yen market to keep that market depressed and to suppress its price.  They do not want it to appreciate any more.

Kevin: The G7 intervened with about 25 billion dollars’ worth of yen.  Of course, it converts into a much higher number when you convert it to yen, but the reason, still, is to depress the value of this moving-up yen.

David: I think if you asked the average guy or gal on the street why that would be, they might say, “Well, they are in crisis and they need help.  The last thing that the Japanese need is to lose an export advantage by their yen appreciating to the point where they are squeezed, they are no longer competitive in the marketplace – with the Chinese, with the Indians, with the Malaysians, with the Indonesians – in terms of finished products.”

Here is a problem with that.  We live in a world that is very self-centered.  Everyone in the world is self-centered, and the idea that we would do things strictly on a humanitarian basis, as a country, or collectively, as the G7, while that is nice, it is not realistic.  We would hope that would reflect the heart of man.  It, in fact, does not.

Kevin: Sure, there may be certain things that are being done out of the heart, but as far as the tens of billions that are going into this yen intervention, that is purely self-serving.  Am I right?

David: Correct, and we will get to that in a minute, because the bottom line issue is one in the derivatives market, and we will talk about what could have been last week, and still remains an issue of complete destabilization within the financial system.

Kevin: David, one of the things we know about Japan is that their interest rates have been low for a couple of decades now.  In fact, not just low, but almost at zero.  Don’t they call that ZIRP?  Zero interest rate policy?

David: That is right, Kevin.  Essentially, what you have, in the context of zero interest rate policy there, and now in the United States for nearly 2-1/2 years, is the setting of the stage for bubbles.  When you have rates that low, you misallocate capital, and you end up increasing systemic risk significantly.  Since 2008 there has been an unwind of the yen carry trade, and we will talk about what the carry trade is, why it has been unwinding, in a minute.  But essentially, this low interest rate environment has been in place for the Japanese, certainly lower relative to the rest of the world, if not in nominal terms, since about 1989, since the stock market crackup there.  Low rates, ample liquidity, and you have the debt-to-GDP figures in Japan, which are north of 200%.

Kevin: Wait a second.  So their GDP figures are half of what their debt is?  Reinhart and Rogoff argued that at 90%, that was a threshold that was critical to economic stability.

David: And the Japanese have gotten away with these high levels of debt relative to GDP for a couple of significant reasons.  One stabilizing factor for the Japanese is their high domestic savings rate, much of which finds its way to government paper.  Their debt is domestically financed, which is a critical variable, and it is in local currency terms, which is another stabilizing factor.  Both of those things play to their advantage.

Kevin: Explain what you are talking about, because not all debt is domestically financed.  How would that play to their advantage for the Japanese?

David: The difference is, if they were financing that in foreign currency terms versus in yen terms, the currency fluctuations somewhere else in the world may impact their ability to pay.   They are really in control of their destiny by having their debt denominated in yen, just as we in the United States have our debt denominated in dollars.  But there is something interesting that has happened to their savings rate.  Historically, it has been between 10-20%, and over the last 5-7 years, it has tapered to less than 3%.  Part of that is demographically driven, but there are a number of variables which are taking their historically high savings rates to lower levels.  The old way of financing Japanese imbalances will, in fact, in the future, have to change.

Kevin: That brings us to the question that we started with:  How can the yen be appreciating, in the context of the earthquake, the tsunami, the nuclear incident that is going on right now, so much so that for the first time in 11 years the G7 nations are actually pumping yen into the system?

David: That is a good question.  Why are we discussing savings rates?  Why would we discuss debt levels in relation to Japan?  What we are interested in is the carry trade.  We are interested in the variables of risk within this so-called carry trade, and we are interested in the parallels between the U.S. and Japan, as we now share a common monetary management style, where we are keeping the same kind of policy in place – keeping rates low, and allowing cheap money to permeate the financial system in the hope that it will, in fact, filter through the banking system and into the larger economy.

Kevin: Dave, in a moment, I am going to ask you to explain in simple terms what the carry trade is, but there is something else on my mind.  The Japanese are the third largest holder of U.S. treasuries.  That is something that we cannot really afford – a flood of dollars into the system.  Is there any chance that the Japanese will sell treasuries into the market, thus depressing the dollar even more?

David: The issue there is, really, if that is the place where they would pull money with which to rebuild from this great tragedy, both the earthquake, and the tsunami.

Kevin: Do you think that will happen?

David: I do not, Kevin, for one very clear reason.  They cannot afford, for a number of reasons that we will get into, to have their currency appreciate further, or at an advanced or fast rate, and that currency appreciation would occur in the process of selling dollars and buying yen.

Kevin: So, it would depress the dollar, it would raise the yen versus the dollar, and it would make them noncompetitive – semiconductors, automobiles, that type of thing.

David: Not just an issue of noncompetitiveness, and we will get to this in just a minute, but there is an acceptable amount of volatility, either up or down, within the currency, and that is what has been challenged.  It has been appreciating too far.  It has gone too far, too fast.

Kevin: Then that takes us back to the carry trade.  What is a carry trade?

David: It is basically this.  You borrow a currency, assuming a low rate of interest, which is preferred.  You could look at a market like Japan or the U.S.  You borrow a currency, and then you sell it to buy another currency with a higher yield.  Essentially, if I am borrowing from the Japanese with virtually 0% interest, and buying 10-year U.S. government bonds and collecting 3.5%, I am going to make 3.5% on someone else’s money.  I am borrowing it, virtually for free, investing it, getting the proceeds of 3.5% back – that is a carry trade.  Whenever you are using someone else’s money and benefiting from it, it is a version of a carry trade.

Kevin: I have also heard that these carry trades can grow much larger than the original borrowing that occurred, so is there leverage that plays into this, as well?

David: Typically, if you are involved in a currency carry trade like this, you will add leverage to the trade.  Five or ten times leverage is pretty common.  So, at 3.5%, let’s call it 4%, on borrowed money, times the 10-to-1 leverage on the trade, and with someone else’s money, you can collect 40% a year.

Kevin: So why isn’t everybody doing it?  Is there a danger to this that we are starting to see unfold?

David: Sure, there are variables that you have to watch and this is where not just anyone will participate.  You have to be keenly aware of these variables – how they move, and how they can impact you negatively.  First of all, you have interest rate movements which can create fluctuations in fixed income asset values, so that interest rate fluctuations are one critical risk variable to keep an eye on.

Kevin: There is also the currency fluctuation, isn’t there?  That is what we are talking about, trying to keep the yen from appreciating.

David: Exactly.  For example, if you borrow in yen and then go invest in some other currency, and that currency begins to appreciate, you have to pay back the loan at an appreciated level.  Equally important is the currency that you then go and invest in.  You have borrowed in yen.  If you go invest in dollars, what happens if that currency depreciates?  You have the potential dual-currency risk:  Appreciation in the currency you borrowed in, and depreciation in the currency you invested in.

Kevin: So we have the interest variable, we have the currency fluctuation variable, but these people are borrowing to go do something with that money.  Is there a variable as far as the payout on the investment that they are spending that money on?

David: Exactly.  An investor is going to assume that the asset that they have chosen to allocate capital to is a winner, and that they are betting correctly on the market.  So a third variable of risk is that the investment they have chosen, the vehicle they have chosen, should be appreciating instead of depreciating.  It should be going up in value instead of down.

Kevin: Has the yen been a stable currency that people could count on for this carry trade, or has it been rising or falling outside of the context of what people would expect?

David: Let’s look at the period of 2008 to present.  As the world has made strides to de-leverage, and de-risk, if you will, portfolios, the funding currency of choice for the carry trade has been the yen, at least for the last ten years or more, and instead of yen being borrowed, sold, and the proceeds going to purchase another currency and another asset, you now have the reverse happening, where those loans are being paid back, which means that yen have to be purchased, and the loans repaid.

Kevin: Is that what is creating the increase in the yen?

David: Correct, and it has been doing that since 2008.  The yen has appreciated close to 40%.

Kevin: Wow!  40%!  I thought this whole carry trade was resting on the original currency not appreciating.  40% is huge.

David: It has been a significant move and I think what defines this period from 2008 to the present is that it has been done in modest steps.  It has been done in a controlled range, and it has not been extreme appreciation or depreciation one way or the other, so that it has been a predictable variable for people involved in the yen carry trade.  But with every up-tick in the yen, you have the carry trade participants having to consider the cost of paying off their loan at that new elevated price level, so as the world cuts back on both leverage and risk, it is no surprise that the yen has been on the rise.

Kevin: David, you are saying it is no surprise that the yen has been on the rise, but why?  Why did the yen tick up here over the last couple of weeks?

David: Kevin, there is certainly a short-term burst of demand for yen, the actually currency, in the context of the crisis, but we also are coming into the government’s year-end, which is March 31st.

Kevin: So the tsunami was bad timing.

David: It was, and it is not uncommon for corporations to match up their year-end with the government’s year-end, so you do have some repatriation of proceeds from foreign transactive business now coming back and being translated into new yen purchases.

Kevin: David, every March is year-end for Japan, so that was an expected occurrence.  That is something they could have actually planned for.  I am going to ask you why they are intervening now, but I would like to go back and just have you give a simple example of what a carry trade is to the common man.  I am not talking about the people dealing in tens of billions of dollars, but what is a carry trade on the street?

David: I have my own carry trade at present, and it is simply this:  I have borrowed from Bank of America at 4.87% for 30 years, so I have fixed the term, I have fixed the rate, and instead of paying off my house, I have chosen to carry a certain amount of debt, and on the other side of my balance sheet I have an asset that I am preferring to invest in rather than pay off that debt.

Kevin: What would that asset be if you do not mind sharing?

David: Specifically, it is gold and silver.  So, I have my own version of the carry trade, and this is the hurdle:  Rather than borrowing at 0%, if I were borrowing from the yen, I am borrowing from Bank of America at just under 5%.  Each year, I have to, on the asset side of my ledger, see gold and silver appreciate greater than the 4.875%, or I do not have what is called a positive carry.  If I am actually making greater than 5%, and for the last decade, in fact, gold and silver have far outperformed that number, to the tune of 12-18%, depending on how you are figuring it, but 12-18% puts that 5% figure, and yes, I am happy to carry some debt on my balance sheet as long as I have the asset on the other side outperforming the cash payments to service the loan.

Kevin: So a carry trade is not as complex as I think people would like to make it sound.  However, the complexities get larger when the money gets larger.  This is where G7 comes in, isn’t it?

David: That is right.  You have the expected and acceptable range of volatility.  It appears that the issue is not so much the yen appreciation as it is the rate at which that appreciation has been occurring.

Kevin: It is very rapid right now.

David: Let’s call that an acceptable level of volatility.  This would be sort of having an upward-bound and a lower-bound…

Kevin: Sort of a ceiling and a floor.

David: Right, in which market participants are not compromised in any way, that their positions can be held.  But consider the move outside of that acceptable level of volatility, what currency fluctuations or interest rate fluctuations – what I am getting at here, Kevin, is simply this:  Are there things that would trigger a credit default swap to be forced to pay?  To trigger an insurance policy, what we today call a derivatives product, which is really just an insurance policy on an underlying asset.  What would cause that trigger to happen?

Kevin: So there are points where those would be triggered and have to pay off the losses?

David: It depends if we are talking about interest rate fluctuations, if we are talking about certain variables.  Keep in mind, most derivative contracts are just that.  They are contracts, they are not things that trade on the open market.  Two people sit down at a table and at the end of a long week you have a ream, probably 500 pages long, which details who is obligated to pay what, and under what circumstances.  I think the issue here is this:  The G7 intervenes directly in the yen, because although the yen has been appreciating for the last three years, it is now appreciating at a level, and at a pace, which is unacceptable.  It is going out of that upward bound.

Kevin: And so those credit default swaps were actually written with volatility that is much lower in mind.

David: This is just it.  Whether you are talking credit default swaps related to interest rates, credit default swaps or other derivative products relating to just market volatility in general, many derivative products are used to protect against default, protect against extreme price moves, essentially insurance on the core investment.  If volatility exceeds that anticipated level, then the derivative contracts require an insurer to pay the insured, so not only do you have what we talked about earlier, Kevin, the interest rate variable, which is a risk, the currency variable, which is a risk, the investment that someone is buying on the other side of this leveraged carry trade dynamic.

Kevin: Those first three variables that you are talking about, David, those are only in play when the system is working perfectly, but what you are talking about now is when the system starts breaking down from other areas.

David: Right, and then, in the context of a carry trade, you have two new variables of risk.  One is counter-party risk, and behind that counter-party risk is the liquidity and solvency of the counter-party.

Kevin: Can those people who are insuring pay?  That is the question.

David: Right, you have the insurer who sold the protection against interest rate fluctuation, just as an example, or against catastrophic loss, or against a defined volatility parameter.  This begs several questions.  Does the insurer have the resources to pay when the payment on that contract is required?

Kevin: Didn’t we see this in 2008 with American companies like AIG?

David: Exactly.  So the next question is, how has the insurer invested the proceeds from the derivative contract?  Are those resources even liquid?  Or have they appreciated or depreciated?  In other words, you have bets behind the bets, and you are hoping that everyone has their ducks in a row.  If they do not, this is where you see concerted intervention.  This where you can expect to see the G7, not just as they did on last Friday, but on any Friday, step into the market, and create stability, because they cannot afford for there to be an unwinding of a single bad bet that can have a cascade effect.

This is the nature of the derivatives market.  This is the nature of this market where you have a bet, on a bet, on a bet.  If you begin to see an unwind with one bad trade, you may see a cascade effect into other financial institutions, into other asset classes.  So there is a key operative word here, and we saw this in play with the G7 this last Friday:  Containment is the operative word.

Kevin: It is amazing, as I am listening to you, I am thinking of the metaphor, or the allegory of what is going on in physical terms.  You have, not just an earthquake in Japan, but then you have a devastating tsunami, but not just a devastating tsunami, you now have a nuclear crisis.  It builds, and it builds, and it builds.  It started with a 9.0 earthquake, but that was not the only crisis.

David: You may say, well there is really no connection between the derivatives market, perhaps to a small degree, because you have insurers and re-insurers, different kinds of insurers and re-insurers, who are on the hook for property losses.  We are not talking about those insurers.

Kevin: This is all finance.

David: We are talking about just in the world of finance.  Kevin, the point is simply this:  There is a reason for the G7 to intervene in the currency markets, and the reason is not protecting the Japanese from a depreciating currency, because they have been allowing that since 2008 – 40% appreciation, and they are just now defending it?  I mean, has it reached a critical level, or was it, in fact, the rate at which it began to appreciate over the last week or so, that has caused it to reach critical mass?  It is the rate, not actually the nominal figure.

Kevin: So what you are saying is, it is not to keep Japan competitive, even though that is necessary, by keeping the yen lower than the dollar, or lower than these other currencies, but rather, a much larger snowball is what we are talking about.  It almost seems that what we could have had was another financial crisis like we had in 2008, where all of a sudden you have these derivatives at risk again, and it was all based on this initial rise in the yen, the need for liquidity.

David: Right, if we reach a certain critical point, it will be because we got there in a time frame which was too short for them to hedge it out, for them to create another insurance on the insurance product, a layered derivative upon a derivative.  In fact, it was the rate of change which got ahead of them.

Kevin: You have mentioned commodity indexes in the past, based in dollars.  How does that play out based in yen?

David: This is an interesting point, because it could be argued that, in fact, we have the competitiveness of Japanese products, which is in decline, in the context of the yen increasing.  I think one of the things that misses is that there is also a basic discounting of input costs with that yen appreciation.  Let me give you an example, specifically, from the commodities markets.  If you look at the commodity indexes, the CRB or the CRB, in dollar terms, we have exceeded the 2008 highs by about 8%, so we are at new levels, and we have exceeded those old highs, so we have had a breakout in the commodities prices.

Kevin: Commodities are rising versus the dollar.

David: Right, but if you put them in yen terms, you actually have an 18% discount to the peaks that we saw in 2008, so you have us paying higher prices than we have ever paid for particular commodities, and they are still 18% below the peak, priced in yen, because the yen has appreciated so much during that same three-year period.

Kevin: Let me take the other side of the coin then.  Japan is going to have to be rebuilt.  There is a whole lot of commodities that have to go into Japan to rebuild this northern tip of where the real devastation was on the island.  Wouldn’t it be better for them to keep a high yen so that those commodities and the lumber and copper and everything else that is going to go into that rebuild, are cheaper, in yen terms?

David: From an economic management standpoint, you weigh the benefits of being able to buy more of those commodities cheaply in the marketplace, set against your exports, and how competitive they are in the marketplace, but that is not why the G7 was keeping the currency suppressed.  The G7 is not trying to keep the Japanese export market alive.  States are far more self-interested than that, and we are talking about six other countries – Japan being one of those seven countries – who have far more at risk than seeing Japan lose competitiveness.

Kevin: Now, there is a strange anomaly because, out of that G7, how many of those countries actually carry surpluses?  You would borrow from a country that has a surplus, would you not?

David: There are only two, and ironically, it is the Japanese who are one of the two that actually have a trade surplus.  The only other one is Germany.  Everyone else – we are bringing money to the table that frankly does not exist.

Kevin: We are a deficit country.

David: 25 billion dollars in currency intervention in a single day.

Kevin: Where did it come from?

David: This is like the magic of the tooth fairy.  Where did it come from?  A modern monetary policy is no different than the world of the tooth fairy, Kevin.

Kevin: Modern monetary policy, really, has only been one thing.  It is printing money and lowering interest rates, which are very much the same thing, are they not?

David: True, and that is, I think, one of the things that we have, unfortunately, to look forward to because, in the present context, the U.S. has stepped in and replaced Japan as the favored carry trade lender.  In other words, what are our interest rates today at the short end?

Kevin: They are almost zero.

David: So if you look at our yield curve, our short-dated paper is ¼ of a percent.  If you are borrowing from the Fed window, you are talking about less than ½ a percent – very, very, very cheap money.  You could take that to the Brazilian real, and in short-dated paper, look at 11¼ percent.  That is interesting, and you do not even have to leverage the trade.

Kevin: So what you are saying is, the United States is actually a pretty darn good place to borrow right now, as long as all those variables that you talked about before do not start kicking in.

David: Exactly.  The stability of a dollar carry trade has everything to do with our interest rates.  They need to stay low.  If they do not, that is a problem.  Keep in mind, we do not fund the way the Japanese do, domestically.  We fund most of our debt internationally.  It may be denominated in dollars, but a lot of it is held by the Japanese and the Chinese, and countries throughout the Middle East, and now, of course, the new big purchaser of treasuries is the Federal Reserve, itself, so I guess you could argue there is a domestic component to treasury consumption.

But most of it is international, which means that there is not as much control, in terms of our interest rate environment.  You could look at the Japanese and say that the yen has been yielding next to nothing for a very long period of time.  Why hasn’t it bounced up?  It has a lot to do with the fact that the primary purchaser is the Japanese people themselves.  It is a stable audience, a loyal audience, very different than when your debt is financed internationally.

Kevin: Well, it is a surplus country.  Being a deficit country, we can only keep interest rates so low for so long without inflation.  Last week we talked about the theme being inflation, inflation, inflation.  Low interest rates and money that is coming out of thin air leads to inflation, does it not?  And the second largest economy, the up and coming superpower, is raising interest rates right now, as we are talking about lowering interest rates and pulling out this carry trade.

David: Specifically, with reserve requirements, they bumped them another ½%, so they are requiring banks to keep upwards of 20% on the books, which is a pretty big deal.  It lowers the leverage ratio, if you will, for the banks that are lending.

Kevin: Is that an inflation-fighting move?

David: Essentially, it is a de-leveraging of the markets move.  They are trying to tame things down and calm down the markets, to try to squash speculation.  Meanwhile, in the U.S., as we started by saying today, when you have a zero interest rate policy, what you are encouraging is a misallocation of capital.  What you are encouraging is speculative tendencies, which distort all kinds of markets, and that is, in fact, what we have in place.  We are not taking on the attitude that we need to fix the world of finance, and fix our economy.  We are actually in a very dangerous place, Kevin, a very dangerous place.  If you look at the last nine recessions in the United States, all of them were immediately followed with a reduction in interest rates so that we could stimulate the economy and get back to recovery.

Kevin: We had that parachute in the plane.  It seems that we have run out of parachutes, and we still have more recession.

David: Right.  You and I might as well be lined up to hit the door of the plane anyway, parachute or no parachute.  That is the problem: with zero interest rates today, we have nowhere to go.  We have nothing to do to solve our fiscal problems except print more money.

Kevin: Now, we can do that.  David, we talked about this last week.  We can do that, as long as the world accepts the dollar, and says the dollar has strength.  We talked about the Saudi royal family last week, and we talked about how we may be seeing certain things jeopardized with the discontent that is going on with the youth over in the Middle East.

David: Yes, treasury and dollar security.  When you think of the treasury market, you are thinking about stability in interest rates.  We have talked about what it takes for there to be a yen carry trade that is successful.  We have talked about the risk variables, interest rates, the currency denomination.  You do not want to see extreme increases or decreases, necessarily.  We have talked about what you are investing in on the other side.  That needs to be something of stable value, or you need to be winning in your bets.

What we have seen happen is a deterioration in the infrastructure for our treasury market.  Not only are the Chinese and Japanese not buying what they used to, but the reasons why the Middle East, another huge component in the purchasing structure of our treasuries, are not buying either is because we are not delivering the goods.  We are not providing the safety infrastructure that they need to maintain their regimes.

This is fascinating, Kevin, the Saudi king, just this last week, in desperation, is hiring 60,000 young males, and he is putting them into military service.  This is, frankly, not unlike the Chinese.  If you have too much testosterone for there to be political stability, you hire the young men and you put them to work digging ditches, marching in circles, under the guise of serving their country.

Kevin: Khadafi was just behind the curve.

David: He needed to increase the size of his military.  The Chinese are trying to take over the world with having that many people in the military.  Their one child policy has created a demographic nightmare.  They have too many guys and too much testosterone.  What do you do with an 18-24 year-old who thinks he is right about everything, and invincible?

Kevin: Don’t you think the Saudis are basically looking at what is going on in all these other countries – Egypt, Libya, Yemen – and saying, “You know what, we have the money right now…”

David: (laughter) “Let’s put these guys to work.”  “Go dig a ditch in the sand.  We are going to give you benefits for doing it.  We are going to take care of your family.”  This is desperation in the Middle East.

Just to wrap up, there are some things that here in the states we should keep in mind, too, because it is not as if we have a recovery here, and we need there to be a recovery here.  We are hoping for a recovery.  The monetary mandarins, the folks on CNBC, are certainly calling this a recovery, and yet just this last week, we had, since the home start numbers have been kept starting in 1965, the lowest number on record for new home starts!  So we do have a creation of liquidity, it is going into the financial houses in the United States.

The bank lending mechanism is broken.  Why?  Because banks make their money doing two primary things:  Servicing the consumer for consumption purposes, and servicing the consumer for real estate purposes.  “You want to own a home?  No problem, we will finance it for you.”  Your local bank is dependent on those two things, and if you do not need the money, if you are not buying a new home, if you are not willing to re-leverage your balance sheet, then guess what?  Bank lending ain’t happenin’.

Kevin: That brings up another point.  We are talking about new home starts.  Those are new loans.  What about the ones that already exist?

David: April starts a whole new round of resets for your adjustable rate mortgages.  That is frankly not going to be a very big deal in this environment…

Kevin: Because interest rates are still low.

David: But, you typically do not get the benefit of rates dropping, either.  Your rates, in terms of payment on ARMs [adjustable rate mortgages], have an infinite upside, but they usually cap the downside.  If it is at a 7%, if it is at a 6%, if it is at a 5%, they have tried to cover themselves, so that if you go into a low interest rate environment, they have a basement level return for their investors.

Kevin: How about equity in housing?  That is the one thing that keeps a person in their house, other than just loving where they live.  Equity in the home is what the bank knows is the Velcro that keeps you there.

David: I think that is one of the things where we are seeing a dual wealth effect, and they are working in opposite directions.  Most people in America have most of their assets in a home, not in a stock portfolio.  In the 4th quarter, we saw 650 billion dollars in equity evaporate in U.S. real estate.  So the housing market is now about 6.4 trillion in equity, down from just over 7 trillion in equity.

Kevin: So it is still falling.

David: It is still falling.  This is the issue.  On the other side, as a result of QE-II, we have seen the stock market pop.  If you look at the numbers from November to today, it is impressive.  The problem is, that does not help most Americans, because most Americans are not sitting with 3 million dollars in equities, they are sitting with a couple of hundred grand, or maybe 50 grand, in home value equity, and it is gone.  They did not have the asset side appreciating on the other side of their balance sheet.  They are just seeing the one asset that they own diminish.

Kevin: We have talked about the stock market not necessarily being a monitor as to whether you are recovering or not because with the bailout money – where else is it going to go?

David: Exactly.  Again, Kevin, we come back to two issues:  A zero interest rate environment sets up a carry trade, like we have had in Japan for 20 years, like we currently have here in the United States, but a carry trade sets you up for misallocation of capital, and speculation with that capital.  In addition to that, not only do we have low interest rates, but we have ample liquidity that has been provided, so we are actually doubling up in terms of the misallocation of capital, and the bubble dynamics.  These are things that are going to get unwound here in the next 6-12 months, in our opinion, and it makes a lot of sense for people to lower their risk profile as much as possible.  This is an environment where people want to get as conservative as possible in their investing, even exiting equities to the largest extent possible today.

Kevin: David, with so many risk variables out there, there are a lot of moving parts, but there is a lot of confusion in the news right now, from a day to day basis.  One day we have the nuclear situation maybe getting better, and then all of a sudden smoke appears, and then we have the yen appreciating, and then we have this market rising or falling.  A managed portfolio and a conservative outlook is probably very, very important, as far as hedging that risk.  You need someone professional who can do those kinds of hedges.

David: We have done that, Kevin.  What we have talked about today, a lot of this has already been taken into account in our managed portfolios.  But what any investor should keep in mind is simply this:  CNBC and the news networks follow these markets on a tick by tick basis.  Nothing has changed in the last ten years in terms of the larger context.  We have just gone from broke to broker, and I am not talking about your stock broker.  We were broke financially, and now we are more broke than we were before.  The problems have only gotten worse, not better.

The fragility in the stock market, the fragility in the financial markets, the fragility in the credit markets – we witnessed this last week the same kind of thing that we saw in 2006 and 2007, at the front end of a financial crisis, which has morphed into an economic crisis, trying to hold a trade together, protecting the connected, protecting the leveraged speculators in the marketplace, and it required a G7 intervention to do it.