October 14, 2015; When Bad News is Called Good News: Think for Yourself

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

“I think smart money is recognizing the degrees of risk that are in the marketplace today. You have a move to cash, a move to gold, a move to treasuries – it is a move to safe havens while safe havens are still available. That is what we are seeing as a major shift, and it reinforces that the underbelly of the market is very concerned, and that sentiment has indeed changed.”

– David McAlvany


Kevin: Dave, do you remember the time we were in New York and we had not planned, or at least I hadn’t planned, for an absolute downpour three days straight. I didn’t have a rain jacket with me, I didn’t have an umbrella, and I really didn’t know where to buy one.

David: You weren’t the only one beating their feet to Macy’s. We had to find all the gear, and frankly, cost was not the issue, we just had to have what we had to have.

Kevin: What did you pay for that cab ride?

David: And the jackets that were available, it’s just, “Okay, well, here we are in New York with need of a jacket, so swallow hard.”

Kevin: I’m going to tell you why I brought that up because your family has been in the gold business for 42 years and I’ve been with you guys for 28 years, and I’ve seen periods of time when people wanted something – they wanted gold, or they wanted silver, and they couldn’t get it. It seems with what is going on right now, Indian imports of gold, Chinese imports of gold, they are going through the roof, I mean, astronomically, and we are seeing premiums on coins and even bars starting to rise because they are becoming scarce.

David: When I was a young boy my mom told me the story of putting a trade in for a doctor. She tried to actually convince him not to do it. Silver was about $50 an ounce and this goes back a number of decades. She said, “You know, it has moved very far, very fast, why don’t you just wait a few weeks and let it simmer down?” And like most doctors I know, he knew that he knew a little bit about everything. In fact, he kind of transferred his expertise to a universal, “I think I’ve got the world figured out.” That was two days before the collapse in silver, all so many decades ago. Now, there was a scarcity of silver at the time, and what created an adjustment was the price, and the price moved rapidly. The other thing that you will find, and we talked about this a few weeks back, is that you can have an adjustment in the premium on given products, and premiums will rise as an indication of increased demand, and low levels of supply.

Kevin: I should say it is not demand necessarily coming from America right now. Look at what is going on internationally and I’d like to get into this later in the program. You have some of our main buyers of U.S. treasuries shifting out of treasuries and into gold at this point, but I just want to talk about India at this point. Indian imports this last month have just been incredible.

David: August imports, specifically, were a monster – 138 tons. And on top of that, you had the Chinese adding 16 tons, officially, 31 tons for the Russian central bank, and of course the Chinese buying began probably a month earlier than it usually does. I think because the Shenzhen and the Shanghai stock exchanges sold off so hard, 30-50%, Shenzhen being a smaller market and selling off a little bit more, I think you should look for big Chinese buying to come next year on another downturn in Chinese equities. No reason for there not to be something of a rally in those equity markets now, but I think you have the normal seasonal Chinese buying. It, again, stretches from this period through the end of February, but it was, actually, I think, exaggerated to some degree by the concerns of a selloff in the stock market.

We have seen the same thing happen here in the United States. Since the selloff starting in August we have seen, definitely, a significant pickup in demand on the street. And as I have tried to talk to various people on your commodities exchanges, they have said this: “We have plenty of product if you are talking about 1000-ounce silver bars and 400-ounce good delivery gold bars, it is just that everyone seems to keep on asking for small products, and we don’t understand it.”

And I do understand it because the reality is that a $2000 gold price, your 400-ounce delivery bar, is 800 grand, and there is not a whole line of investors waiting to sort of swap and change cash for an $800,000 gold bar. So, you end up with a limited audience with those large products. You keep a very wide audience with smaller denomination products. And I think the encouraging things that I see, the positives on the gold front are this. The silver chart is confirming a stronger upswing in the gold price. And again, silver is one of those confirmational things.

I remember sitting on the CNBC floor in Singapore and I was being interviewed alongside a gentleman who was a technical analyst and we got into a bit of a debate, which leads which. Does silver lead gold? Does gold lead silver? And he effectively made the case, based on technical analysis and looking at the charts, that silver had to confirm a move in gold, otherwise you couldn’t really rely on the gold move. And I thought that was an interesting case, and as I have thought about it over there last year, year-and-a-half, since that interview in Singapore, yes he is right, and we have a confirming stronger upswing in the gold price predicated on follow-through there in the silver market. Silver has moved up pretty considerably.

Kevin: Does that sometimes bleed into gold shares, as well? I mean, the mining shares?

David: It does. If you ever see the mining shares lagging and not following through, then you are probably talking about a very short and weak move in the gold price. But if you begin to see confirmation of the gold shares, then I think you are talking about a more significant move in the gold price. And I think that is what we are going to end up with.

So, you have Indian demand which is up, you have central banks acquiring, still, aggressively, and you have a sentiment shift. And I think the biggest sentiment shift we have discussed in recent weeks is this move away from complete and blind faith in the Fed, the ECB, the Bank of Japan, and the People’s Bank of China. It’s not that their pronouncements don’t have an impact on the market. They have, and they will continue to.

But I do believe that duration, in terms of the impact of their announcements, is going to decrease more and more as time goes on, because you have had this issue of people saying, yes, but QE1 was supposed to work and it kind of didn’t, it required QE2. QE2 was supposed to work and we ended up needing QE3. QE3 we left a year ago, October 2014. Why would be contemplating QE4?

And as conversation progresses today, that really was the dynamic we had late last week. It wasn’t the equity markets moving up on good news, it was the global economy and a really punk situation in the global economy pressing in on the brains of investors to say, “Uh-oh. Not only are we not going to see a rise in rates in October, we probably won’t see one in December, might not see one until the end of 2016, might even need a QE4.”

And as they started working themselves into a lather, guess what happened? Stock market goes up 1,000 points. Why? Because, again, the knee-jerk reaction is, worse is better, because it is going to require the central banks to save the day. I think we are going to have a very different outcome. We’ll get to that in a minute.

Kevin: Yes, sub-surface, Dave, there seems to be a shift in the confidence that we have talked about for months as far as the confidence in Janet Yellen, confidence in central banks. It was Ben Bernanke before that. At this point it feels like there are a lot of people on a bus in a foreign territory and they are realizing that the bus driver is lost, and the bus driver, at this point, is Janet Yellen. When she didn’t raise rates, that seemed to send a signal that she may be lost and without a GPS. But I want to go just to this last week, because we are starting to see very clear indications that the economy is going south, not just in the United States but worldwide. Look at Germany right now.

David: Yes, the curious developments which were sort of packed into last week, but I think have a broader importance and are very critical if you are looking at a broader context. Deutsche Bank reports a 6-1/2 billion dollar loss equal to close to 10% of net equity. That’s a significant deal. Granted, that’s one institution, but you have industrial output in Germany at its lowest in a year. “Not to worry (this is what the New York Times says), it’s merely the most connected of the world’s biggest economies due to its high-end machinery and car exports.” And not to worry is the point. Yes, of course, we should be worrying because industrial output from an industrial giant, when it begins to decline, is sending you a signal.

Kevin: Some of the pieces are coming together on Glencore. We are starting to see the numbers come in at this point, and it is looking much more dismal than even what you talked about last week.

David: We mentioned a few times in recent weeks the market finally figuring out that it’s not the 50 billion dollars in liabilities the companies have projected into the public space, it is actually about twice that. When you count in their revolving lines of credit and other credit facilities, they are right at 100 billion dollars.

Kevin: Somebody is holding that debt.

David: Yes, it leaves us with a question – “Who are the counter-patsies? I mean counter-parties – excuse me. I hate it when that happens.” (laughs) The Bank of England was last week expressing concern and talking to U.K. institutions.

Kevin: It’s not just over there, I mean, it’s here, too.

David: Well, they wanted to know the exposure of U.K. firms. What exposure do you have to Glencore? Why? Well, because you know what? When you start talking about beyond your single-digit billion liabilities, double-digit, and in this case, we just breached the triple-digit billion mark, 100 billion, who has what? Who is exposed? Who is working with them that might be put under the gun so to say? Maybe they shouldn’t have been lending so much money to a business which is very cyclical in nature.

Kevin: Including the United States banks, as well.

David: Well, that’s right. We would guess that your top five U.S. institutions have at least hundreds of millions in exposure, if not billions, but at least hundreds of millions in exposure to Glencore. Also last week you had Saudi Arabia and Norway join Taiwan, China and Russia who have already been in the process of reducing their U.S. treasury holdings. And we mentioned the central bank gold acquisitions a minute ago. It is just a curious series of events to have, not only some of our trade partners and petro dollar traders selling treasuries, but also acquiring gold at the same time.

That is very interesting to me, and I think that last point warrants a little focus. Trade surplus dollars from Asia, petro dollars from the Middle East. These are sources which have been classically recycled into treasuries, providing a very reliable source of deficit financing for the United States government. And of course, that adds support for the currency at the same time. Thus far we have seen banks and financial firms here in the United States take the place of these big financial interests overseas, as they have been selling treasuries we have had the banks and financials and individual investors offsetting those liquidations, buying those treasuries, so we haven’t had a major move in interest rates as of yet.

It is filling two purposes. On the one hand you have the regulatory capital ratios which are requiring banks to own more quality assets, but then you have also got amongst individual investors, the market concerns for safety, and so there is a move to treasuries on the basis of the volatility that we have seen since August, as well.

Kevin: Dave, there was a movie that came out about 35 years ago. It was Jane Fonda and…

David: Rollover.

Kevin: Rollover – that’s exactly right. And when you have talked about how Saudi Arabia now is selling treasuries and buying gold, that is exactly what was happening at the end of that movie, Rollover. Now, we’ve talked about the petro dollar which had always been sort of a guarantee that the dollar would have value, because Saudi Arabia was paid in dollars and the rest of the OPEC nations were paid in dollars for oil. That was part of the agreement.

Now with Saudi Arabia selling petro dollars back and buying gold, I remember the last few lines of the movie, in fact, it might have been the last line in the movie. They said, “What just happened?” They’re standing in Wall Street, all the Wall Street computers are covered. He said, “Well, Wall Street has crashed, and gold is now $3,000.” And the whole idea behind the movie, back in the late 1970’s I think it was, was what would happen to the dollar if the guaranteed buyers of that dollar stopped buying those treasuries? It was Saudi Arabia at the time. It has become Saudi Arabia and China. But they’re not buying right now, they’re selling.

David: It’s more than a thought experiment, it is a risk in real time.

Kevin: Right.

David: There is a whole host of other things that I think are important this week. Again, that shuttle item, where we’re going toward the end of the year, and where we launch into 2016, and I think it is one of the reasons why the Fed, our monetary policy mandarins, are concerned. You have wholesale inventories. What is a wholesale inventory? It is rising at the same time sales are tumbling. You have inventories which are up 4.2% and sales which are down 4.5% year on year. And at the same time we have this swap, inventories increasing and sales declining. Goldman-Sachs decides to cut their third quarter GDP growth estimates from 1.7% down to 1.5%. And they are basically saying, you have to subtract out a part of the growth in GDP because of this growth in inventories.

Kevin: When I was in school, Dave, I was a manager of a toy store, and we watched inventory very carefully because when inventory was growing, all things being equal, what that meant was our sales were down. That meant that there was a slowdown. Inventory is one of the first things that you can look at to see how things are going. Not actually bottom line sales, but how is your inventory moving?

David: So, how is it built? You know this from those days, but you can watch it in real time today. When product is created and available for anticipated sales and those sales don’t materialize, then inventory builds. You overestimate either growth into the future or just a normal demand in a given sales cycle, and you end up with corporations that overproduce, ergo, a rise in inventories. Then, following a rise in inventories comes a softness in price to enable you to move excess inventory. It is not always that you see a softness in price in a snap second. That can be on a lagging basis several months later as people start to clear inventory. For instance, you could expect some exceptional sales post Christmas, say, in the January to February season, or you might have, instead of 50% off, perhaps 70% off. If they have bought way too much inventory and they just need to get it out of there, those are the kinds of things that you can anticipate.

Kevin: Well, and you have brought out that the market now expects good news for themselves if they get bad news. You talked about Goldman-Sachs cutting GDP estimates, but you are also talking about inventories building. If people who are out buying equities see that as a slowdown in the economy, aren’t they just going to expect quantitative easing 4, 5, 6, 7 – right on down the line?

David: Yes, well, and I think that is the reality. We saw that show up in last week’s massive rally in stocks, and in select commodities as well. They appear related to an acknowledgment that economic growth is rocky enough to require more direct stimulus in the future, ergo a weak dollar, and really, for the commodities, and the commodity-producing countries, at least last week, anyway. So, on the commodity front we have not yet seen dramatic production cuts which on a lagging basis would take down your inventories of commodities and begin to support your prices.

Kevin: You are talking about the basic metals – iron, aluminum, nickel, that type of thing, right?

David: Exactly, because you could have inventory problems with commodities just like you can with finished goods. And so, you end up with commodity stockpiles that are just literally pouring out of the warehouses, and at some point, the way that you solve it is one of two ways. Either you find new sources of demand, which brings down those inventories of commodities, or you allow normal demand to slowly draw it down and just cut production so that you are not continually stuffing the storehouses with commodities. So, again, I say we haven’t seen that yet. You have iron ore, you have aluminum, you have nickel, you have copper – they continue to suffer from both slower demand in China, but also a glut of product which had been developed to meet the perpetual growth dream which was sort of a China that is going to grow at double-digit rates from now until eternity. And so, that was the emerging markets’ boom, so to say, of the 2010 to 2014 period.

Kevin: And it is not just Goldman-Sachs that is cutting down estimates of GDP, you are starting to see a lot of economists saying, “This may be a slowdown.”

David: Right. So again, this is so funny. Traders buy stocks and commodities on the idea that more stimulus must be around the corner because more economists are agreeing that the third quarter and fourth quarter are going to look ugly. “QE is coming.” We don’t doubt that QE is coming, we merely question whether the markets have already wised up to this awkward reality, that versions 1, 2, and 3 of QE didn’t bring about the Keynesian dream of – what do they like to call it? An increase in aggregate demand. And because it didn’t increase aggregate demand, what is QE4 likely to bring? Exaggerated wealth disparities via a new round of asset price inflation.

I wonder if that is even possible. I wonder if they can pursue that given the fact that we are in an election cycle and the difference between the rich and the poor is very much on the tips of the media’s tongues. And what you see is the extreme right and left drawing attention to the fact that something is not quite right, and the extreme left is certainly there to say, “Look, it’s the fat cats on Wall Street.” And we would interpret that differently. You may have fat cats on Wall Street, I don’t disagree with that, but it is a question of cause and figuring out what has caused this wealth gap and income gap and we lay it firmly at the feet of Fed monetary policy. When you create easy money policies it creates asset price inflation. The only people with assets that appreciate and incomes that go along with it are those that already have the assets, so the poor get poorer and the rich get richer, and it is not because of fat cats on Wall Street gaming the system, it is the system being gamed internally by the Fed, and they are not willing to admit that.

The reality is, in this political environment, far left and far right should take aim at the Fed and they are not. It is only the far right that is taking aim at the Fed, but really, the income disparity issue has everything to do with the Fed. Why am I mentioning this? Because at the end of the day, QE4, you would expect it. You would expect another round of stimulus sometime in 2016, except that you have politics front and center in 2016, which means, as we mentioned a few weeks ago, it may have to be the fiscal nuclear option instead of the monetary nuclear option.

Kevin: Well, the ones who never suffered from quantitative easing 1, 2 or 3 were the big banks. The big bank earnings seem to have been just fine. Now we are starting to find out that they may have been tweaked with reserves rather than actually being profits.

David: Yes, I think as you come into this third quarter earnings season, it is going to pay to pay close attention to both the technology space and the financials. These are two areas to watch. Techs should be fine this quarter, but I would watch and listen for the year-end guidance and fourth-quarter guidance. That is going to be even more important than third quarter results.

Kevin: But how about the banks?

David: Financials – according to the Financial Times this week, they have been boosting the profits – we have mentioned this, but now it is the Financial Times that get to validate it – they have boosted their profits over the last five years by creatively shifting loan loss reserves into quarterly numbers. And they are, in essence, reducing their financial buffer in the process.

Kevin: That is like spending your savings and thinking that it is income.

David: That is exactly right. So the concern now is that banks and financials, in light of a teetering global economy, will need to rebuild those defenses, save more for a rainy day, and thus see more significant revenue declines as we head into the end of the year. If the financials are seeing sort of a down-tick in terms of revenues, what does that mean for the rest of the market? I think you are going to see, again, support for this notion of a changed sentiment, where people are saying to themselves, “You know what? Whatever gains we have for the year, we just need to bank them, let’s move to the sidelines, let’s see what happens in 2016 election cycle. We’re close enough now. We need to figure out the direction of politics.” And I think, for a number of reasons, capital gets very quiet in the 2016 to 2017 timeframe.

Kevin: I know that investors are watching for profit margins and there are ways to make a profit look more like a profit than a loss, simply by, like you said, spending loan loss reserves, maybe buying back your own shares. The other thing that they can do, though, is they can start reducing the work force, they can start cutting back, and that also looks like a profit, even though there is shrinkage.

David: The Wall Street Journal this week discussed the focus that investors will put in this earning season on profit margins. And you have had revenues which have failed to increase in recent quarters, and so the issue now will center on whether corporate managers have the ability to cut costs further. You have sales for the S&P, companies which are forecast to decline by 3.4% compared to last year, and we have already had two consecutive quarters of revenue declines amongst your S&P 500 companies.

So, looking toward year-end and 2016, sort of future expectations, further cost-cutting is going to be critical. But you are right, this brings us to the jobs issue, and this has been sort of the litmus for Fed policy success. It has been, “Okay, well how are we doing?” Well, look at the U3 number, it has gone from 10.2 to 7.8 to 6.5. Now we are at 5.1%. That is the U3 unemployment number.

Kevin: I have had several clients who are very nervous. They may have been employed for many years and they said, “I’ll know better about my employment prospects after quarter three is over. In other words, they may lose their jobs.”

David: Well, irony has a space here. The brightest note of the day, the jobs number, is really not that bright if you are working for Caterpillar as they lay off 10,000 people, if you are working for ConAgra which is cutting 1500 office jobs – your higher paying jobs, I might mention. Monsanto, 2600 jobs, and they have also announced a 3 billion dollar accelerated share buy-back – talk about gaming earnings per share numbers, there we have it again. Walmart is canning 450 people at the headquarters. Again, that is high-paying jobs. We have Target letting 2700 people in corporate positions go. We have Whole Foods – Whole Paycheck – as some people know the store to be – 1500 employees. ESPN, 200-300 employees, and I thought football season was just getting going – that doesn’t make sense to me. How can ESPN be letting people go?

Kevin: This is their peak season.

David: We have all kinds of things happening. Viewership, I would assume, is still pretty good. HP, last month, added 35,000 new job cuts, that is new jobs cuts, and 35,000 is actually a significant number. AMD, Advanced Micro-Devices, is reducing its work force by 5%. Marvel is dumping 17% of its employees. Seagate technologies is letting go over 1000, about 1050 people.

Kevin: Well, and look at Microsoft.

David: And all of these cuts follow on the heels of Microsoft’s announcements of 8,000 job losses, QualComm is reducing their work force by a total of 15%, and you have a few other tech companies, EMC, NetApp, Lexmark. Again, the 5.1 is a really good number as long as we are working in the rear view. If we are looking forward, we are saying, “Um, actually, there are some issues here.” And the only way the corporations are going to be able to improve their earnings and numbers moving forward is a focus on profit margins, which means they are going to cut as much to the bone as they possibly can.

What does that mean in terms of the jobs picture? Well, it doesn’t leave much in the way of good news. Also, lest I forget, going back to that 3 billion dollar accelerated share buy-back by Monsanto, Johnson and Johnson is throwing their hat in the ring on share buy-backs, as well – ten billion dollars, using about a third of their total cash, to buy back shares. I will have you know Johnson and Johnson is not selling at a discount, it is not a cheap stock, and that is par for the course. Most corporate execs, when they go buying their shares, it is usually at all-time highs.

Kevin: But it reduces the shares out there and so what it does is it increases the profit per share. You have explained that many times, but I think it is important to understand why they are doing what they are doing.

David: That’s exactly right. So, the share buy-backs, it improves the numbers, it doesn’t improve the revenues, the sales don’t necessarily increase. But I will have you know Johnson and Johnson did get a free pass on having awful revenues – covered over that and actually beat market expectations because they were handed a lower tax rate. What a beautiful thing to be getting. It is almost like Christmas in July. “Here is your lower tax rate and it turns very negative numbers to very positive numbers.” We have talked about technology is in a tough spot. Corporate execs are going to be doing anything they can to maintain their margins.

Kevin: You have been talking about emerging market currencies and how they have just been in freefall. Strangely enough, and this came right on the heels of Janet Yellen showing a lack of understanding or feel for what is going on in the markets, now you have these currencies going up and the dollar going down relative to them. I’m talking about the Brazilian currency, the Indonesian currency – some of the currencies that really have taken it on the chin now are rallying.

David: Yes, and again, we go back to the activity last week and it is very interesting. The consensus grows that, “Oh, we’re not going to be able to hike rates. Oh, we may need QE4. And Oh, by the way, that is dollar negative.” Well, if it is dollar-negative, then sure enough, the dollar shed a few points, Brazilian real moves up 4.3%, the Indonesian rupiah recovers 8.4% of its losses. And by the way, Indonesia – I have a brother lives there, this is very important to me – Indonesia has a brewing corporate debt problem, which is likely to throw them into a financial crisis in 2016. It is called a 42 billion dollar corporate rollover. It is a massive rollover in a very tough context because the rupiah, their currency, has absolutely been slaughtered over the last two years. So, with the devaluation of the rupiah, you have this rollover which centers on debt – how many times have we talked about this – debt denominated in a foreign currency, all 42 billion of it, which comes due in the next 12 months. So, more corporate pressure in Indonesia.

Anyway, back to the currencies – rupiah recovered 8.4%, was up 8.4% last year, the ruble was up 7.4%, again, as the dollar shed two points. And why did the dollar shed two points? As we’ve said, worse is better. And that’s not a Lenin quote, that’s what happened to the market last week. The Aussie dollar is up 4.1%, the New Zealand dollar is up 4%, crude oil is up 8.7%. Again, it’s not on good news. It’s on speculation that the Fed will do nothing in terms of raising rates, and may, in fact, implement QE4. Only, they might get beaten to the punch if the Chinese offer some sort of market intervention themselves, which is, of course, yet to be announced, but not only presumed, it is hoped for, it is dreamed for, it is prayed for, and that is the confidence you should be putting into your market portfolio, your equity portfolio, because the major operators are dealing on presumption, hope, and prayer. Wow.

Kevin: Who would have ever thought that “Go buy stocks” is the order of the day when you hear that the economy is falling apart.

David: (laughs) So, we’re facing a rocky earnings season. There may be more of this sort of “bad news is good news.” Does QE4 repeat the cycle of asset inflation and economic wage stagnation? That has been the issue, we have had wage stagnation even as the cost of goods has gone up and the cost of assets has gone up. And as I mentioned earlier, I think it is much tougher to pull that off. This time around I think the Fed is going to be much more politically constrained. As much as they would like to, people are connecting the dots to income and wealth disparity, and if the Democrats are champions of QE4, if the Republicans are champions of QE4, they may lose the election, as the issue becomes social revolt over the rich becoming richer. The wealth gap is front and center and so I think the Fed is somewhat hog-tied.

Kevin: Not only are they hog-tied, but people are losing faith in them. Fisher, himself, last week he brought out – he said that monetary policy has pretty much been played out, but he’s not the only one.

David: No, the head of Macro Strategy at State Street Corp, Lee Ferridge, is quoted by Bloomberg this week. “There is a lack of faith, he says, in monetary policy. You’ve thrown the kitchen sink at it, you’ve cut rates to zero, you’ve printed money, and still inflation is lower. It leads to a risk-off environment.” As we have been saying, again for some time, what is different this time is the level of confidence. It is diminishing. So the same commitments, if made by the Fed, the same kind of radical measures taken may have a very different outcome this go-round.

Kevin: We’ve been picking on John Maynard Keynes, and I want to continue to pick on John Maynard Keynes because he was just a socialist as far as I am concerned. But to be honest, we have been in a monetarist policy. We should be picking on Friedman, because really, this whole central banking theme that we have been looking at since 2008 has been a monetarist exercise. I remember in economics school when I was there, they said the easiest way to determine the difference between Keynes and Friedman is this. Friedman believes in the manipulation of money – period. That is what he is looking at for controlling the economy. Keynes had two elements. There was the manipulation of money called monetary policy, but you also had fiscal policy. Now, we haven’t really experienced much in the way of fiscal intervention here in our lifetimes, but that could come back in. That is very similar to what happened in the 1930s and 1940s.

David: Yes. Deficit spending, that is, solutions via the governmental purse. I think that is going to become front and center 2016 and 2017, you have political cover for it. You can simply contrast the rich and the poor. You can say we’re doing our very best to avoid deficit spending. We’re going to increase spending but we’re not going to do as much deficit spending, and that proves that we are responsible from a fiscal standpoint. The way we are going to spend more without going into the hole to do so, yes, we are going to increase taxes on the 1% – again you have political cover for this – and you initiate your works program to generate jobs and increase economic activity. The economic activity will pick up, but it’s not really private sector economic activity.

Kevin: It’s government driven.

David: It’s not via entrepreneurial endeavor. Get ready for the infrastructure spending days of the 1930s and 1940s, and when government project spending, when that kind of spending becomes – let’s call it the policy expression of “choosing winners and losers” – I think what you can anticipate is that capital, that is, people with money, are going to get very quiet. Capital is going to hibernate for some time.

Kevin: Capital goes dormant when either it is not earning a safe relative rate of return or there is uncertainty in the market. Now, the central banks have been providing so much certainty over the last few years.

David: But beyond that, what if money becomes a political target? If money becomes a political target, it more than hides in the mattress. It needs to seek to get off the radar, and I think that is what we are moving into. In this last stage of crisis, I think we are moving toward money becoming a political target.

Kevin: Speaking of Federal Reserve uncertainty, one of the big roles of the Federal Reserve Chairman is to present an air of confidence. We had Alan Greenspan, we had Volcker before that – that was confident. We had Alan Greenspan and that was confident to the degree that he would play to the field. We had Ben Bernanke, and people thought he was confident because he was an academic and he just knew more than they did. He could always talk above their head, and even the Congressmen just didn’t really understand what he said.

We have Janet Yellen in right now, and there seems to be a lack of confidence. I want to take us back to the days before Paul Volcker, before that confidence came back into the Fed. The 1970s were a travesty as far as Federal Reserve policy, and we got to see the outcomes, which were severe drops in the stock market and also high inflation.

David: Probably the best retro on the 1970s that I have seen is by our friend Bill King, and this retro happens to overlap the year that I was born. The year I was born the AMEX, the American Stock Exchange, that index lost as much as the Dow Jones Industrial did in 1929 to 1932 – 89% was the loss for AMEX in 1974. Dow Jones Industrials was off about half that much by the end of 1974. Monetary policy was loosened at Nixon’s request to help with the re-election bid in 1972. The Fed started hiking rates in early 1973.

Kevin: And the equities crashed.

David: And equities immediately crashed. The Fed got nervous watching this crash in equities and they cut rates again because they didn’t like the selloff and because, really, the obvious nature of a full-blown recession at hand. You will never guess what happened next.

Kevin: I’ll bet you it was like the announcement of QE3.

David: Oh, well, you start cutting rates again, and compliments of the Fed you have, lo and behold, a rally – a rally compliments of Fed accommodation. Now then, there was the dark side of the intervention. Inflation to a degree that had not been seen in decades. You had the accommodation, which was before the election, the panic accommodation in the third quarter, that is sort of September-ish of 1973, which set the stage for massive inflation that lasted through the end of the decade.

Kevin: And look what gold did.

David: Well, in that context gold tripled from $60 to $180. That was just from 1972 to 1974, it tripled $60 to $180. When the Fed accommodated the second time, gold took a 30% haircut.

Kevin: That’s when they raised rates again.

David: That’s right. Kevin, we have talked about that 1974 to 1976 bear market in gold, where it dropped by 50% to $102.50.

Kevin: That’s when your dad took a walk in the woods, if I remember right.

David: He was so battered by the experience that he nearly got out of the gold business. He recounts that story of going on a day hike out near the Maroon Bells outside Aspen, and he was reflecting on the pain of the last two plus years, and he was feeling so gloomy that he came to one conclusion. The depth of frustration that he was feeling was a reflection of broken down sentiment in the gold sector.

Kevin: He always said he would be the last guy to throw in the towel.

David: And at that point he realized the bottom was in. What he witnessed thereafter was the market’s reappraising monetary policy commitments of the early 1970s, and the inherently inflationary basis embedded in them. The decline in equities did not continue at the same pace, but what you did see was that because of the increase in inflation, your real rates of return were just absolutely awful. They got destroyed. And again, as the recognition of inflation and the anticipation of more of it became obvious to investors, gold doubled, gold doubled again, and then doubled again. And this was all following the conclusions drawn from my dad’s walk around the Maroon Bells.

Kevin: I can tell you, having been employed here for 28 years, I’m glad that he came to the conclusion that he needed to stay in the business.

David: (laughs)

Kevin: You know, I’m going to bring up something completely unrelated to what we have been talking about, Dave. Why don’t you talk about your 20-dollar bill that ran through the laundry pile?

David: That’s a story of lost and found. Hope lost and refound. And the Fed this last week – this is hilarious – don’t you love it when you can’t find 2.7 trillion dollars, and then it shows up again?

Kevin: It’s got to be here somewhere.

David: (laughs) It happened to me the other day with a 20-dollar bill run through our laundry pile. I was grateful to find it again. Well, the Fed managed this feat recently as they revised our total U.S. debt numbers, and they went from 330% of GDP to 350% of GDP because they “discovered” an extra 2.7 trillion dollars in debt.

Kevin: It’s all about debt, isn’t it, Dave? You have been harping for the last year about margin debt in the stock market. Margin debt is just continuing to sit at or near all-time highs. That is always a sign, ultimately, of a crash coming.

David: And it is also an indication that the worst is still to come, not behind us. You might not like having gone from 18,500 on the Dow to just a tick below 16,000 here in recent weeks. But guess what? All you have reduced in terms of your margin debt – 506 was about the peak – we are at about 470 now. 470 –you know what? That is still a multiple of the previous peak in 2007. And what it indicates is that there are a lot more forced liquidations ahead. Forced liquidations are not particularly cognizant of price. It is just one of those desperation moves where you have to clear the account and make sure that the house gets paid before they start zeroing you out and selling things themselves to cover their exposure.

Kevin: And another thing that is a concern – margin debt is high, but cash levels and mutual funds are extremely low. If you have a number of liquidations in a mutual fund, say fear hits the market again, they will have to sell stocks to raise the cash for the liquidation.

David: Yes. It is, again, an indication of where we are in the cycle of things. You will generally see mutual funds with the highest level of cash allocation at the very end of a bear market because they have been forced to raise cash and raise cash to meet redemptions as investors get out of those mutual funds. And they get in the habit of raising cash and to see it 10%, even 12% or 15% of a mutual funds portfolio, is a good indication that the worst is behind you, and now the manager is basically managing for survival, so he has created this massive cash cushion. Nobody does that ahead of time, and as we mentioned a few months ago, cash levels got to about 3%. It has barely moved from those levels in the last few months. But you also have the VIX, which has, in the last week, settled down pretty considerably. The VIX, you remember, is a volatility index. It is an indications of threat, if you will, in the marketplace. Dow is up 1,000 points in a matter of days, and so the VIX settles down from the 20s back to the teens.

Kevin: But it wasn’t on good news, it was on bad news.

David: This reminds us of that sort of counterintuitive nature of investing today. It goes beyond counterintuitive. Again, sort of the “worse is better” scenario. It is the kind of behavior you see when the common allocation process – common – I mean very typical – is a misallocation process which willingly ignores both the context that we are in and implicit risks in the marketplace. And I think smart money is recognizing the degrees of risk that are in the marketplace today. You have a move to cash, a move to gold, a move to treasuries. It is a move to safe havens while safe havens are still available. That is what we are seeing as a major shift and it reinforces that the underbelly of the market is very concerned, and that sentiment has, indeed, changed.