The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: David, continuing directly into the questions. We said last week that we had a stack that we hadn’t gotten through, so let’s go to a question that we have been asked several times in different ways, but it really comes up about the same. Here’s the question:
Love your show. Why is gold dropping in tandem with the markets, when one would think that, with more uncertainty and growing bailouts in Europe, gold would be heading higher?
Is this strictly trying to de-leverage, or is this money going into the dollar, or is it just a normal correction, David?
David: This is a great question, and actually, we have this echoed in a number of other questions, as well, to one degree or another, and as we mentioned last week, where we see some overlap, we will just try to consolidate around that particular theme.
In a nutshell, I think we are looking at a temporary tandem move on the basis of liquidity announcements, so we are seeing a boost to all asset classes on the basis of availability of liquidity in the marketplace. More money is going to be spent in Europe, more money is going to be spent in the U.S., and all of a sudden the speculative juices are flowing, and so you do have that short-term impact, really, to all asset classes, which is changing the correlation between equities and gold, but, I would emphasize, on a very limited basis, on a very short-term basis.
Kevin: David, we talked about noise sometimes being the short-term market moves. We have looked at the Dow-gold ratio for decades, but let’s just look at the last decade. We have gone from a Dow-gold ratio, in which you divide the price of the Dow by the price of gold, of 42-to-1, down to between 6 and 7-to-1 at this point, but David, even though sometimes gold and the stock market, in the long run, go in opposite directions, you can’t count on that in the short run.
David: Right, Kevin, and looking at that Dow-gold ratio, because that is really where we see the forest for the trees, when you get too close to it, that’s when you being to lose, I think, the proper perspective on what is a major move in non-correlation. Barring 2008, and barring the present short-term correlative blip, we are looking at close to an 85% non-correlation between gold and equities, making it one of the only asset classes that is non-correlated today.
Now, here is one of the things I would also emphasize: The classic non-correlation extends to the bond market and to the dollar market, as well. I think this is where we begin to see fuel added to the fire for the gold market here in the coming 6-12 months. A significant rollover in the bond market will end up fueling the next stage of the gold bull market. What you see on a very short-term basis as positive correlation is just that – very short-term, and we would be going back to the Dow-gold ratio as a support for that.
Kevin: David, I think it is important to note that when a country goes through a currency collapse, like Germany in the 1920s, you can’t really look at the value in that currency to see what the correlation is. When we are talking about the Dow-gold ratio, we are literally talking about taking the price of the Dow and dividing it by gold, because, of course, in Germany in the early 1920s, their stock market rose just fine. Gold just rose quite a bit more.
David: Another point to make on the equity market is that this is an impact due to short-term liquidity provisions. If this had to do with liquidity impacting the equity market and changing something structurally – where we were, in fact, adding stimulus adequate to bring about a new growth cycle – you would see a reduction in the gold price and you would begin to see equities move forward. Again, the primary reason that you want to own gold in a period like this is the non-performance of equities, the non-performance of any other asset class. When you have negative, or low, real rates of return, gold is favored. If the prospects were changing for the equities market and we had a new growth trend in front of us where you would have positive real rates of return…
Kevin: In other words, the real bottom of the market that you think may come in the next few years.
David: Exactly. You would begin to see a drift, and if there was new stimulus, that stimulus may, in fact, drive the equity market higher, and gold lower. That is not the case, and I think the market understands that this is a knee-jerk response. Everything is going to get a boost, given the profligate spending by the Fed, or other central banks, and in what it acknowledges, too, is that there is no way to discern where that liquidity will flow.
It should flow into the financial market somehow, some way, but what you do have is an acknowledgement that there is likely to be an inflationary impact, and that inflationary impact is likely to hit commodities. So commodities are almost a higher beta play on equities when you are talking about these short-term liquidity spurts. Please focus on the long-term trend, though, because that is absolutely critical. It is what we have talked about before – ignore the noise and look for the true signal.
Kevin: David, you used the word beta, and I don’t know that all of our listeners necessarily understand what you mean by beta on an investment, but I think it is something that everyone needs to know.
David: Essentially, it is what we have been talking about, it just happens to be a word that is used, specifically, in this industry, and it implies correlation. Something that has a beta of 1 is directly in correlation, or directly in lockstep, with the market. So if you have a lower beta, if your correlation is less than 1, then it is going to be that much divergent from the market, or a higher beta is going to exaggerate whatever the market does.
Kevin: On the subject of having more gold than the third in the triangle at different times, maybe some in cash, some in stocks, I think we should go to Steve’s question.
David: Yes. Steve says:
I get the concept of the investment triangle and its purpose, but wonder why, in this climate, precious metals would not qualify for, not only the insurance side, or base of the triangle, but also for the liquid, or cash, side. With fiat currencies continuing to slide worldwide, in purchasing power, and the value of metals continuing to rise, I am hesitant to rebalance moving out of metals and into cash, especially dollar-denominated. Thanks for the weekly commentaries. I look forward to Wednesday mornings, and listen to each of your podcasts repeatedly.
Kevin: Okay, so David, there are times, and I know you have brought this up to me, when you treat the right side of the triangle, which is the cash side, as also a quickly liquid gold side. You have put some gold in there, if you knew you weren’t going to need to spend that money in the next two weeks. And how about even the left side? Do we sometimes invest in gold for a growth process, keeping the insurance intact?
David: I think this is one of the things that investors have to take an accurate and honest appraisal of, and this comes back to what you know, and what you don’t know. The reality is that none of us knows what the future holds. If you don’t begin the investment process with a degree of humility, you will learn very quickly just how humbling the market can be.
Kevin: And even gold can humble you.
David: That’s exactly right, and this is the point. I think it is a bad idea to overload on the metals, because you are essentially concentrating your risk around one asset class. Now, that is in theory. In practice, I have chosen to take a part of my “liquid position” there on the right hand side of the triangle, and substitute kilo bars, and something very generic – the Krugerrand is just as much a substitute. There you are talking about something that has to be the cheapest possible product on the planet.
Kevin: Yes, because you may liquidate it quickly to pay for a bill.
David: Exactly. The difference between what you paid and what you get for it really does matter if you are talking about moving in and out of a position within days or weeks or months, whereas you can take a little bit more of a sanguine view if you are holding something for 5, or 10, or 15 years, and allocate accordingly.
I generally think that it is a bad idea to concentrate your risk, on the basis that you don’t know what happens, and I am not suggesting that we adopt a blasé, or what I would consider the Wall Street cop-out of diversify, diversify, diversify. Diversification, absolutely, has its place. It does. And I think that is represented in the investment triangle. The question is, are you overdoing a good thing?
I grew up in a family where if a little was good, a lot was better. I have to pause and say, no, actually, a little is good. Period. A little is good, period. A little vitamin D is fine. A little too much, and guess what you end up with? A sunburn. Your 30 minutes in the sun per day, which is the new prescription, sans the sunscreen, is now supposed to be good for you. Just beware of getting a sunburn. A little is good, but that does not argue that a lot is better.
I appreciate the question, though, because we are really at an interesting point in time, and you need to keep those disciplines in mind, and come up with a personal solution that you are comfortable with, realizing that if you choose to concentrate your risk, you may be forced to play the patience game, and may have to adopt a regular daily dose of Maalox or Pepto-Bismol, because by concentrating your risk, you realize if you are wrong in the short-run, you will have far more volatility in the portfolio, and that is something you have to accept at the front end if you are looking at making that kind of a decision, Steve.
Kevin: David, I think it is important to talk about risk as a relative term, as well. When we talk about risky investments, there are investments out there that are paper assets that are just pure fly-by-night, and they may not even have any value in the future. No one has ever gone broke owning gold. It goes up, it goes down, and yes, maybe you have too much gold when it is going down sometimes, but maybe not enough when it goes up.
David: You know, I think that is a healthy appraisal of the psychology of being in a bull market. When you are in a bear market, you own too much of anything. When you are in a bull market, you don’t own enough. And I think that is something you have to acknowledge as an investor. Are you allowing your own emotions to take over, and the reality of potential profit? Or perhaps you are on the other side of that, and simply are looking at the potential for loss in other asset classes. Are you being ruled by either greed or fear? If you can parse that out, determine that you are making a wise decision, know what is involved in having a concentration beyond a regular allocation, then you may be in a position to deal with the consequences of those choices, which is very important. You have to own that up front.
Kevin: David, in a similar vein, we have a question from Vermont that I think was very well worded, very well thought through. As we talked about last week, these questions are coming in and you can tell we have very thoughtful listeners. This is from Paul:
Over the past year, this program has done an extremely good job addressing so many issues that this year I am having difficulty coming up with questions you haven’t already answered. But recently, you have talked about the need to focus not on liquidity issues, but instead, on solvency issues.
The institutions that are the most obviously bordering on insolvency are large banks and governments. Do you see these solvency issues, and the corresponding counter-party risk associated with them, extending beyond these current suspects? For example, do you see credit unions, or traditional conservative insurance companies, being touched by insolvency? What about other industries, seemingly unrelated to finance, like Apple, or Google?
Also, could you explain the distinction to be made now between a precious metals base and a cash base, in relation to the triangle? As fiat currencies begin to devalue, I see great difficulty in cash instruments having the ability to perform their mandate to be available for buying opportunities. In this environment, what advantages do cash instruments have over precious metals in fulfilling this mandate?
Thanks, as always, for your incredible insight and the thoughtful questions you pose to the wide range of experts on your program.
Thanks, Paul, for the question.
David: Diving into the first part, with the current suspects, banks and governments, and that does get extended to credit unions, and even insurance companies, I think this is an issue where you have to know what is hidden under the carpet. We know that there are a few insurance companies that have looked at the risk in the marketplace and have taken an accurate appraisal and have positioned their portfolios accordingly. For them, that means they have less than 1% exposure to gold, and they still have 99% exposure to paper assets.
Kevin: Look at Northwestern Mutual.
David: We are talking about some institutions that I think will survive, but the question is, to what degree are they impaired in the process? The mutuals are, obviously, much more stable than any other insurance company, but I think you will find a tremendous amount of leverage in their portfolios, a tremendous amount of illiquidity, particularly in the insurance companies, where they have been enticed into private equity. They have been enticed into a number of new venues, hedge funds and private equity, primarily, and are hoping to derive a greater rate of return on that basis – new allocations. So they have, in fact, compounded the risk over the last ten years, not reduced it. Again, for the few that have, in the instance of Northwestern Mutual, taken on a gold position, it represents such a small share of their total assets. While it is there, and I am glad it is, it is token, at best.
Kevin: Don’t you think it telegraphed, though, that they are thinking that way, a little more than some insurance companies?
David: Absolutely, absolutely, and I think that makes all the difference in the world, in terms of who survives and who doesn’t, because this is an environment where, certainly, if you are related to finance, if you are related to the investment worlds, if you are tied to what happens to the U.S. currency, or your ability to finance on cheap terms – yes, you will be impacted, and that does go beyond banks and governments, and it does eke into the corporate world, as well.
Kevin: So, an Apple, a Google, a 3M – you talked about 3M last week – solvency is something that nobody wants to see go away.
David: But the issue, really, with some of these institutions, nonfinancial, that are actually producing something, or have a service that is very attractive, is that they have revenues to offset losses, and in fact, don’t need to finance their operations.
Kevin: They are making widgets.
David: Yes, they are making widgets, and have balance sheet strength. Frankly, the greater risks are with banks and governments, more than corporate America, or any other corporation around the world. I am not saying that you won’t see share prices dive over the next several months or years in the general equities markets, but we are talking about the difference of being able to survive intact, and actually come out with a product that is still attractive. This is the issue: If you think of Campbell Soup, their shares actually did all right during the great depression. They were actually able to reduce the water content in the can and increase what they could deliver in terms of calories to the end person, and increase profits in so doing. This is the difference. Corporations are compensated by thinking outside the box and coming up with creative ways to survive.
Kevin: As opposed to lending institutions and banks, that type of thing.
David: Lending institutions and banks are also creative, but they are subject to an increase in the cost of capital. That is out of their control. There are variables that they cannot control, which can cause their demise. Governments – guess what? You don’t have creative, out of the box thinking. The bureaucratic red tape that we see, even in certain emerging market giants today, you would say that is not the case in the U.S. Clearly, we are a well-oiled machine. Look at our gross domestic product. Look at the size of government. We have a large institution that requires so much capital just to feed itself – the concept of leviathan. They are not interested in changing. They are interested in existing and growing. Actually, they are interested in existing and growing just like any other corporation, they just don’t have to be creative about it. They can be confiscatory instead of creative, and I think that is one of the underlying problems.
Kevin: I think that takes you to the second part of the question, David. Again, this motive to confiscate wealth, whether it is through inflation or the stimulus money, printing of money, however you want to put it. The second part of the question is asking about liquidity and how liquid and how viable cash will be in the future if the government continues on the path that it is on.
David: I think this is maybe the question for the long-term investor versus the short-term trader, and there really is a different response mechanism here, because the long-term investor is going to be wrong on this in the short-run. You can come up with an appraisal that says, “I don’t want to be in dollars, I don’t want to be in fiat currencies of any kind, because ultimately, I think they will reach their demise.” Just understand that you may be dead-on, you may be absolutely correct in your long-term conclusions, and the market may correspond with that.
Guess what? In the short-term you may be wrong, and you are going to have to decide whether or not you are comfortable being wrong in the short-term, because what you cannot underestimate is the trained behavior, the recent muscle memory trained into Wall Street managers, which is, when you need liquidity, even if you are concerned about solvency, where do you end up going? You end up going to the deepest capital pools possible, and that does mean the Treasury, that does mean the U.S. dollar. Even though when you are talking about solvency issues, yes, we are talking about balance sheet bankruptcy, that still does not get around the trained behavior, again, what we were describing as muscle memory, trained into Wall Street practitioners.
So I think in the short-run, you can see an additional run-up in Treasuries. In the short-run, you can see an additional run-up on the dollar. But what we are watching right now, Kevin, is evidence to just how that is shifting over time. We are not seeing the same volumes that we did in 2008, coming into the dollar. We are already at elevated levels in the Treasury, and we have yet to see a rollover in equities. So, from what point do we go, if we do see a rollover in the equities market, you are buying high in the Treasury space? Are you convinced that there are people going to be buying even higher, and even higher, at these nosebleed levels?
Kevin: Not just in the paper markets, but David, let’s just hypothetically look at real estate – a property that you have been looking at for a while, let’s say it has dropped 50, 60, 70%, and you need liquidity that you probably should have kept in dollars, short-term. If you knew you were going to buy it soon, you probably should have kept it in dollars. But no, you had it in gold instead, and now you sell that gold for that piece of real estate. If you are selling early, you made the wrong liquidity decision, did you not?
David: I think there are a couple of factors there, Kevin, and I don’t want to diverge too far from Paul’s question, but with real estate you are talking about supply and demand, and the areas of the country which have been hit hardest, have been hit hardest on the basis of an over production of supply. There is just too much on the market, and it has to be chewed through. But what that neglects, if you are out there buying value at these levels, is the re-pricing of all those assets. Even if they are on sale today, everything gets re-priced as the Treasury market gets re-priced, and as yields begin to increase. Is that in the next six weeks? Is that in the next six months?
Again, we are already at nosebleed levels in terms of the price of Treasuries, which means we are in the bottom basement levels for yield. We see an increase in bond yields as a response to the world appraising risk in the Treasury market differently over the next 6, 12, 18 months. Maybe I’m off on the timing. I’ve been off for two years on the timing on this, Kevin. The reality is that the turn in the interest rate market has surprised me in terms of how long it takes.
Kevin: Your tax dollars have been what has kept that interest rate market down, Dave, so it is not being wrong in the timing if somebody is messing with the system.
David: Direct monetization of Treasuries is certainly responsible for suppressing yields at this point, so where would yields be today if not for suppression of those rates by the Federal Reserve? And I guess the same question can be asked, “Where would the price of gold and silver be today if the CME hadn’t changed rules at a strategic point?” They were very effective, probably more effective than they anticipated being.
Kevin: But they can’t control it in the long-run.
David: That is exactly right, and so the trends, whether interest rates or gold, I think, are compelling – one to avoid, one to very much participate in, because nothing has changed, in terms of the trajectory of either of those markets.
Kevin: David, here is an interesting one. Let’s go ahead and go to various currencies, the topic of other countries. Here is the question:
First of all, I would like to congratulate you on your show. I think it is excellent. Thank you.
As I understand, you are open to receiving questions from your listeners, I wanted to take this opportunity to ask if you have ever done some sort of study on the main currencies of the world to see which ones have more “backing of gold,” although I know, in reality, no currencies are backed by gold these days.
I hear you often speaking a lot about the Fed, and saying that the U.S. is printing too much money, and it definitely looks like that is the case. However, I just wonder how the Fed’s monetary policy compares to other central banks around the world. I came across an article today which suggests the Bank of England has been increasing its balance sheet substantially, more than its U.S. counter-party, and if the sterling pound was to be fully backed by gold, an ounce of gold should cost 30,000 pounds.
I was very surprised to see some of these graphs. So, I wonder, how much “backing” of gold does the dollar have, and what would be the price in dollars for an ounce of gold if the greenback was backed fully by gold? What about the Swiss franc? What about the euro? It would be interesting to get your views on this subject.
David, this has to do with gold reserves of countries. Even though the currencies are no longer tied to gold, is there something we should be looking at as far as the reserves of these countries?
David: Kevin, I think, certainly, the gold reserves of any given country add balance sheet support. That was one of the reasons why the Swiss franc, for years, was considered a “hard currency.”
Kevin: Even though it wasn’t fully backed, they had a lot of gold.
David: That changed within the last decade. They still have a small gold backing, but nothing like it used to be. The euro has a small gold backing, as well. The U.S. dollar has a small gold backing. Relative to our liabilities, it is insignificant. This is a helpful illustration because, essentially, the method used in 1933 by FDR to back our liabilities, when he confiscated gold, brought in the metals, and wanted to assure, and created a two-tier system for our currency.
Kevin: Sure, the Europeans knew they could trade dollars in for what they were worth in gold.
David: Right, but that was not allowed domestically. So, what he did when he bought gold from the general public at $20-21 an ounce, and then turned around and pegged the price at $35, he ran the math. Very simply, how do we back all of our liabilities with the reserves that we have? And we are going to put gold at that price. It was an essential downgrade of the U.S. dollar. It was a devaluation by close to 65%. But it gave our foreign creditors the assurance that, on a balance sheet basis, we were, in fact, in balance.
Kevin: If we had somebody step in right now who said, “I’m going to fix this dollar problem. We are going to revalue gold to the amount of dollars that we have printed.” What would we need to put gold at, David?
David: Over $11,000 an ounce. There is an interesting correlation here. Yes, whether it is 30,000 pounds to offset their liabilities, or 11,000 dollars, or more, to offset our own liabilities here in the U.S., we are talking about very significant numbers. I am not sure that is going to happen. Just because that was the method used in 1933 doesn’t imply that it is the method that would be used today.
Here is the issue, though, when you are looking at relative strength or weakness of currencies. Let’s say, for instance, that the argument is made, “I like the Canadian dollar,” or “I like the Swedish krona,” or “I like the Australian dollar, better than the U.S. dollar, because they are resource-based economies, and therefore, I would rather have exposure to their currencies than the U.S. dollar.”
There is strength and weakness in that argument. The strength of the argument is, yes, in fact, they have tangible assets. They have the underground substructure asset that does legitimize their currency, and it means that they may be the better currency to own when all the dust settles. But the problem is this: You are really talking about having a relative winner. In absolute terms, you can still lose money. The dollar takes a hit by 30% and they take a hit by either more or less, mainly because in the environment where you assume the dollar is cratering, it is also an environment where you can assume that global GDP is contracting.
Now, what is the cash flow into those countries? It is on the basis of those natural resources which they are selling in the open market. So, you see, if you view the currency as something of the stock of that country, and they are losing cash flow significantly because global growth is contracting, and international trade is in decline – then guess what? The shares of that country are going to decline, too.
All we are saying is that on a balance sheet basis, you do have greater strength in those countries, and they are likely to survive. But that doesn’t mean that in absolute terms you are not going to lose money. You are only a winner on a relative basis. So, again, you may lose 10-15% in the Canadian dollar, and 25-30%, or if we actually end up in an extinction event for the U.S. dollar, then yes, you did much better being in those foreign currencies, but that doesn’t mean when you look at your statement that you are not going to be seeing red.
Kevin: David, one of the things that we have seen through the decades of watching people try to get into various currencies for protection, is that, more often than not, the politics of the country, itself, actually has more effect than the resources, more effect than the markets, or inflation/deflation. It is almost always some political change that causes people to say, “Oh, my gosh, I had the safest bet out there, and now it’s a horrible loss!”
David: For simplicity’s sake, if I was looking for a foreign currency, I wouldn’t look at the Swiss franc just because it has gold backing. If the only reason you are buying the Swiss franc is because of its gold backing, then just buy gold and forget the Swiss franc, because then, you don’t have to worry about the Swiss National Bank, you don’t have to worry about the fiscal and monetary authorities who can change the direction of the currency in the short term, while you thought you had a good bet going.
Eliminate the people risk. Eliminate the Ph.D. risk. Eliminate the management risk of a currency, and own the currency which is not subject to those variables. Again, for simplicity, if you are looking for a foreign currency, I would probably choose gold bullion over something even like the Australian dollar, or the Canadian dollar. We have allocations to those currencies at times. We don’t today. We might tomorrow. But again, we take a mature perspective, that we are comfortable being relative winners, even if in absolute terms, we do see a loss.
Kevin: And David, you have a staff of people who do this all day long, and have done it for decades, and so this is not something that, for the person who just comes in and checks their portfolio every couple of weeks, they want to be playing in other currencies, do they?
David: We mentioned the Brazilian real a few weeks ago. They have moved interest rates up to astronomical heights. For the fixed income investor, and perhaps the neophyte coming into the fixed income space, they look at U.S. yields and, “That’s not a very attractive yield, I’d rather buy Brazilian real yielding 10-12%.” Well, guess what? As they have lowered rates 50 basis points, and again recently, 50 basis points, what happens to the currency? You see a 20-25% decline in the value of that currency in less than two months.
Kevin, that’s very interesting. When you begin to chase yield, yes, you can find that there is, in fact, greater risk attached to it. That is one lesson to learn. But the other thing is, you cannot think, as an investor, in generalities. “Brazil, the bread basket of Latin America, surely, on the basis of natural resources and trade with China, it is a sure bet. I’d rather own that currency than some bankrupt old maid like the U.S. dollar.” Well, guess what? The U.S. dollar has actually fared better in the short period of time, than the Brazilian real.
Again, back to that question of time frame. If you, as an investor, are willing to say, “I can make a bet for the long-run, and I don’t care about the short-term volatility,” you may be comfortable in taking foreign currencies into the fold, into your portfolio, and you may be proven right in the long-run. My view is that foreign currencies are to be traded, not to be invested in. There are short-term opportunities that make sense, and can boost yield within a portfolio, particularly in the liquid part of an account, but playing currencies on a long-term basis, you are at the end of the whip, and that whip is controlled by the fiscal and monetary authorities, just the same as the U.S. dollar is by the Fed.
Kevin: It reminds me of the commercial that says, “Trained professional. Do not try this at home.”
David: (laughter) Right, exactly.
Kevin: David, a lot of these questions right now are factored on the triangle, and I am so happy that our listeners are getting this triangle, because as they ask the questions, they are asking them in relation to rebalancing the triangle – what percentage, why we would have different mandates. I will go to Hugo’s question right now. He says:
What triggers a rebalance of the triangle?
David: And he goes on to say:
Is it a certain percentage over/under 33% from one side of the triangle? If you are an advocate of the inflation or hyperinflation scenario, wouldn’t you want to leave your precious metals side alone to keep growing, keep something on the stock and bond side, and minimize cash? If you believe in a deflationary future, wouldn’t you want a bigger cash side, some precious metals, and fewer stocks?
David: Deflation versus inflation. He goes on to say:
While I have been in the inflation/hyperinflation camp, the deflation argument seems to have some merit. Yes, there are a lot of Federal Reserve notes, paper and electronic, out there. But if debt was required for their creation, then wouldn’t the destruction of debt, de-leveraging, result in fewer Federal Reserve notes, making them more valuable, and in demand? I know Mr. Bernanke is trying to thwart the de-leveraging process, but it must ultimately happen, or we will be mired in an economic malaise for a long time. I enjoy your weekly commentary immensely, even when your guests and I are not in sync, as the discussion makes me re-evaluate my ideas.
Kevin, I think, on that last point, that is why we have divergent opinions on the program. Not because we are trying to sample and be fair, and in a kind of open fashion, say, “Anything’s possible, and we just must keep an open mind,” but very much like G. K. Chesterton, who said, “An open mind is like an open mouth, intended to be closed on something solid.”
Our explorations with different guests are toward a direct end, but we want to make sure that we are not mistaken, and so we continue to reassess and re-analyze with each step along the way, and that does include talking with people with very divergent opinions.
Kevin: Sure, sometimes it will be a Keynesian, when we don’t necessarily like Keynesianism.
David: And that’s okay. The question is, how refined is our thinking in the process, and I think Hugo is right. Ultimately, those discussions make you re-evaluate your ideas, and check your assumptions to make sure that they are, in fact, valid.
Kevin: Okay, and to the answer of his question.
David: Let’s look at the triangle again, and I know we have talked about it many times, but the idea of the triangle includes that we don’t know everything. We cannot know the future, and I am not taking a position one way or the other, whether or not an outcome is inflationary, or hyperinflationary, or deflationary. We are in a position to weather the storm, and if your first priority as an investor is to keep what you have, then the perspective triangle does a very adequate job of positioning you to survive, and to thrive on the other side, whether the outcome is inflationary or deflationary. Having a balance between cash, having a balance between equities, having a balance between precious metals, puts you in a position to be right, even if you are only partially wrong, or to be wrong only partially, and still remain right.
Kevin: It allows that healthy schizophrenia that we talked about a couple of weeks ago, Dave.
David: I would suggest that where someone begins to place a bet is where they diverge from the triangle, and where you see an over-emphasis is, in fact, where someone is saying, “I’m comfortable playing the odds, increasing my risk, and not just playing for survival,” so to say, “not just trying to preserve assets, but grow them.” That is where a client would say, “Well, I would want a little bit more of an allocation here, or I am willing to increase my risk there.” Why? Because just getting through is not, in their minds, sufficient.
But I think the perspective triangle is, in fact, sufficient to cover all the bases, whether it is inflationary or deflationary. It is the deflationists who have a deep faith that it can only go their way with 100% cash and having nothing in gold, and that has been a very painful process over the last decade. It is the inflationists who neglect just how severe the de-leveraging is, which does, in fact, need to occur, and Hugo’s point is well made.
Kevin: Sure, and they may have 100% in gold, or close to it.
David: And they, at some point, have to face the music. You may have a year, two years, three years, where you are so wrong and so upside down, and forced to play that game of patience – waiting, waiting, waiting – until you are vindicated, and that is not a position that I think most investors can handle from an emotional, and from a stress, perspective, so I think the balanced perspective is very helpful.
Back to the first part of his question: “What triggers a rebalance of the triangle? Is it a certain percentage over/under the third for one side of the triangle?” Kevin, I think this is a tricky point, because the classic Wall Street rebalancing is essentially, when you move out of target on a 1%, 2% basis, you immediately reallocate and reshuffle. I guess what we are looking at is for the wise investor to look at the perspective triangle and up front say, “I don’t know what’s going to happen, but I think balance, to me, looks like this: A balanced perspective includes the potential downside in a lot of different areas, and so I have this particular balance.”
What you are going to see is one of those particular themes develop and be proven right, whether it is the inflation/hyperinflation scenario, or the deflation scenario, you will see it in the values of the perspective triangle, in one side or the other of your portfolio, and as you have supporting evidence for a theme that is now gaining traction, as opposed to just theoretically possible, you will know that yes, you were right. The question is, do you change the theme and rebalance at that point? And I would suggest, no. I would not suggest that you compound your risk accordingly. If the deflation theme begins to materialize, I wouldn’t sell gold to move to cash in support of being able to buy more ounces at a cheaper price. Allow your cash to multiply its purchasing power and just let it go.
There is going to be a trigger event in the future, and it has more to do with macro-economics, it has more to do with the structure of debt, and that unwind which you had anticipated, and it needs to run its course. To allow something to run its course – that is one of the reasons we look at something like the Dow-gold ratio and say, “Now that you are at inflection points – 3-to-1, 2-to-1, 1-to-1, even a negative ratio, that’s not theoretically impossible – then you begin the process of reallocation. But you are getting to places where, historically, you have evidence for there being a turn of the tide, and that particular thematic, having been worked out to its ultimate and final conclusion. The humility that comes with the Dow-gold ratio of 3, 2, and 1, is that you don’t know when it is going to turn, you don’t know if the rules will change on you in the middle of the game, and so you prudently, and in advance, begin to allocate toward other assets before you actually need to.
Kevin: This brings me to a conversation you have had with several clients of ours just over the last week or so, in which they were coming to you and saying, “All right, Dave, I started with a third in my triangle in gold and silver. Now it’s two-thirds of my triangle. When do I reallocate?” Specifically, we are looking at reallocating into MWM, the managed side over on the left side of the triangle. You are very good about telling them, “Yes, I understand you are heavy on the base, but how do you feel about the insurance right now?” And they say, “I really want it.” And you say, “Well, let’s just watch. Let’s watch these ratios. When we get to 5-to-1, maybe you are going to start easing into that, or 4-to-1, or 3-to-1 on the Dow.” It’s going to be specific to the client.
David: And we discussed that last week, Kevin, in saying that this really has to do with the degree of commitment made, or the percentage now that it represents of your total portfolio. If someone is at 90% metals, out of their liquid assets, because of the growth in those assets, then they need to be very diligent about being, not only early, but very early, instead of a 3-to-1 ratio. Maybe a 5-to-1 ratio is adequate to begin that process of reallocation. If, on the other hand, it is a 5 or 10% allocation, and that is what it has grown to from a 2% allocation, I think you have the ability to wait and allow that to play out a little bit more to your favor, and 3-to-1, 2-to-1, and 1-to-1 being, again, at least according to that metric, something of a guideline for a reallocation.
But the point that is being made here, is that you allow the theme, as it is evidenced in the perspective triangle, whether it is cash taking on a greater and greater import, or metals taking on a greater and greater import, allow that thematic to play out, and what you are really looking for is not a number, but you are looking for an environment. You are looking for things that will change that particular thematic, radically.
The classic case in point would have been 1979, Volcker being elected, and there being the real “come-to-Jesus” that you needed to have in relation to your portfolio. Does this change everything? So what is our effort every week, Kevin? It is to look at things from various perspectives, not just the ones that support our perspective, but to see what is changing. Is there something that radically alters our perspective, and thus, would force or trigger an event?
It is not a number, unfortunately, and as much as we like the 3-to-1, 2-to-1, as there is a certain elegance and simplicity to that, it actually is not a number. You have to be apprised of geopolitical issues. You have to be apprised of political issues. You have to be apprised of the changes in rules that relate, specifically, to the financial sector, even. I think when you continue to look at the world broadly, and continue to analyze those issues and the ways they interrelate, you will know. I know this is vague, but you will know. What is the significance of an individual event? We have to weigh every event, every day, and see if that is, in fact, the event that changes the game.
Kevin: So for now, if we looked at Bernanke and said, “I knew Paul Volcker, and you’re no Paul Volcker…”
David: Bernanke is not a game-changer. He does nothing but perpetuate the game as it is being played today.