The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: David, let’s just face it. A lot of people right now are demoralized because gold hasn’t done what they thought it would do in the time that they thought it would do it. And I understand what they are saying, because the signals that are coming in right now would make a person think that gold should be sky-rocketing.
David: Last week my son offered a simple prayer at breakfast. He said, “Lord, may the price of gold go up.” And I thought, “Well, I agree with you, but I don’t know if God listens to those kinds of prayers.” Maybe he does, I don’t know. But it was interesting, and it was followed on this week by a comment from my oldest son, because I told him the price of gold was down by $14 earlier this week, and he said, “Oh, that’s great! Yes!” And with just such great enthusiasm. And I said, “What are you thinking? What are your thoughts?” He said, “Well, I’m going to wait until it’s a dollar an ounce, and when it’s a dollar an ounce, then I can buy a thousand ounces.” It made me smile, because he does get it, that lower prices are intriguing if you’re not finished purchasing, and he’s not finished purchasing. In fact, he hasn’t even begun. So he’s looking at it as a positive thing. I just said, “You know, it’s going to be difficult to hit those numbers.” I think you’re right, there are a lot of people who say, “Well, gosh, on my timeframe, my expected timeframe, gold has not traded in the direction I hoped it would in the timeframe I hoped it would.” I would boil it down to something really simple. Keep it simple, because it is this simple. Number one, money printing has never worked in the history of mankind.
Kevin: Yes, there is no occasion of that.
David: In fact, it’s axiomatic. On the other side of that, and this is point number two, money printing has always led to inflation. It doesn’t matter if it is immediate inflation or on a lagging basis, because typically you will see asset price inflation before you see consumer price inflation, and sure enough, what do we have already? We have money printing to the tune of 10 trillion dollars, which is in the pipeline via all the world central banks.
Kevin: Yes, but Dave, what if this time it’s different? What if the central banks have finally figured out a way to print unlimited amounts of money and it will always have the same buying power.
David: And that may be the case, they may have cracked the code. They may have, through all kinds of different new technologies, created a way of sterilizing the creation of new money. Maybe I’m stuck in the old days where sterilizing meant one thing, but this is interesting. They assume that 10 trillion dollars is not going to move the needle in terms of inflation.
Kevin: You know I was being sarcastic when I asked that question. When we were kids we were told money does not grow on trees. Now, central bankers can argue with that. They are going to say that is doesn’t necessarily take a tree, but we can certainly add zeroes any time we want.
David: So here’s my basic summary of the conversation I had with my oldest son. He amended his projected price. He said, “Well, fine. I’ll wait until it’s $15 an ounce.” And we weren’t talking about silver, and he’s not a young Harry Dent, either. So, $15 an ounce for gold? I said, “I don’t know that you’re going to see that.” But, do aggressively buy on any price weakness and make sure you have very clear goals in terms of the number of ounces that you want to have, because you are going to reach those goals a lot faster at cheaper prices.
Just a few years ago I had done that with a silver position, deciding how many ounces, as a lifetime goal, and it was a fairly lofty goal. Granted, silver was $36-37 an ounce, so I projected how many dollars it would take, how much savings, how many months, and how many years it would take for me to reach my long-term lifetime ounce goal. And it was a little bit discouraging because I figured, “Boy this really is a lifetime goal.” And I’ve been able to speed that process up, and frankly, every time the price of silver takes a hit, I think to myself, this is intriguing. I get to add that many more ounces, with less money involved. I like this. I’m getting closer to my lifetime goal. Why is that important to me? Ultimately, it is important to me because the number of ounces that I own today are not the number of ounces that I am going to own tomorrow. And I have already done the math, to say that ounces are going to, basically, be cut in half.
Maybe the math is a little bit different for each family, but I know that there is going to be a reduction in exposure to gold and silver, as and when its purchasing power of other assets, whether that is stocks, bonds, real estate, is compelling. We’ve talked about the Dow-gold ratio. In years past we’ve even talked about the gold-house ratio. You can come up with your own ratio for any asset relative to gold, and when the purchasing power of gold, in terms of that other asset, is at a compelling level, you should be selling ounces and moving on to that asset class. The problem we have today is that it is not compelling enough. Yes, we’ve shifted, dramatically, from a 43-to-1 Dow-gold ratio to a 13-to-1 Dow-gold ratio, so we’ve made some progress, and here we are stuck in the mud for the last 2½ to 3 years, but I think more progress is going to be made. And even at a 13-to-1 Dow-gold ratio, I think it is a compelling purchase relative to where we are going to end up, in terms of purchasing power, and ultimately translating into other assets in a net worth statement.
Kevin: You know, Dave, I like to sometimes picture this, and I talk to people about picturing it, as four bowls sitting in front of you. I’d like to talk about all four bowls on this conversation today. Bowl #1: You can put your money in the stock market. Last week you pointed out that stocks are down 70% still, even at new highs, relative to gold ounces over the last few years. So bowl #1 doesn’t necessarily look great, but that is one of the options. Bowl #2 is the bond market, or interest rates. Basically, we are looking at bonds. You can loan governments money, they aren’t paying much interest right now, but if the interest rates rise, the bonds will go down. So, bowl #1 is stocks, bowl #2 is bonds. Bowl #3 is currencies. You can just keep your money in cash. You and I have talked before about the fact that cash is valuable, but the problem is that it is losing value on an annual basis. We haven’t had a deflation, or an actual revaluation of cash and buying power since we went off the gold standard. And then, you’ve got the fourth bowl, the golden bowl. You can put your money in gold. You can put it into stocks, bonds, currency, or gold. I’m not counting real estate in this conversation, I’m talking about liquid assets.
David: Yes, exactly. You are not talking about any illiquid assets, which could be privately listed companies, a company that you operate yourself, or real estate, or a business partnership of some sort, or a private equity fund, or hedge fund, where you are very limited in terms of your access to the capital. You are talking about liquid assets and four general allocations.
Kevin: Right. We’ve seen the stock market nominally hitting new highs, yet income here in America hasn’t risen, so if income isn’t rising in an economy, the only other way to make something grow is to borrow it. That’s credit growth, if you don’t see income growth in the economy.
David: You’re right. And the way you’ve just broken that down into the four bowls, or categories, if you will, we did something similar at Ft. Lewis College when we were talking about reallocation strategy several years ago, and a set of bowls, what was proposed as buckets, the buckets that you put your resources into. Household sector balance sheets. This is something that is very intriguing in terms of figuring out where we are in a long period of time, a long continuum of time. Relative to other peaks, relative to other troughs, are we at a low point? Are we at a high point? 26 trillion dollars has been added to household net worth since 2009.
Kevin: But is it our household, or is it the fraction of 1% that are becoming extraordinarily wealthy?
David: I think that is probably the distortion of the figures. It’s not a median number, a mid number. Averaging out all households, this is total household, which would include the 100th of 1 percent, which have done extraordinarily well, and that does not include the 65%, most of the middle class, entailed in that, that frankly have not done so well. In fact, they have seen, since the beginning of the millennium, about a one-third cut in their net worth. This is the contrast. If you look at median net worth, you have gone from 80-something thousand, and you can cut about 30% off of that, a good 20-25 thousand dollars less in terms of median net worth.
Kevin: So, it’s hollowing out the middle class, but you have the very rich getting very richer.
David: And yet, we are at a record high of 82 trillion dollars in terms of household sector balance sheets, that is, all of your household net worth, and yes, that is distorted by the tenth of one percent, or the 100th, or the 1000th of 1%, if you will.
Kevin: Well, let’s look at some of the markets, then. I mentioned the four bowls, but let’s look at real estate first. How much has real estate risen in relative terms to income or household net worth?
David: Its best days were 2005 and 2006, so it was selling at even higher premiums relative to disposable income. Now it’s at about a 12-12½ percent premium, if you are looking at sort of the average, what real estate represents on someone’s balance sheet.
Kevin: When we talk about premiums, we’re talking about how much more it’s worth relative to the growth of household net worth, right?
David: Kevin, let me back up for just a minute, because what you were saying earlier about income driving the economy, this is very, very critical, because income is an indication of how well people are doing, how well families are doing. As income increases, your ability to do more and varied things in the economy is expanded, whether that is buying a second car, whether that is sending your kids to private school, whether that is increasing your food budget, whether that is buying a second home. There are all these things that with increased income you get to do. So, income becomes relevant to understanding net worth, savings, etc. If you go back to, say, the 1950s, and look at disposable income, and then look at these asset classes, real estate, relative to disposable income, today it is at about a 12 to 12½ percent premium to the average. So, we’re a little bit above the average in terms of real estate values compared to disposable income.
Kevin: And real estate is real stuff. Let’s talk about stocks, then, because stocks are hitting new nominal highs. Where does that factor in?
David: It depends. If you look at just stocks, again, if you are looking at someone’s equity portfolio, and what does that represent relative to their income, you have this average, what it has represented on lots of people’s balance sheets from 1952 to the present, and that gives us some bearing, are we on the high side or the low side? We are currently, in the equity market, about a 43% premium relative to disposable income. That is, unless you also include mutual funds. Then, including mutual funds puts you at about a 78% premium to the average, dating back to 1952.
Kevin: So that would mean that it is overvalued based on averages.
David: It is overvalued, and in fact, when you are looking at either of those figures, you are looking at numbers that we haven’t seen since the year 2000, and 2000 was the most exaggerated that we had seen in stock market history.
Kevin: And that was the crash year.
David: Precisely. So you could say, “Well, we’re doing very well.” Yes, we are doing very well, but incomes, again, are a really helpful guide in appreciating what drives an economy. Without income growth, it is hard to justify market expansion. So, when you see major expansion in the marketplace, with no commensurate income growth, you can look first, if you want an explanation, to the leverage numbers.
Kevin: Which is borrowed money.
David: Exactly. Because if it is not income that is driving it, what is driving it? What is the borrowing that is financing that growth? It could be government borrowing, it could be corporate borrowing, it could be household sector debt. And that is growing in the place of income growth. That’s the problem, because ultimately, that is not expanding. Households are expanding their percentage of credit as of this week, and it is all on the basis of zero percent financing. Think about this. Your clunker, you just want to quit paying for. Sounds like my wife. She says, “I don’t want to take the car to the auto shop again. I just don’t want to do it.” This time it was a seatbelt, not a big deal, except that we have kids and we need to keep them buckled in, right? So, it’s a necessity. We are going to get it fixed.
Kevin: And then somebody comes along and says, “Hey, you want a new one, and no financing charges whatsoever?
David: This is the temptation. Rather than being nickeled and dimed over the things that we fix on a routine basis on our car, we are tempted to finance it on 0% interest. Looking at the consumer spending numbers recently, autos have been up. On what terms? Cash? No. Zero percent financing. It is interesting to see, throughout the economy, a number of companies that have an internal finance wing. Conn’s is an electronics and furniture store in the south, headquartered in Texas, but they have places all over the country, and they have done zero percent financing for 36 months for their clients for many, many years now. And that has given them super growth, I mean, super growth. But essentially, they are no longer in the electronics business, they are in the subprime lending business. That subprime lending business has increased their stock price from $3.39 up to over $77 a share just since 2010.
Now, all of a sudden, people aren’t paying. They have expired their 36 months of free money and they don’t have the money to pay. At the same time, they’ve had groceries that have gone up, and they have had rent which has gone up, and the question is, you still need groceries, you still need a roof over your head. Do you still need the extra flat screen? And the first payment missed is to this subprime market. So we have seen an expansion of household debt and consumer credit, but what is interesting is that it is on very dangerous terms, because it suckers everyone in to, “I can have it now, even though I can’t afford it now.” This is where we begin to see problems. It’s not sustainable growth. Income growth? That’s a different story. If we were seeing income growth driving the economy, hats off to the growth that we would see in GDP, but that’s not where it is coming from. It is coming from very frail consumer credit growth.
Kevin: Well, it’s interesting, the government is the encourager of the low interest rates, the ZIRP policy, the zero interest rate policy that we have talked about before. But it creates, ultimately, an issue when you no longer have the borrower who is coming in and borrowing at zero percent, let’s say at the retail store that you were talking about. Then you have to have somebody who creates that money. If income doesn’t create the money, an increase in income, and if people are not able to pay back their credit, then the government has to print money. Now, inflation, you talked about that earlier. Inflation is something that occurs when you print money. Now, there is talk right now, some pretty big names coming out and saying, “Oh, inflation is dead. Don’t you understand? That’s a thing of the past.”
David: It’s a consensus understanding. Such a strong consensus that I would venture to say, if you interviewed 50 economists, 49 of them would say that inflation is not a concern, nor will it be, which made Ken Rogoff’s article last week very intriguing, saying, no, no, no, it’s dormant. Don’t ever forget this, that it doesn’t matter what professionals believe about inflation, it’s ultimately what happens in the political process, and as a result of social choice. Listen, the era of modern central banking cannot deliver to you an inflation-free environment forever, particularly when you’re are printing like mad. His simple conclusion was that it is dormant, but it will not remain so forever.
Kevin: We’re coming into the Christmas season and I know my kids are really looking forward to the third movie of The Hobbit coming. Smaug, the dragon, had been dormant for years, but he is going to get awakened and very, very angry here, I think, as we come into this last movie. A couple of weeks ago you talked to Adam Ferguson. That was his warning. What happens when a dormant inflation rate, which, in Germany back in the early 1920s, if you will recall, it was running about 2-4% before it exploded into the billions of percent, literally, a collapse of the currency.
David: A money manager that I keep track of from time to time, we’ve met up at different conferences here and there, usually in New York, likes to say that in a democratic political system, with a fiat currency, all roads lead to inflation. Again, going back to the basics, you can look and say, money printing has never worked in the history of mankind, and money printing has always led to inflation. These are very simple axioms. But you throw in the political dynamic that in a democracy where people are going to vote their self-interest, with a government that has access to an entirely fiat currency, all roads lead to inflation. Again, what is the time frame for that? That is where, I think, there is certainly frustration, justifiably so. When do we see inflation? Do we see it tomorrow? Do we see it next week? Do we see it next year? Do we see it in 2025? Do we see it in 2075, when frankly, none of us give a rip?
This is the problem. Timing is never precise in these issues because it is trickle-down. You have a policy that is implemented, like we have had with QE3, and QE2 before it, and QE1 before it, and it does something in the marketplace. It gave us asset price inflation. We have already begun to see consumer price inflation, and that is why we are beginning to see those sub-prime borrowers make tough choices.
Kevin: They are running out of money, Dave. They have to borrow at zero percent. They can’t buy things these days.
David: And my point is, they are having to prioritize, because we’ve already seen rent inflation, we’ve already seen food inflation, and one of the ways that you have seen food inflation is what they are now calling shrink-flation.
Kevin: It’s the smaller box.
David: It’s the smaller box.
Kevin: The Kraft macaroni and cheese is getting smaller and smaller.
David: At the end of the month, for the same calories, you are having to increase your food budget, and even though you don’t have sticker shock, when you are buying the same box of Kraft macaroni, there is still inflation. So, it is trickling through.
Kevin: Let’s go ahead and look at what Draghi did last week, because after our show last week Mario Draghi, we can say, shocked the markets by lowering interest rates, but I think it was somewhat expected. Gold went down relative to the dollar because the dollar went way up. But it was interesting, we looked that day at the other currencies, the euro and the yen. Gold was rising against the euro, against the yen, and…
David: …against the British pound.
Kevin: Against the pound. Let’s look at the pound for a second.
David: Next week is the vote on Scottish independence, which is pressuring the pound in lockstep with what Draghi has done to pressure the euro lower to increase trade competitiveness. We suggested this precisely last week before Draghi’s announcement, but again, not with any foreknowledge that he was going to do it next week, just that he was going to do it eventually and bully the price of the euro lower, which would benefit the dollar. It has benefited the dollar, and as it has benefited the dollar, it has hurt gold in dollar terms. It has not hurt gold in other currency terms, however. That is because we have seen a major decline in other currencies. So, the rest of the world looks and says, “Gold is going up, gold is going up. This is a perspectival appraisal on our part to say, gold has just gone down, because it is not going down universally, on the basis of supply and demand, it is being reflected such by the weakness in a currency and the way it is traded on that basis.
Kevin: So, David, the Scottish independence vote. What does that do for European integration as a whole? We have heard rumblings of various countries saying, “Maybe we ought to just break away.” What is this saying?
David: The euro is already under pressure, and maybe it survives, maybe it doesn’t, but the Scottish independence vote casts a shadow over European integration by suggesting to other separatist movements that there is a course for them to take, there is a course forward. You have Catalonia, you have Northern Italy, just being two, and there are others that are simmering under the surface, and the challenge would be to sort out, in Scotland anyway, the currency, and then the independent fiscal management. And that is easier said than done. We’ve already witnessed a monetary union in Europe, and that has been very tough for the European countries, particularly the peripheral European countries. That may be an option for Scotland to join Europe via the EMU, the European Monetary Unit, or perhaps they could convince London to allow them to maintain the pound. The challenge is, again, it is creating the same policy difficulties already witnessed in Europe. You don’t have a fiscal policy that is unified. You have divergent national interests at the level of currency and monetary management and frankly, it is difficult to imagine that inland, and in Westminster, it is difficult to imagine them allowing the retention of the pound sterling in Scotland, unless it was, of course, for them to leave the door open to reintegration 5-10 years out, if a fresh vote is taken, and inclusion is desired more than separatist tendencies right now.
Kevin: It seems like the pot of nationality and these integrations is being stirred pretty dramatically right now. Look at Putin. Somebody said a few shows ago that Putin is putting the band back together again. Yes, that’s true, but that has limits, doesn’t it?
David: Reliving the glory days of mother Russia, that is not entirely possible. You have the Baltic states, and you have Poland, where NATO and EU integration has already occurred. That would be like a divorced couple that has already been remarried. Some options have already been taken off the table. You can’t go back to the original spouse without it being very, very, very messy. But there are other countries, we mentioned the conflict brewing between Armenia and Azerbaijan in the area close to the Baku-Tbilisi pipeline.
Kevin: And George Friedman said Belarus is another target, Ukraine and Belarus.
David: Right. You have Armenia, Belarus, Kazakhstan, Tajikistan, all of those are potential candidates for reintegration into the Russian network. There are some things that they have lost at the end of the cold war that they are not going to get back. Obviously, East Germany is gone, so in terms of a GDP contributor, Russia is diminished by having lost this access to a larger sphere of influence.
Kevin: Poland has seemed nervous, though. Let’s face it. Poland is watching the response from the West.
David: I watched something on the internet the other day that a friend sent to me. Basically, it was a time-lapse photography of a European map going back to 1200, and it was fascinating, because what they did is, in three minutes they covered the timespan from 1200 to the present, and you get to see how often these lines that we draw and assume the leaders are prospectively drawing, what land would they like to have, it is absolutely amazing. It is like looking through a kaleidoscope. The things that change, on a constant basis, all of Europe has been shifting, and borders have been shifting constantly, from 1200 forward. So, is Poland nervous? Yes, they are nervous. But again, I think that was a major loss. The Czech Republics, and East Germany, those were GDP losses for Russia.
It is very interesting, the U.S. policy today as it relates to Russia is creating a tremendous amount of military insecurity.
Kevin: And Russia is historically, militarily insecure. They are always on, at least in their own minds, the defense.
David: And the military insecurity is something that I want to come back to. The next Cold War move for us to make, is not only to create or exaggerate the military insecurity that Russia is already feeling, but it is to smother the price of oil for the next 6-12 months. If we intend to fight an economic war and a sanction war, not a military war against Russia, then it would be following the same step sequence we did during the Cold War, which is, number one, we could outspend them, of course. And number two, we could drive the price of oil down. And yes, that can be done over the short term, manipulating prices lower, and that would bring Putin, in theory, to heel, via the States’ oil revenues being diminished considerably.
Kevin: It’s key that you are bringing the Cold War back up again, because when we were growing up, Dave, NATO was a military cooperation organization. It was military only. Now, for the last 20 years or so, it has been a political organization. It is more politics than anything. But with this rapid deployment force that has been decided on, are we seeing NATO go back to a military organization.
David: You had the decision in Wales, just last week, to deploy 4,000 rapid deployment fighters, and the significance was not because of the manpower commitment. 4,000 is nothing compared to Russia’s million man army, but it assumes an infrastructure commitment, which, coming from comments of Stephen Cohen of New York University (not Stephen Cohen the hedge fund guy). I think he spent 30-odd years teaching contemporary Russian politics at Princeton before that. He suggested that when you are making infrastructure commitments, you are really saying that you are building military bases, and we are talking about building them in the Baltic Republics. We’re talking about Poland, we are talking about Romania.
Kevin: That is right in the back yard of Russia.
David: Exactly. It is the Western military alliance right to the front door of Russia, which is what I meant earlier by creating military insecurity. So, the transition is a critical one. The transition in Wales was from the political expansion of NATO over the last 20 years to the military expansion of NATO and Putin will feel very differently about this one.
Kevin: Do you have a prediction? When you are talking about Putin feeling differently, what does that mean? This is a man who can’t really go back. He can’t really back down. Politically, that would be suicide.
David: I think he plays more aggressively. I think he is willing to spend from the treasury, and even exhaust the treasury if oil does come under attack, as we mentioned earlier, to smother the price of oil and try to bankrupt him, he will use state funds, and he will use any means possible to fight on the terms that we are fighting him. I think one of the things that this assumes is that he will also increase asymmetrical warfare. The notion that, whether it is terrorist organizations that are funded, keep in mind, most, if not all, of the terrorist organizations were funded by the Soviets in the 1960s, 1970s, and 1980s.
Kevin: It was the AK-47 rule. When you watched TV, if they had AK-47s, they were financed by Russia.
David: Right, you could go anywhere in the world, whether it was Latin America, or the Middle East. It was not the ideology of religion driving extremism, it was the extremism of political ideology that was driving the funding of terrorism, bringing about a certain political end, and the end obviously justified the means in the communist mindset. So, would we see more asymmetrical warfare funded by the Russians? Sure. Would we see things like cyber attacks on the increase? Absolutely. Could we expect to see, not only J.P. Morgan hacked, as they have been recently, but most of the Fortune 500 companies come under attack? Do the Fortune 500 companies have adequate internet security? No they don’t. Could you see the likes of G.E. and G.E. Capital, the likes of Bank of America, the major banks, but then your nonbank but major multinational corporations dealing with hacks that bring them to their knees? Absolutely. And you are talking about something that would debilitate the U.S. equity market and debilitate the U.S. economy, costing us billions, even 10s or 100s of billions of dollars as a consequence.
Kevin: But not even the U.S. economy only. Let’s go ahead and look at the European economy, because really, Draghi is lowering interest rates. He is loosening the policy, he is getting away with a lot of things that really don’t cause any real structural change. Europe is still a mess, America is still a mess, but we’ve sort of bought the last 5-6 years with quantitative easing. What if, again, looking at what is going on in Russia, these things that are going on in the Middle East, the thing that is interesting to me is, if you have not structurally fixed the problem, then when something happens, let’s say it is a hack, or something that happens that is outside of the central banker’s control, then you’ve created all this money, you’ve created all this Band-Aid to go over these problems, but you haven’t fixed anything structurally.
David: And I think that’s one of the concerns, if I were a Ken Rogoff, that I would be looking at, too. You have Adair Turner, who was the former Chairman of the U.K. financial services authority. He is a member of the financial policy committee in the United Kingdom, and is a member of the House of Lords. It was quite interesting. What Mr. Turner was suggesting is that the eurozone faces these major structural and fiscal reforms, and even though Draghi is promising the sun, moon, and stars with his most recent announcement, it does not even begin to touch the kinds of changes that need to happen in the eurozone. And so, Mr. Turner’s suggestion, and this is to quote him, “Optimal policy may therefore require a nontransparent fudge. Monetary and fiscal coordination might mean, after the fact, permanent monetary finance, but without ever openly admitting that possibility.
Kevin: I wonder how you do that, though, because the Germans don’t want to see these things. There are laws against Draghi doing some of the things he is doing, and he is talking now about nontransparent action, isn’t he?
David: He is saying a couple of things which I think are very intriguing. Number one, the kinds of asset securities purchases that Draghi is committing to, 906 billion dollars’ worth of new purchases, is not going to change the structural stuff. So, any of the fiscal deficits that have to be run will be directly financed, will have to be monetized. This is the real critical point, coming back to where we are in the cycle of things. Nothing has been changed structurally in Europe or the United States, to the degree that we can walk away from monetizing bad debts. Monetizing fiscal deficits, and not announcing it, yes, okay, Mr. Turner is right. You are avoiding political risks if you keep it quiet. But what you are not going to avoid is the axiomatic inflation risks of monetary finance. Because remember, when you start monetizing the deficit, you are creating something attuned to super-charged inflation. This has been tried so many times in financial history, it’s almost boring, but it is, in this instance, again, being ignored, being looked over, by the world’s economists saying, “Inflation is not here.” The financial service authority member of the Financial Policy Committee, House of Lords, is saying, basically, “Not only is this the necessary course, you’re going to have to do it quietly,” and he is not even considering the inflation risks.
Kevin: Well, he is saying, “Create inflation. Tell no one.”
David: Tell no one. And maybe he is just stating the obvious, that Mr. Draghi will do what he thinks best and ask forgiveness, not permission, if his market maneuvering is ever brought into the light of day. And as you mentioned earlier, this will be to the chagrin of the German Central Bank, and anyone with the recollection that monetary finance is a deadly game and has consequences for everyone in society. That was the point of our conversation with Adam Ferguson, that monetary financing, when you are financing deficits and printing money just to do that, to pay for current and recycled debts, this is how inflation gets out of control very quickly. For the time being, here we are. We sit back and we are witness to historic decisions in Europe to take rates from negative to even more negative. That was one of the ECBs decisions, Mario Draghi’s announcements. He was already running negative rates, and then he doubled down, if you will, and in addition to that, he is going to take the ECB balance sheet back toward 3 trillion dollars. That is something that we have been saying for over a year now, that the ECB balance sheet was shrinking even as the Fed’s was on the rise, and this would ultimately allow the ECB the flexibility of going back to re-leveraging.
Kevin: Let me ask, though. We have talked about a lot of American companies who have their money overseas. They have their money overseas, not necessarily in dollars, it can be in euros. How does this affect the bottom line of these multinational businesses.
David: The bottom line is, if the revenues are being generated in euros and British pounds, and we are talking about a context in which the British pound and the euro are both going down, then the portion of their revenues which are generated in those currencies, if they are not adequately hedging them, and very few of them have adequate hedges, they are going to take a major hit to their earnings. So, you could say that Q2 was sort of the last goodbye to good news from the multinationals. As we move in to Q3 reporting, and certainly the second half, as we finish Q4, the multinationals are going to be bleeding, because this is major currency volatility.
Kevin: There is a change in the wind, though. We had quantitative easing. Let’s go ahead and use another type of Q, quantitative easing, QE1. QE2, QE1, every time they came out and added QE it caused the stock market to explode. Every time they ended it, it fell.
David: Exploded in the sense that it went higher.
Kevin: Higher, yes. But we’re seeing QE3 tapered down to nothing here. The end is supposed to be in sight in October. How come we are not seeing the reaction that we saw at the end of QE1 and the end of QE2?
David: It’s interesting, because the consensus view is that it will be different this time. QE1 ended poorly. QE2 ended poorly. QE3 will end perfectly. And that is really the market’s behavior today. The market seems to be reveling in the bliss of complacency. I don’t fully understand this. It is absent-mindedness. Is it, as we suggested last week, pinned to the faith in the Federal Reserve? Yes, they have powers, but they are not all that magisterial. It makes me smile somewhat uncomfortably, thinking about our very candid conversation with William White earlier in the year, I think it was February of this year. Central banking is not a science, and central bankers get it wrong as much as, or more than, they get it right, which is critical to realize, if you are presently in a camp that assumes that the Fed is in complete control of outcomes, and that as we get to the end of the taper the end of this month and move into October, somehow this time is different. The end of QE3 will not cause a complete selloff in the stock market because this time is different.
Kevin: For the person who has tried to bet against this being real fact, this central bank control, let’s face it, Dave, the people who are printing the money have been able to spank them every time they do something. It’s like getting a spanking. You go out and buy some gold and you say, “You know, I think there is going to be some inflation in the future.” And then, bang! You get a spanking on the price. You can do this with interest rates, you can do this with stocks. The only people who are really making money right now are the people who are betting that the central banks have 100% control. Now, what kind of risk is that? If we are really sitting on the two pillars of the Federal Reserve and the European Central Bank, how solid are those pillars?
David: You have to go back and listen to the interview with William White, go through our archives and find that, I believe it was February, maybe February 14th. Maybe I just loved it so much that I’m attaching it to Valentine’s Day, I don’t know. But it was back in that timeframe that we interviewed William White, and it was obvious, whether it is the ECB or the Fed as the twin pillars holding up the hope and expectations of the masses in the markets, or other central banks around the world, at what point in history has money printing been the solution?
Kevin: Name one.
David: Can’t think of any. And following that, at what point in history has money printing not led to inflation?
Kevin: Name one.
David: And we mentioned this earlier, the collective efforts of the world central banks – 10 trillion dollars.
Kevin: Okay, now adding 10 trillion dollars. The central banks, over the last 5-6 years, that’s like taking a city of 10 million people and handing each one a million dollars. That is making 10 million new millionaires, if you just printed out of thin air and handed it to them. That’s amazing.
David: But there is not going to be an inflation event. The expectations of inflation are, as the Fed likes to say, well-anchored. It is not without surprise that at the same time we see expectations of inflation at zero in the context of rampant money printing, 10 trillion dollars’ worth, that we also have what is called the investors’ intelligence bull. I know, it sounds like an oxymoron. Investors’ intelligence bull. It reaches a 27-year extreme where those who are bearish on the stock market, that is, those who are thinking that the stock market will go down, are at 13.3%. That is the lowest level since the summer of 1987.
Kevin: So 13 people out of a hundred, let’s even be generous, let’s say 13-14 people out of a hundred, believe that the stock market can go down. I started with your family in the summer of 1987, and your dad was pointing this same thing out. He said, “This is crazy.”
David: Investor confidence is off the charts.
Kevin: We had the worst crash that fall that we had had since 1929. Confidence is at very high levels, as high as it has ever been, and frankly, it’s not a bad thing if prices and sentiment are unidirectional. If they can only go one direction, then the fact that they have gone high, maybe we can assume they will only go higher from here, but one thing we do know about price and sentiment in the marketplace, is that they are what they call mean-reverting. They go up and they go down, and they hug this mean, this middle point. Sometimes you have over-exuberance in the marketplace, and sometimes you have over-pessimistic views in the marketplace, and right now, we are tapping that “never been more enthusiastic, ever” number – 13.3%. Well, I should say, it hasn’t been that enthusiastic in 30 years.
Kevin: Isn’t it strange, though, the divergence between people’s feeling about the overall economy and the stock market? Probably some of the same people being polled think the stock market is only going to go up forever, yet they will say that the economy absolutely stinks.
David: Again, go back to that 82 trillion dollar number, 26 trillion in wealth created since 2009. Try to square those numbers. Keep that in mind. Just hold those numbers in one part of your brain. A George Washington University poll released this week has 70% of Americans believing that the country is headed is headed the wrong direction. Compare that to last month, a poll from NBC News, Wall Street Journal, it was a dual poll, that showed 71% of Americans think that as a country, we are on the wrong track – 64% are dissatisfied with the economy, 79% are down on the U.S. political system, 76% with a real lack of confidence that the next generation will have a better life than the last one. Listen to this. How do you square these numbers, well north of 50%, with the stock market being at all-time highs and real estate having recovered? What I am saying is that when you think about a 26 trillion dollar bonus, it was a Fed gift to the ultra-rich, and it was a Fed gift to the banks, so this is not something that is well spread out amongst the hoi-polloi, amongst the average Joe and Suzy lunchbox. There is a gap between the realities faced by the man on the street and the bankers at the Fed that maintain credibility with the Wall Street denizens. The growth in asset prices, this goes back to that idea of income. The growth in asset prices has far exceeded the growth in the economy. We have had stagnant real wages for a long time now.
Kevin: So, it’s not sustainable.
David: It’s not. When you see asset prices go up and you haven’t had an increase in income, something that is fundamental to driving the economy further, growth in equities, growth in real estate, they’ve outpaced the growth in income. It begs the basic question all over again. If income is not the economy, are we safe to assume that central bank printing is really the new cure-all? Is that what the future success of America is based on? Not manufacturing, not jobs growth, not innovation, but money-printing? Really?
Kevin: Dave, you have pointed out before, any time money is printed, it turns to inflation. Any time there is inflation, gold goes up. What is your comfort level right now as to holding your gold?
David: I would say any time there is inflation, gold will play catchup. It is not on a day-to-day basis. Let’s say the inflation figures peak up tomorrow. Does gold axiomatically go up that same day? Nope. In fact, it can go a long period of time before it is realized by the general public that they need an inflation protector. And then they will go to gold, and that is when you begin to see inflation – I think you can see inflation numbers move higher and higher and higher, and then gold play catchup as people try to remedy the circumstance they find themselves in. I remain very comfortable owning gold and adding to positions every chance I get. This goes back to that dinner table conversation I mentioned. Gold was down $14 and my eldest son said, “Yes! I want it to be $1. I can own 1,000 ounces!” It was a great conversation, but what we talked about was the importance of a low cost basis in an investment, and I argued that we had passed the Rubicon at 4 digits.
Kevin: So when it hit $1,000 that was passing the Rubicon.
David: And gold below $1,000, let alone $1, was a very low probability. Of course, then I had to explain Caesar crossing the river and setting in motion a series of events which could not be undone. His actions, you may recall, led to a civil war. So the kids know that, in my view, the die is cast, as Caesar said, higher gold prices are in their future, as a consequence of monetary and fiscal policy missteps.
Kevin: We can angrily talk about what the central bankers are doing, we can angrily talk about what is happening in politics, but Dave, politicians and central bankers and Wall Street, they can’t really be heroes in this situation and actually go in and fix something, can they? Because they will be thrown out of office.
David: That’s what it would take, though. And funny you mention that. Stephen Roach, just at the end of August said, “This is a time for heroes, not cheerleaders. No, I don’t think we have politicians who are heroes, who are willing to sacrifice their political careers to do the right thing. Myopic authorities,” says Stephen Roach, “need less guidance from frothy financial markets, and they need to focus more on structural repair of a post-crisis world. This is a time for heroes, not cheerleaders.” But you know exactly what we have? We have cheerleaders. We have Morgan Stanley, Stephen Roach’s alma mater, mine as well. This week, they are projecting 50% growth in the S&P. That’s supported by U-Penn finance department, you remember Jeremy Siegal who wrote the book, Stocks for the Long Run? “Oh, we’re going to finish the year at 18,000 on the Dow,” he says. It’s possible. But the question is, are we getting to levels that are sustainable? Are we getting to levels that are justifiable? And for Stephen Roach, a veteran economist with Morgan Stanley, to have walked away from the business, he is teaching now in the Yale Economics Department, to say, “Guys, we haven’t fixed anything structurally, we haven’t even begun. Where are the heroes? Where are the people who are implementing structural reforms? Where are the people who are putting in place fiscal restraint necessary to bring us back into line with where the economy is actually growing, or not growing? We are still living beyond our means!
Kevin: But Dave, I’m going to play the role right now of the person who cannot earn an income on their interest. They are retired. They really don’t have rental properties, they don’t have other means of income, and they are looking at you, and they are saying, “I understand this, I get it. The stock market is too high. But I think I can make some money there and then time it just right before this thing falls apart.”
David: Right. The number of investors that assume they will get out of stocks, even as the price is moving higher, and they are going to get out just before the next correction, you know what they believe? They believe there will be someone, or a whole group of people, waiting in line to buy their shares from them when they want to sell.
Kevin: Okay, but stop there. You have talked about some axioms. I love axioms because you could say, “In the long run, you can count on an axiom.” There is another axiom. The axiom of any market is: To get out of it, you need someone to buy it.
David: That’s right. If you are a seller, you have to be matched up with a buyer, otherwise you are stuck with the product. People don’t think about that in relation to stocks. They know it full well in real estate, because you can sit on a property for six months, a year, I’ve seen properties on the market for a decade, with someone trying to get out, and the only thing they can do is desperately drop the price until they find a bid in the marketplace, an offer from someone to say, “I’ll buy it at that price. It takes buyers to match with sellers in order for someone to unload a position. This is what people don’t appreciate. If you think you are going to be able to get out just before a market correction, listen, there are large positions which are unloaded as prices rise, in advance of a peak, because they are aware that when a peak is reached, part of the dynamics of a peak, what makes it a peak, is that liquidity dries up, buyers disappear, the preponderance of market activity becomes liquidations and sellers instead of buyers. So, you’ve got to keep this in mind. The old adage of selling into strength is always wise. It is also the only time that large quantities of product, whether it is paper or otherwise, can be moved without tanking the market.
Kevin: Dave, in review, we have talked about the price of gold, we’ve talked about the creation of paper, we have talked about Europe, we’ve talked about Putin, but there are some axioms, as you have talked about, that if we just stick to, it always plays out. I think about when your mom and dad started this company. Gold was $35 an ounce. Then I came along 15 years later in 1987 and gold was $300 an ounce. And then we passed the year 2000, went to 2005, and gold was $500-700 an ounce. Now gold is $1200 an ounce. That axiom is playing out. Starting at $35, and yes, there were ups and downs, but really, it has done exactly what it is supposed to do. An ounce of gold buys about a month’s worth of food. Throughout history, if you have an ounce of gold you have about a month’s worth of food for your family, don’t you?
David: As long as you are not eating foie gras and Sauternes.
Kevin: Well, okay, not your diet.
David: I’m kidding. No, I’d have gout if that was my diet. You’re right, these axioms are important: You can’t spend more than you make. So why am I not impressed by the latest consumer credit numbers, 26 billion, the July surprise? I’m not impressed because you can’t spend more than you make, and if you assume that the success of this country is built on paying people back money that you now owe them, that’s not a success story. That’s called debtism. That’s called debt slavery. Do you understand? This is not a success story. You can print your way to success, but for only so long. It was Schäuble, the gentleman from the Bank of Germany, who said this week, “Sure, money printing buys you time, but that’s all it does.”
Kevin: It doesn’t fix the problem.
David: No, it’s not the tools that we need right now. That’s what he was saying this week. He understands that Draghi is going to buy time for Europe, just as the Fed has bought time for the United States, just as the Bank of Japan has bought time for the Japanese. And yet, even after the end of the monetary experiments, what do we have in Japan? A decline of GDP growth by close to 7%, we have retail sales plummeting as a result of an increase in taxes, they are trying to plug holes. What’s the conclusion? It’s a mess.
And am I comfortable owning gold today? Oh, you bet I am. Do I want to own more ounces? Yes, I have lifetime goals, and they are pretty high marks. I don’t know that I will ever reach them, and I will be aggressively buying for a long time to come. I will also be aggressively selling when the right time comes.
This is just it. Inflation has always been a consequence of money printing. We have massive money printing, have had for five years, and it continues unabated. If you want to wait and see if the consequences are different this time, be my guest.