September 6, 2017; Mr. Bubble is Full of Trouble for the Markets

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

 

“You have something more basic in the gold market than a catastrophic event driving people in. You have a lack of supply feeding existing demand, which is automatically going to put pressure upward on the price. You bring investors in for any reason and yes, it will exaggerate a price trend, but what you and I know is that the price trend is firm already on the basis of supply and demand. The only thing that we get from here is fireworks.”

– David McAlvany

 

Kevin: It has been crazy David, even through this holiday weekend. We see Korea number one in the news, we see, in India, Modi is now being criticized for the currency grab that we talked about last November because his GDP just fell directly through the floor. Gold, while we were all holidaying, went on up into the $1330s and held very nicely, so the world seems to be aflame, and I’m not just talking about Los Angeles right now.

David: Yes, there are a number of things that are new and different that you can’t necessarily see coming. One was Harvey, and our hearts continue to go out to the people who are dealing with the aftermath of that, and still reeling with waters that have yet to recede. And of course, Irma finding its way to landfall in Florida.

Kevin: And your wife has family down in that area. I’m sure that they got soaked. I don’t think they got flooded out, but they certainly got wet, didn’t they?

David: They’re very wet. On several hundred acres of land, only a few acres was actually above water. There was the house and this little knoll where all the cows gathered, and everything else looked like a giant lake.

Kevin: You know, it’s strange, though, Dave, the stock market has only reacted just a little bit to a lot of the international conflict that we seem to be facing. In fact, the news that seems to be coming out is growth. The picture right now seems to be economic growth. Sometimes you can have the day-to-day things look like they’re creating crisis, but the overall economic picture – is that what we have done? Have we turned the corner?

David: Well, with good news comes the need for the central planning community to shift strategy. And at this point, they are not shifting strategy. And this is, in fact, how bubble dynamics go from the original central bank instigation to the self-reinforcing dynamics of a latter-stage bubble.

Kevin: And you would call this a latter-stage bubble?

David: I would, where you get the last buyers who enter the market – they’re chasing price, they’re chasing returns, and they’re not really appraising risk or how far the market has come in a certain timeframe.

Kevin: Dave, I’m getting calls – in fact, I just did five minutes before we stepped into the studio – from people who are in their 70s who have been retired. Gold owners – they have owned stocks and bonds, 401ks. They are calling me and asking if they should buy bitcoin right now. So crypto-currency – is that a bubble?

David: I guess that is what I mean by late-stage bubble dynamics. When the central banks of the world create excess liquidity, it finds its way into asset prices and it certainly changes the mood for a time. And what we have at this point with crypto-currencies, the initial coin offerings, or even in biotech with a nearly 30% return from the beginning of the year, these trends become self-reinforcing. Buying begets more buying. Selling, ultimately, begets more selling. And that is the nature of any market, one direction or the other, but at this point you still have buyers lining up.

Kevin: Isn’t it amazing? I saw that Paris Hilton, of all people – and a lot of celebrities – is offering her own initial coin offering.

David: Well, if that doesn’t get us close to talking to the elevator boy at the local hotel as you’re going to your floor, when he’s talking about what he is buying or selling, I don’t know what does.

Kevin: Right.

David: Well, these trends continue, to a point, and then, of course, as I said, selling begets selling, just like buying begets buying. And all you need is a single point of concern which shifts sentiment, and then the market shifts direction.

Kevin: Well, let me ask you a question because obviously we can criticize what we call broken window economics in the long run. You don’t want to break something so that you can rebuild it. But in a way, sometimes those things come to us without us asking. And the Houston event, what has occurred in Texas – you were talking about automobiles, and how automobile manufacturing was really getting into trouble. They had over-inventory. I don’t know how many cars will be lost in this event that occurred down in Texas, but those cars will have to be replaced.

David: Yes, and I think that is important. I want to say one more thing on the initial coin offerings. When you look at Bitcoin and Ethereum, and some of these newer iterations, the tech boom was up over 1,000% and that is what gave us the late 1990s tech bubble and burst. Bitcoin is up already over 3000%. So by definition, yes, we are in bubble territory. What ultimately causes a reversal, I don’t know, but this is a market. The entire market of crypto-currencies is a market where you have all buyers and virtually no selling. And so it is an interesting phenomenon within the world of finance to have, not a two-way market – generally, when you look at a healthy market, it runs in two ways. And this is a little bit like a four-lane freeway going in and a goat trail coming out. There is virtually no liquidity in the crypto-currencies.

Kevin: It’s the greater fool theory, is it not? The greater fool theory can work in any market where you just assume that you are buying something that someone will pay more for in the next ten minutes.

David: And there are people who will continue to buy the crypto-currencies. There are people who are just now becoming aware of it. As you said, somebody 70 years old who says, “Gosh, maybe I should own some Bitcoin.” Well, that’s an interesting thing to occur. One more person added to the line of interest. You don’t have a market that gives you the ability to sell, to liquidate. I don’t think people are aware of that. If you owned a million dollars of bitcoin today and tried to sell a million dollars of bitcoin today, it is actually quite a laborious process. And so, it is a one-way market, a little bit like buying shoes from Footlocker or Payless. You can buy them, but you’re not intended to bring them back. And so far we haven’t seen the development of a market within the crypto-currencies, to be robustly two directions.

Kevin: Dave, you make a great point. When I was experimenting with Bitcoin, and I have some on my phone, not to speculate, but to learn, it took me over seven days to accumulate the coins I bought, and they didn’t show up in my wallet for seven days. The same occurs when I go to sell it. I can’t just go right away to sell it, they have to go find a market for it.

David: I think that will be interesting, as people learn on the dark side of the cryptocurrencies, what illiquidity looks like. But you mentioned autos, and I think that is a really interesting point, because the ISM manufacturing numbers this last week were very strong, and are likely to improve in coming months. The Institute for Supply Management – again, these are auto inventories which, frankly, over the last few months have been very high, worrying high, and were an issue for your auto manufacturers. Lo and behold, with Harvey, you have 500,000 automobiles which are going to get scrapped. That takes the pressure off of the sector and puts some spring back into the step for General Motors and Ford and what not. So there are some positive aspects.

And I’m not looking at this as the broken window fallacy, people buying new autos, because obviously, those resources could have gone to things that were more productive. But at least it’s a Hail Mary for the auto sector, even if it’s not broadly beneficial for the economy. We did have the GDP stats come in at 3% growth, and that is interesting. If you were to question that, if you were to scrutinize it, you could also bring alongside last week’s GDP numbers from Canada.

And because they were very strong, coming out at 4.5%, actually the strongest in the world right now, sans China, guess what you end up with? You end up in support of the story of broad-based improvement in economic recovery. You look at the export component within the Canadian GDP statistics, and it improved considerably. And that goes a long way toward saying, yes, there is some legitimate growth here in the United States, we are their most significant trade partner, and so if we have a 3% GDP growth number, they have a 4.5% GDP growth number, both are moving positively in the right direction.

Kevin: I think it is interesting – you bring up that we are a significant trade partner, or the significant trade partner. You can understand a lot by looking at people’s friends or their enemies. You have the Canadian thing where you’re basically saying, “Look the growth in Canada. Maybe that does paint a picture of growth here.” It is also playing a role, actually, in this Korean side of things because of trade partnership between China. We have a lot of diplomacy that cannot be understood without trade partners.

But going back to growth, Dave. At this point we really are starting to see real, live evidence that there may be growth. Granted, it was stimulated by central bank intervention. But what do they do now?

David: And that is the question. Is the growth sustainable without continual central bank intervention? Because at this point in the playbook, they’re supposed to be pulling back. They are supposed to be, actually, normalizing interest rates and taking away the punchbowl, so to say. So, we have many statistics, economically, which are, in recent months, taking out highs we haven’t seen since 2011 and 2012. If you have economic conditions improving, which is very different than what we have had in recent years where the Fed talked a lot, central banks were telling us that improvements were there, and actually, very little growth was on the radar. So they were talking about growth and it wasn’t there. Now, it’s here and they should be changing their tack. They should be changing the things that they are doing in the marketplace.

Kevin: In other words, raising interest rates.

David: That’s right. But now that economic activity is picking up in earnest, the academic central bankers need to shift their real-world decision-making. And if they don’t change their real-world decision-making, we’re going to have issues. What are we talking about? We’re talking about the kinds of decisions which Paul Volcker would have made, the kinds of decisions which William McChesney Martin would have made. A central bank is, in the modern era, supposed to bring monetary stimulus in those lean periods of growth. That’s what they did. And they also are supposed to curb that stimulus significantly, not when growth picks up but before the growth picks up. Translation – they are now risking being behind the curve. And they are, in fact, very much behind the curve. We have 4.5% unemployment, we have 3% GDP growth. And lo and behold, the conference that we had recently at Jackson Hole suggests that gradualism is the course, normalization of rates, which has been the topic of conversation since the beginning of the year, looks like they’re not going to raise rates between now and the end of the year.

Kevin: Yes, so talking about being behind the curve, we’ve talked about coming in and stimulating an economy for maybe two, maybe three years, at the maximum. Dave, we’re eight, nine years into this stimulation. They haven’t changed tack any of those times other than turning quantitative easing into artificially low interest rates.

David: And it brings us to this point which I think they realize that the economic growth that they see has been dependent on financial monetary stimulus. And that it has not been organic in nature. And there is a question. Is it sustainable if they normalize? And on top of that, this brings us to a very important issue. Can they truly normalize in a world that is over-extended with debt? In other words, are there real-world constraints to allowing rates to rise when your debt burdens are a multiple of what they were a few years ago?

Kevin: And isn’t a lot of that short-term debt? It has to be renewed on a regular basis.

David: The bulk of that debt is short-term in duration, you’re right. And that requires refinancing in the short-term. So whatever the prevailing rate may be, if they are refinancing now, it’s at historically low rates. If they’re refinancing over the next two to three years, and they are, in fact, normalizing rates back to 3%, 4%, 5%, 6%, then you’re refinancing those rates at significantly higher levels, and this is where the Treasury has a problem. The Treasury cannot afford an increase in the interest component. They cannot.

Kevin: Do you think that is what the Russians understand right now, the Chinese understand right now, the Indians understand right now? There is an awful lot of gold-buying going on everywhere but here, Dave.

David: That’s right. We’re talking about unprecedented central bank commitments, not just at the Fed, but the ECB and the Bank of Japan stand out, as well, and there are consequences, ultimately, to those massive central bank balance sheet commitments. And I do think that is what the Middle Easterners see, I think that’s what Asians see, I think that’s what Russians see, and why they are buying gold very aggressively at this time. So, the world is aglow with growth, yet some people are still hedging that bet, and the reason they’re hedging that bet is because they understand the nature of the growth. They understand what was driving that growth, and they understand how superficial it was to begin with.

Kevin: You talked about the bubble that we created with the tech stock boom, but in the past when bubbles have popped we have been able to move that growth elsewhere. So when the bubble popped in the tech stock boom, the Federal Reserve was able to, under Greenspan, move that bubble over to real estate. When that popped, the government came in and pretty much institutionalized, with the Federal Reserve buying of mortgages, the real estate market. There is no one left to bail us out, Dave, except for the savers, at this point.

David: And where do you shift? What asset class do you shift to? When you tinker with interest rates too long and it impacts all asset classes, it’s not as if you can shift from technology to real estate. Real estate has recovered. Granted, it hasn’t gone through a real boom cycle, but it has recovered from its lows from 2008-2009. I guess, I view the next financial crisis as a very critical period – a very critical period of fear. This is where we are. When you look at the constraints that are on the central bank today, and the academic views of what has to happen, reconfiguring the financial landscape, shifting it to be more extractive from savers…

Kevin: That’s you and I.

David: That’s right. There is a period ahead which actually requires a high degree of social fear and concern for the Fed to be able to operate in a way that gives them a free hand at what they want to do. I’ve considered the possibility of tax increases on the wealthy, and that remains a possibility, but quite frankly, it is the wealthy elite that run the show in the first place. So I have reconsidered that to some degree and said, “Look, self-inflicted wounds are not all that reasonable to expect. That would only come if you had leadership of the Bernie Sanders type.”

The backdrop for a broad-based extraction from savings pools – that’s already been set. And by backdrop, I mean the academic and intellectual justification for it. We’ve talked about Michael Woodford’s book, Interest and Prices, and we’ve talked about the work that Ken Rogoff has done in justifying closing the financial system and moving toward a cashless society.

Kevin: But John Maynard Keynes said that inflation is the tax that only one in a million may understand. They understate inflation at this point. That’s probably their greatest form of extraction on a year-to-year basis, is it not?

David: That’s version one. Version one of broad-based extraction from savings pools is via inflation. So you have the classic fudging of the inflation statistics, you understate the inflation statistic, run inflation at a higher level, and that allows government to pay back debt with ever cheaper dollars. And that is one way of gaming the saver. But the financial repression tools – this is version number two – of low to negative interest rates are equally viable in the years ahead. And they need a closed financial system to get that done. To be able to extract value from every saver across the country, the choice of leaving the system has to go away.

Kevin: That’s à la Carmen Reinhart. That’s what she said. She told us they are going to have to create a captive audience.

David: Right. So, no more money in the mattress. No more opt-outs. And that kind of lockdown is not likely to occur outside of a public invitation for it.

Kevin: So, a crisis, or a crash, where people say, “We have to do something right now.”

David: Exactly, which would have to come in the context of fear. You have the accepted narrative which they would be promoting. It will have to match the academic narrative, that is, will have to match an atmosphere of panic, where the government then offers a perfect solution to abet the concerns in the marketplace. And so, it is possible – we’ve talked about the death of money before, and the inflationary death of money which classic books have been written about. The death of money in this episode of financial history may look more like an extinction event for physical currency as the world shifts toward a digital alternative.

Kevin: But how many people really care anymore, Dave? When you open your own wallet, how much cash do you have versus how many cards do you have? I think a lot of the people would let it pass and just say, “Well fine. Fine. It was inconvenient to have those pennies in my pocket anyway.”

David: It was interesting, when we were in Europe over the last few weeks we did operate with a lot of cash. It was very convenient to do so. And actually, there are a number of places … you know, American Express is not accepted many places outside of America.

Kevin: So you can leave home without it these days.

David: And actually, very interesting, to take a Visa and Master Card, you need to be in the European banking system, not in the U.S. banking system, and have a European credit card to be universally accepted in Europe. It was interesting because there were a number of places that were not interested in taking Visa, or Master Card either. So we found that cash was still a very good alternative in terms of just operating. And certainly, once you got out of the cities, I would say that half of the places that we went which would not take credit cards or debit cards at all. We went to the grocery store and they only took cash, which actually was very relieving to me.

Kevin: So you see that as different than the populace here in America.

David: And I think, as we made mention a few weeks ago, just in interacting with some of our clients at the client conferences, certain places in the world, China being one of those, 70% of the population doesn’t mind the move toward a digital alternative because they’re already there, for the convenience factor. They can do everything on a digital phone, a Smartphone, and the idea of having the burden of cash is consistent with Rogoff’s idea of the curse of cash. Who needs the stuff?

Kevin: But what about that remnant, Dave, that other 30% like you and I, who think, “Do you not see what is happening here?”

David: Exactly. The other 30% need the coaxing of financial panic to soften their defenses. And so the size and scope – what are the things that we know? We know that the size and scope of government doesn’t voluntarily shrink.

Kevin: Leviathan gets bigger.

David: It grows. And the expenses to maintain it rise over time. And the burden on society grows with it. So what we have now is debt levels which have reached unsustainable heights. So, if you’re going to continue the game, if you are going to continue to maintain the state apparatus, you now have issues. How do you finance it? The state is not going to remain neutral on this. It is going to fight for its existence. And it will do it at the expense of citizens. It will do it at the expense of savers. So again, these extractive techniques have to be perfected so as to get the most out of people without them realizing it is happening to them.

It’s a little bit like a vampire bat extracting a quart of blood from you while you sleep. You wake up with a small nick and you think, “I wonder what that’s about?” But what happened? Not realizing that you feel a little peckish the next day because you happen to be missing a little blood. That’s what they want to do. They want to take from you without you necessarily knowing what was taken. And that is a critical point because just like inflation is not understood, I’ll tell you what. Financial repression – if you want to see a blank stare on someone’s face, just say, “Hey, you what their best technique is? It’s financial repression.” They will say, “What are you talking about?”

Kevin: You can exemplify it – when you talk to someone who is retired and they’re just wondering why they still have to work. There are a lot of people out there with part-time jobs who are in their 70s, even 80s, that probably wouldn’t be working if they were doing it the way their parents did it. Their parents were able to earn interest on their savings. You can have somebody who is a multi-millionaire right now, not earning enough to actually pay his bills without a job.

David: Inflation has always been something that has pressured those living on a fixed income. The pensioner, the retiree – they’re going to feel it the most, and probably not understand what is happening. As you say, frustrated with not understanding why what they saved isn’t enough. So, that idea of financial repression – it’s an academic term today, and it’s a term that very few Americans have ever heard of, but it is critical to the funding of government, both present and future tense.

And to complete the task of implementing the repressive structures, the financial system has to be 100% controlled. We’re talking about every movement tracked, we’re talking about every transaction accounted for, every dollar known. And so the next financial crisis is the perfect period for bringing in what is an oppressive regime, but won’t be seen as such. It will be seen as, actually, a relief – again, the savior of the system, if you will – but it is what will account for extraction from every dollar in the system on a non-voluntary, non-disclosed basis.

Kevin: And what you have just described, Dave – I was talking about the call from this man who is in his 70s who asked if he should be buying Bitcoin. Bitcoin is based on block chain technology, which does track every little event. It has every element of the transaction coded into it. Now, granted, you have to be able to break the code to understand it, but it is there. There is a trail that is left that is unlike any other kind of currency transaction. When you traveled around and did the various conferences with your dad this last couple of months, you brought out that you think possibly that technology will be co-opted away from the private parties and into some sort of government currency system. Is that what you see?

David: It gives a perfect record of who has owned what, and when, and when they disposed of it. And the distributed ledger, which is, again, a part of that block chain technology. It is the best technology for creating – and I know this will be controversial, but there are many people who like block chain who say, “No, it’s quite private. Nobody knows who owns it or what is happening.” And I’m just telling you, I’ve spent enough time in Palo Alto, and with guys who know far more than I do in the world of ones and zeros, and understand the digital ether far better than I do. And every one of these crypto experts would say, “Yes, it’s fine now. But there is nothing that can’t be hacked. There is nothing that can’t be co-opted. And ultimately, in the crypto-currencies and the block chain, that will be done.”

Kevin: And you see the paradox, because if you ask someone about privacy, if they love block chain and they love Bitcoin, you can say, “Well, what about the privacy?” And they say, “Nobody can get to it.” Then you turn around and you say, “Yes, but what about fraud.” And they say, “Well, the proper parties can actually go back and recreate everything that is needed.” So you hear both sides.

David: That’s right, the proper parties. Wall Street is in the transition process. They are reinventing themselves in terms of how they process transactions – this is buying and selling of stocks – and they love the block chain technology because it is far more efficient. It is faster. It will allow them to settle transactions in a more efficient transactional basis. So I think block chain is here to stay. Block chain will be a part of every transaction we have on Wall Street three years from now. I think that is a given. It is a given. I don’t know what cryptocurrencies will survive the next three years, and how many more will be birthed over the next three years.

Kevin: But they are the guinea pigs for the people who will ultimately control the system.

David: And ultimately, the system having control of everything financial, and operating within a closed system, requires a tracking. It requires the exact process which is there in the distributed ledger.

Kevin: So, we’ve been talking about bubble dynamics, since we’re talking about crypto-currencies and some of the other areas that we are seeing bubbling up right now. All it takes is a shift in sentiment. In the beginning of the program I mentioned North Korea. I mentioned what is going on with the GDP drop in countries that are taking currencies away. We have these hurricanes that are hitting. We have natural disasters that are occurring. What changes the sentiment, and does it have to be fear, or could it be something different, like a nuclear bomb, God forbid, going off somewhere where we didn’t expect?

David: Right. You look at past issues, and maybe the present and future concerns in terms of financial instability will play very differently. But one thing that has been critical in most instances of past financial concern is credit. So, do we have a credit event? Probably, we will. I don’t know when, or if that will be the catalyst this time around, but where does the shift in sentiment come, from which we see a market decline? Maybe it’s a credit event. Could it be a political event, such as an impeachment, or an indictment, or something like that – some sort of political crisis? Possibly.

Kevin: Or Korea?

David: Military confrontation. Exactly. Maybe it’s the U.S. throwing its support behind Poland, and it’s the final straw for the Russians. Maybe it’s defending South Korea in an overt way and we end up with North Korea and a twitchy finger.

Kevin: Or how about a larger enemy than North Korea, like China?

David: Blocking China along the 9-dash line. We find ourselves, already, in the Middle East, and in military engagements. Maybe we extended and over-extend. Maybe it’s a terror event involving EMP on U.S. soil. Frankly, it could just be gravity.

Kevin: You know, it doesn’t matter, Dave, because we already have the credit event built into the system. The credit event is already there, and so the trigger – how often can we actually predict a trigger? We can predict a downturn, but we can’t predict a trigger because the trigger, itself, is only identified later. It’s the breaking of the ice.

David: There is a young man who climbed Engineer Mountain just north of town. This goes back nearly 15-20 years ago. He was a chef here in town, a mountain climber, and he went up and he sat on top of a mountain. And little did he know that he was participating in overhang and gravity. He was on the top of an ice sheet which was extended over the edge of a cliff and he didn’t realize that it wasn’t actually a part of the frame of the mountain that he has just climbed.

Kevin: He and his dog, if I remember right, and I think his dog survived the crash.

David: His dog survived the fall, and he did not. Gravity is all that it takes, and we already have an overhang of debt. Gravity exists, and it is at work all the time. That is what makes credit market growth so fragile, because gravity is always there to exert itself on the markets. And credit growth is a variable that, when it is primarily responsible for economic growth, it has to be maintained at an ever-expanding rate, and it is inherently unstable. In the end, it is unstable. But in the interim, it is impossible to say no to. It’s what we have done, it’s what has worked, and so it’s what we continue on with.

That’s the conversation that we have had over and over again with Richard Duncan. He has said, “Look, we have to do credit growth, and we’re addicted to credit. Yes, we’ve gone from capitalism to debtism,” he would say. But now that we’re addicted to debt, if you cut the addiction, you know what happens. You have a system that collapses, and you don’t want to deal with the ramifications of that. So, on we march with credit-driven growth.

Kevin: But we’re solidly into the tenth month, Dave, of this Trump trade. Steve Bannon was directing the ship, talking about draining the swamp, Trump was repeating him. We had this momentum on November 8th that changed, and debt no longer mattered because we had Trump in office.

David: Because growth was going to supersede the debt and get us ahead of the curve.

Kevin: You were going to have tax cuts. Health care was going to be reformed. So, where are we, especially post, or sans, Steve Bannon? Where are we with the Trump trade?

David: It’s critical because you have so much built into the stock market today which is dependent on the Trump trade. The Trump trade is over. Again, we have the backdrop of an overhang and too much credit. We have economic growth which has been driven by credit growth and it has to expand on an ever-growing basis. And that, ultimately, is not sustainable.

Kevin: But we bought time with the Trump trade.

David: Bannon is gone, and with him is also gone any hope of draining of the swamp. That’s just a reality. Anybody who is sober-minded recognizes that, because you have Democrats which effectively control the White House. You look at the folks who are in the West Wing. How many of them are card-carrying Republicans who have always voted conservatively, down the line?

Kevin: Right.

David: Oh, you can’t think of anyone?

Kevin: No, and there are an awful lot of RINOs in there.

David: Right. So we’ve got the reasons for the election rally, which have dissipated, and yet, prices have yet to recede. We have political developments which helped the markets over the last eight to nine months. And now the oval office continues to devolve into nothing more than a dysfunctional family office, because who is there? You have Kushner, you have Ivanka, you have daddy, and it’s just going to be interesting to see how traders position themselves in the fourth quarter. As investors look and say, “He promised the sun, moon and stars,” and actually, Bannon was kind of jet fuel, he was getting some things done, he was talking things up. And he was anti-establishment to the core. And yet who, in that anti-establishment mode is still there? Um, I think they’ve been drowned in the swamp.

Kevin: So POTUS lost their modus, is what you’re saying, at this point. Because the modus – ultimately, the guy behind it was Steve Bannon.

David: Right. The campaign trail promises had a chance of being acted on when you had the iconoclastic Bannon pressuring for change. But in a post-Bannon White House you have more Democratic holdovers from the last administration. Keep in mind, a lot of the appointees from the Obama administration have never been replaced. And you have all the Democratic appointments from Trump, including some of his own family members. And the issue here for investors is that the markets have priced in positive policy shifts in the area of tax reform, in the area of health care reform, in the area of infrastructure spending.

And so far, Trump’s policy agenda has been locked down – locked down by Democrats, but also locked down by his own party. So, you have political dysfunction, and a failure to deliver on promises which have already been priced into stocks. I should say that differently because what has been priced into stocks is the delivery of those promises, and the failure of them has not.

Kevin: Right, so it has to unwind at this point. It’s called unwinding a trade when you want to get back out.

David: Momentum can carry a long way in either direction. It can go up and up and up. It can also go down and down and down. Bannon said as he was leaving the White house, “The Trump presidency that we fought for and won is over.” I don’t think this was him bitterly leaving because somehow he didn’t get to stay for three to four years, or eight years, or what have you. I think it’s a sober reality that what the American person who voted for Trump voted for is no longer a possibility. That has not been priced into stocks. So the end of the Trump trade may allow for gravity to be felt once again. Because again, we have had the sense of elevated, whether it is feelings, or credit growth, or what have you – we’ve been able to defy gravity.

Kevin: Let’s say that that is the case, and you are a hedge fund manager, Dave. You’re going to have to try to squeeze returns out of something that – because they’ve had great returns over this last year based on the Trump trade. So at this point, do we see an increase now, even beyond what we have seen? We have record leverage in the market right now. Does that leverage actually go higher?

David: Yes, the intended consequence of the central banks’ playbook in recent years has been to inflate asset values.

Kevin: Yes, and they’ve done it.

David: They’ve done it. The rates that we see today, near zero – they reflect that. The problem has been that as rates have come down, risk-taking has gone up. If someone can’t get the returns that they need from the traditional products they go to ordinarily, they go to either more esoteric products on the one hand, or they simply add leverage to the plain vanilla products that they used to buy. So hedge funds are transforming products with less than one-half percent return, into products that yield 5% or more by adding 10-20 times leverage. Let that sink in.

Kevin: That’s like Bear-Stearns ten years ago.

David: Yes, half a percent can be 5% if you add enough leverage. So no, it’s not Bear-Stearns 40 times leverage, but you’re already up to 20 in many instances. That creates an unstable layer in the investment snowpack.

Kevin: You were talking about snowpack, you were talking about the overhang that this chef had fallen from. I think that was about 20 years ago here in Durango. That was very sad. But you do a lot of stuff in the snow and the ice, and there is a time when you realize it’s about to slip.

David: Right. An ice and snow hoar is where you have a degraded layer of snow because it has been exposed to sun. And as it bakes there is a degradation of the snow layer by those external conditions, and it turns sort of an interlocking matrix of flakes into tiny ice pellets which are more akin to ball bearings. So again, you get pressure from above, you get any more snow on top of that, and it makes for a very unstable layer, and that is what catalyzes a collapse in the snow pack. I look at the synthetic CDOs which they are coming back out with. These are the kinds of products…

Kevin: It’s what we had in 2006

David: Yes, exactly, which led to the global financial crisis, and they’re back in vogue. Tremendous amounts of implicit leverage in the products. I’m just telling you, the quality is such, there is a degradation of quality there that is like that weak layer in the snow pack. It doesn’t mean that you don’t have stability above and stability below, but all you need is that thin layer in between that acts like a ball bearing, and the pressure that is exerted by that layer above, the assets above, or in this case, the snow above – gravity does its work on any unstable layer, and that is where the catastrophes come from.

Kevin: We were talking about growth. Now, one of the things that would accompany growth in an economy oftentimes is the rising of interest rates. Even if the Federal Reserve keep rates artificially low, you still have corporate bonds out there. You have a lot of private entities that loan money to other people. Are interest rates going to rise? It is strange. What is going to happen to the bond market, because when rates rise, bonds do go down.

David: If you don’t go to our Wealth Management website every week, I would, and read our credit bubble bulletin, read Dave Burgess’s summary on Friday of what is happening in the markets and how it affects our managed portfolios. But this last week Doug Noland pointed out that ordinarily you would see pressure in the bond market in an environment where economic conditions were improving, stock prices were rising globally. But not this time. Not this time. Bond-holders are content for the time being. And perhaps it is because they are sharing company with central banks who are buying everything under the sun, and seem intent to continue buying assets, perhaps well beyond the point at which they should.

Again, this brings to mind William McChesney Martin. He was the man who advised taking away the punch bowl before the party gets started. And his ghost doesn’t even exist today. Central banks need to transition, and they can’t. If they transition, they raise rates, and the system has too much debt overhang in it to allow for an increase in rates. If the market drives interest rates higher without permission from the central bank, you are talking about catastrophe. You are talking about chaos. You are talking about a disorderly march through critical levels, which the financial system cannot afford to breach.

Kevin: Sometimes I wonder, though, Dave, because the Wall Street model – if you’re sitting and talking to a normal Wall Street broker, and you’re saying, “I’m really worried that the stock market is too high,” he will say, “Well, that’s fine. We’ll just move you over to the bond market.” That’s the natural thing that Wall Street teaches. But actually, the old money realizes that stocks and bonds are both vulnerable, and they move from the paper asset sector, ultimately, to the physical asset sector. And then back. They move back and forth like the Bass brothers.

David: Right. Old money knows that the long game in asset management is between paper assets and real assets. And there are long periods of time – we discussed this years ago when we looked at the Bass brothers and how they transitioned from paper to tangible, and then back to paper assets again. Richard Rainwater, of course, guided them through several of the most critical portfolio transitions for that family. Arguably, the transitions which made a difference, if you were looking at a 100-year period, those were the critical decisions to make. Yes, they were in oil and gas and gold and water, and yes, they came out and went to paper assets.

Kevin: When did they come out? 1980? 1981? They had made a huge killing with oil and gold.

David: They came out of inflation-sensitive assets in 1980, went to cash, sat in cash for a couple of years, went back into paper assets in about 1982. Those kinds of moves, again, whether it is the tangible asset world – gold is one of many assets in the tangible world, but it is a good one, one that provides a lot of liquidity. Others don’t have that. Paper assets have their day in the sun, too. Knowing where you are in the cycle is absolutely critical.

Kevin: It just reminds me of the Dow-gold ratio that we have talked about so often. The Bass brothers played that ratio. Whether they knew it or not, they were playing the ratio perfectly.

David: That’s right. Whether they knew it or not, they caught one of those key transitions. And transitions are key. You and I both talk about jazz, and how in the world of jazz, it’s the transitions. Transitions matter. But you look at paper assets – they offer significant gain potential as long as markets are well supported by monetary policy, as long as they are supported by long-term, organic growth trends, whether that is demographically driven or by innovation and technology. But it is also well understood that the longer the central bank and that planning community stay supportive of the markets, the closer you’re getting to a period where paper assets move instable, and all of a sudden the gains which it took you years or even decades to accrue can be given back in years or even months.

So actually, the old money does a little dance. The old money moves between paper assets and real and tangible assets, and that’s important to watch. We see the transition already beginning, first with a move to cash, and out of growth. And that move is underway in a process of re-risking. Second will be a move to tangibles, and out of cash.

Kevin: That’s when they start to worry about the currency, itself?

David: Well, that’s just suspicions about the currency stability, as those suspicions rise. And of course, we live in this bubble – the United States, which is a bubble, a little hot house for growth over here, tomatoes are riper and everything is fine. But you step outside of this hot house for growth, and you already have the suspicions of currency instability elsewhere. So when we talk about investor demand for gold, you see it in the Middle East. You see it in Asia. You see it in Russia. And it is, in part, because they recognize that what built growth over the last 20-30 years, this long-term secular trend of growth, has come to an end. And all we have had is central banks buying time in the interim.

And actually, it’s over. All they have done is buy time. But actually, it was over six or seven years ago, and all we have been living on is borrowed time. They are already experiencing suspicions of currency instability, and that is driving demand for gold. And we’re seeing growth in the price. And I think you will continue to see that as the U.S. gets on board. It doesn’t have to get on board. Note that we’re already through $1300 in the gold price. And that is not from U.S. buying. I promise you that. As I have talked to people in the industry, this is the slowest period, in terms of gold consumption in the United States, in probably 40 years.

Kevin: Yes, but nowhere else. Everywhere else they are buying gold.

David: Exactly.

Kevin: But let’s talk about the paper market, though, for a moment, because it may seem that we criticize paper, but paper has had a very good run. This is one of the longest runs for the paper assets in the history of the United States.

David: Yes, well, institutional money is, to some degree, locked into that trade. Old money and private assets know the historical record of central banks. They know that central banks will commit, and that is where you get these adages, “Don’t fight the Fed.” But they also know that the Fed can overstay a policy, and overshoot a target. And inflation remains off the radar at the Fed, but it’s more and more on the radar for old money. With the consequences of all of this credit creation we see inflation in asset prices, and we see, already, the rumblings of discontent among the hoi-polloi, the common man, who says, “It’s not working for me. I’m running out of money before I’m running out of month.”

And the stirrings of social discontent are already there. I’m telling you, smart old money and old money gets a sense for that, and they know when to get quiet, they know when to go underground, they know when to switch asset classes. And so, you’re right, paper has had a good run, not just the 2009 to present run, but looking at fixed income, as an example, a 36-year bull market.

Kevin: Yes, interest rates have just continually dropped. That’s very nice for a fixed income owner because the bond prices go up during that time.

David: We have matched, here in 2017, the longest credit trend in U.S. history. What I am saying is, the average directional trend in interest rates is around 28 years, the short ones being in the low 20s. The longest was 36 years, happened once. Arguably, we put in lows, in terms of interest rates, last summer, 2016, 36 years after the decline in rates began, and the march higher in bond prices began. So now we have two times in a 200+ year history that bonds, as well as stocks, are vulnerable. Going back to your comment earlier, ordinarily, people will move from stocks to bonds when they want to de-risk, but look at this. Bonds being at an inflection point, as well – that puts the entire modern portfolio at risk. Ordinarily, Wall Street guides you to a mix of stocks and bonds, balance the risk between the two assets in a period where fixed incomes come under pressure, too. Now you’re in a position to lose on both sides.

Kevin: Right. And old money, like you said, understands that. That is why they move to real things when that is about to happen.

David: It could be farmland, it could be gold and silver, it could be water.

Kevin: It could be cows on the hill (laughs).

David: (laughs) Exactly.

Kevin: But you have brought out in the past that the indexes that we watch, like the Dow-Jones Industrial Average, sometimes lie. They are not necessarily indicative of the entire market. At this point, I think the overall indexes are degrading while the Dow has been continually holding near to all-time highs.

David: Right. This is where you are seeing a divergence between the broad market and the indexes like the S&P, the NASDAQ and the Dow. Those indexes continue to rise while the broader markets are, in fact, moving lower. John Hussman noted this last week that more than 50% of U.S. stocks have broken below their 200-day moving average. You need to think about that because 50% of the stocks that trade today are in a downtrend such that they have moved below a technical sell level. We have, already, broad-based selling, but it is covered over by the index strength. Again, as you have late cycle investors putting money into what we would consider a valuation-blind purchase of index funds.

Kevin: Right. It’s the greater fool theory. Again, it’s just hoping somebody will pay more for it tomorrow.

David: What is something we don’t hear about much today? We don’t hear much about the currency manipulation by the Chinese. The U.S. dollar is down 9.5% year to date. The RMB is close to being up 6%.

Kevin: Yes, so the Chinese don’t seem to be pegging it anymore.

David: No. And again, we’re late in the cycle, and I think at the very end of the cycle as things fall to pieces, there will be finger-wagging, and there will be blame, and I don’t know who, ultimately, will be blamed. A lot of that will depend on who is in office when the chickens come home to roost. But the fingers will point and people will be tagged, and certain subsectors within the U.S. will be required to pay for the mess. And it is coming fast. But we originally were setting up a narrative, and Trump was setting up a narrative where the Chinese would be that go-to blame. The oval office wants the tariffs, they have been asking for tariffs, and yet, with the current currency trends, it is not supporting the narrative.

Kevin: How do you justify it?

David: It’s currency manipulation for trade advantage. If anything, maybe we’re the trade manipulators (laughs).

Kevin: Do you remember, Dave, before the last bubble popped, there were a lot of integrity problems. In other words, there were a lot of mortgage lenders who were giving mortgages to people that they absolutely knew were not going to pay. Integrity really does matter, and when you come toward the end of one of these cycles, like you said, there will be finger-wagging when it does comes apart. Where is the integrity when you look at a Wells Fargo who is just creating artificial accounts out of thin air? I think the latest news is, it is 70% more than what we thought, is it not?

David: I can’t help but think of Warren Buffet. He is one of the largest shareholders, or was, of Wells Fargo, a champion. The best and the brightest, taking the least risk, great management, great leadership. You have Jim Cramer who tweets, “you have charlatans running the joint,” as he talks about Wells Fargo in recent weeks. And what did Warren Buffet say? “You get to see who is swimming naked when the tide goes out.” And as the tide goes out, and financially speaking, we see a decline in equities. You are going to have a repeat of that 2000-2002 period, where it’s Tyco, it’s Arthur Anderson, it’s Enron, it’s WorldCom. They came under pressure for unethical business practices. But today I don’t know if that is even possible.

But as you see a change in sentiment in the marketplace, do you know who is going to suffer? Google is going to suffer. Why? Because they have already had to admit, and they are paying people back as we speak, that they fabricate their traffic numbers in order to bid up advertising costs. So they have been using false data. Again, there is no payback in the marketplace today because positive sentiment still exists. Stocks are still holding out at near all-time highs. And so they will continue to be in business as if ethics don’t matter. But what you see is a very different accusation that is leveled at a company, and a very different treatment of any business that has not done right by their customers, when you move into a bear market.

Again, what you are saying is right, we’re going to find it’s not only Google, it’s not only Wells Fargo fabricating accounts and creating fake accounts, as you said, 70% more fake accounts than originally uncovered. It doesn’t matter as long as stock prices are going up. But you get any trip-up in price and not only will you find that Google is to blame, or that Wells Fargo is to blame, but there are dozens of other places where integrity has been breached, laws have been broken. Again, these are the things that make for catastrophic declines because people all of a sudden say, “Well, if we can’t trust Google, who can we trust?”

Kevin: And Dave, it just feels right now, and I hate to talk just about feelings, but we have done this now for many years. I remember the crash in 1987, I remember the crash in 1999-2000. I remember the crash in 2007-2008. It feels like we’re nearing a tipping point. And I’m wondering, just to finish with gold – gold has broken above $1300. We have been in the $1330s. Obviously, there will be corrections, but we seem to have made the shift, like we talked about. The 65-week moving average, now, has been moving up very, very predictably, since June of 2016. So, are we near a tipping point, and do the people who are buying gold smell the same thing we do?

David: I think people will still look for a catalyst, what is going to drive the price of gold to $2,000, $3,000, $4,000 or $5,000 an ounce, and they will make their decision based on whether or not they can come up with a catalyst that satisfies an intellectual checklist. Yes, this is likely. Yes, this is probable. Maybe this is going to happen, so maybe this is the reason. Or maybe it’s not going to happen and that’s why I’m not going to buy gold.

What people don’t recognize – the World Gold Council came out with this two weeks ago. The World Gold Council came out and said, “Look, we plateaued in terms of production a couple of years ago. From this point forward we’re going to see a decline in gold production because every mine has had to cut back their exploration budgets. Every mine has had to shut down non-economically viable projects.

And so what was in the pipeline years ago has been mothballed.

Kevin: So supply is decreasing while demand is increasing.

David: And it is an interesting dynamic because nobody cares, and everybody is looking for “Well, look, we have growth here in the U.S. economy, we have growth in Canada, we have growth in Japan. We have growth hither and yon. Why do we need gold?” Number one, that growth has been fabricated, and is highly dependent only the credit which comes from central banks. If they normalize, which I don’t believe they can, there will be hell to pay for it.

But you have something more basic in the gold market than a catastrophic event driving people in. You have a lack of supply feeding existing demand, which is automatically going to put pressure upward on the price. You bring investors in for any reason, then yes, it will exaggerate a price trend. But what you and I know is that the price trend is firm already on the basis of supply and demand. The only thing that we get from here is fireworks.