September 9, 2015; Can China Beat the Great Bear Market?

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

“Sentiment is radically shifting, suggesting that this very well may be the big one. And what do I mean by the big one? A major correction where people just basically say, “I’m taking my marbles and going home.” And these three words, I think, may be the most memorable words from 2015 – “Get me out.”

– David McAlvany

Kevin: David, thank you. Thank you for going to China, because the leadership in China has now guaranteed that the Chinese government will step in and back a nullification of volatility and they have promised that we are near the bottom of this incredible crash that we have seen in the Chinese market.

David: Well, don’t you know that central planners know something that you and I don’t know, and that is, the direction of the markets? They know not only where it will go today, tomorrow, and five years from now, but they know exactly how it is going to get there.

Kevin: I thought you had something to do with that, though, Dave [laughs].

David: [laughs] Yes, we had some great conversations, certainly met with some very interesting, intriguing businessmen, as well as economists. Some of the most important Chinese economists alive today, I sat with at dinner on two occasions, and then sat in lectures, as well, so I thought it was very, very informative. The reality is that on the ground China is succeeding in some respects and failing in others. They are succeeding in their move away from investment and manufacturing, and toward consumption as a core component in their economy. Services, today, represent a greater percentage than infrastructure, investment, and exports, combined.

Kevin: Which is incredible because China was built on exports, let’s face it.

David: So, that’s the good news, and as I was in a panel discussion while overseas, I said that there is this issue of the good, the bad and the ugly, if you are familiar with the spaghetti western with Clint Eastwood from years and years ago. So, that was the good news. There is the bad and the ugly, and it is that they have a tremendous amount of reform to take on, and it is in about five categories and they are trying to get it all done at once, which may be more complicated than they can handle. That remains to be seen.

There is a project that we will talk about in future programs, not today, but about an 8 trillion dollar project that is the equivalent of a Hail Mary pass. They are going for the next phase of globalization. They believe that they are going to be central to the next phase of globalization, and they are going to spend 8 trillion dollars to make sure that they are center stage for growth in the 21st century. And again, I say it’s Hail Mary, because at the end of 8 trillion dollars is the end of their bank account and the end of all forms of solvency. So, if they get it right, maybe they are propelled, without the intervention of our U.S. State Department, of course, into the number one economic seat in the world. If they get it wrong, then they have squandered 40 years’ worth of savings and wealth accumulation.

Kevin: China is in the news every day right now because they are taking the blame for the volatility that we have in our own markets now. I don’t know that necessarily the blame is completely right, but what was your feel when you were in China? Is China the driver of the volatility worldwide or are there other factors to that?

David: You know, the timing couldn’t have been better to be on the road. We have a tremendous amount of volatility packed into one two-week period, the third week of August. Think of this. You have a 1000-point decline in one week. Then the fourth week of August, we open up that week with a 1000-point decline in a day, and actually, in the first 90 minutes of trading, that’s Monday, the 24th of August, we have the Dow traveling 3000 points as it gyrates up and down. And of course, again, rolling back the clock to the preceding week, the preceding Thursday and Friday were the biggest two-day loss since November 19th and 20th of 2008.

So, it was a great time to be overseas to get the temperature of a lot of folks, economists and investors, from Shanghai, from Shenzen, from Singapore, from Malaysia, all over Malaysia, from Indonesia, and even a few people from Europe, as well, this particular gathering was very, very talent-packed, I should say. And so, their insights and their questions were unparalleled. And I think it cut right to the chase – what are the issues in play?

And China, while it is an over-arching concern because they have these issues of migration from the countryside to the big city, they have these issues of opening up the next phase of globalization, which, as I mentioned earlier, we will talk about on another occasion, these are all big picture issues which have nothing to do with the current volatility in the stock market. And this was the key – I think this is the key – there are more core things which have been lingering in the U.S. markets which serve as the context for anything being a trigger.

And so what, ultimately, on a causal basis, is responsible for major problems here in the U.S. equities market? Is it capital flows in China, which are significant, or is it basic debt levels here in the United States which are way out of step, and frankly, represent something that is a ubiquitous problem, not only here in the United States, but globally? Too much debt is the problem of our day.

Kevin: Yes, but we criticize China often for trying to manage the perception of the people. We have talked about this back in the days when Russia was a communist country and they managed the perception of the people. But obviously, the plunge protection team, the Federal Reserve, doesn’t want us to believe that debt is the problem. And so, the plunge protection team, Dave, on those huge crash days, was right there to step in and save the market.

David: Yes, the mantra is, “Buy the dip, this is a great time, look at the values.” And all the pundits from your Wall Street firms lined up in support of this, Morgan Stanley actually suggesting that it is only once in a blue moon, which is about a once in 50 years occurrence, that all of their signals are pointing for this being a perfect time to buy. And it is fascinating that they are saying that, because you look at the amount of leverage that is in the system, you look at valuation metrics which are anything but cheap, and you have to say, well yes, this really is a question of managing perceptions.

The plunge protection team stepped in late on Monday, that is August 24th, and buoyed the prices in the afternoon. And it was interesting, even overseas, watching that action, because every forced rally was fed with more selling. And so, the lows, in and around 1860 – I think, those moving forward need to be watched carefully. That represents sort of short-term support. And getting below those numbers becomes sort of a Katie bar the door moment. Getting below what were the lows of a nasty selloff suggests that you have much more constructive interests that just want out because they believe that the big picture has changed, growth dynamics have changed, and it’s time to get liquid and get the cash.

Now, it’s interesting, when we’re looking at things it is often from a valuation perspective and things are over-valued. Louise Yamada is a name that may be familiar to some of our listeners. It is certainly a name that I have brought into the Commentary on a number of occasions. She and her compatriot, Alan Shaw, were at Smith-Barney, running a technical team that had been together for about five decades. They did some of the best technical analysis in the business. And about the time central banks became the dominant theme in the marketplace, Smith-Barney decided they didn’t need technicians anymore, because quite frankly, what does a pretty picture tell you when the driving force in the market is really just money-printing?

Louise has been on her own since then and runs a great service. Her conclusion is that after four months of the market failing to reach new highs we are signaling a bear market in U.S. equities. So again, you roll the clock back to four months ago and this had nothing to do with China. Now, we can talk about China being somehow causally connected, but the reality is we have had a difficult time making new highs. We have been grinding it out here for three or four months in the U.S. and we have talked about the fact that the Russell 2000, the S&P Midcap 400 – these are indexes that have already peaked – they peaked months ago. We began to see a major expansion in the spread, talking about the credit markets. High-yield bonds began to, again, reflect some concerns, long before we had these last two weeks in August and the catastrophic declines seen there.

Kevin: Does it feel, though, Dave, that the weather has changed little bit?

David: Absolutely.

Kevin: And what I mean by that is, we have looked at this market and said, every time there is bad news it is being taken as good news, which usually is a sign of a bull market. It seems now that bad news is being looked at as bad news by the investors.

David: You’re right. Bull market dynamics – good news is good news, bad news is good news. There is always a reason for the stock market to move higher. And something amongst investors has changed. Sentiment has turned from bullish to bearish. You can listen to CNBC and they are still waving the pompoms, you can turn on Bloomberg and there is every reason to be in the market and buying. But I’m telling you, amongst investors sentiment has already turned from bullish to bearish. And again, all year long, up until the last two to three weeks, bad news has been, in a very sick and twisted way, good news, because it meant that the Fed would postpone a rate increase and keep easy and cheap money flowing for longer. That was the logic. So, good news – good was good, bad was better, if that makes sense. And that has shifted. Now bad news is, in fact, bad news.

And so, really, what has changed? I think two things. Number one – and this is where China does feature prominently in the equation – I think central bank activism on the part of the People’s Bank of China has been shown to be ineffective in stopping the decline in stock prices, both in the Shanghai and Shenzhen markets. And this is critical because the popular narrative amongst investors and investment professionals has been that central banks can do whatever it takes, whenever they want, to direct outcomes and determine results. And that narrative is falling to pieces.

Kevin: Well, do you think, possibly, it is falling to pieces because a lot of the tools have already been used? Look at our own central bank, Dave. They have already kept rates near zero through what was supposed to have been an expansion. Now, if we’re going back into a bear market or a recession, what tools do they have left?

David: Right. So, the second component of central bank activism being proven as ineffective is beginning to encroach on the minds of investors. I think the second issue is the honest appraisal, a growing recognition that rates are already at the zero bound. We’re at zero percent. That leaves the Fed with limited options. So if, in fact, emerging markets and Chinese market declines become contagious, then the Fed really doesn’t have that many tools in the toolbox. QE is always an option, quantitative easing is always an option, but as a policy tool. It, to date, has done very little to boost economic activity. I emphasize economic activity because it did have an effect in terms of asset price inflation and it went a long way toward exaggerating the income and wealth gaps which, in and of themselves, are becoming now very politically contentious. Ergo, if the Fed issues a new round of quantitative easing, it would have to be in the context where they had sufficient political cover. Does this make sense?

Kevin: What would that mean? Thousands of points more off the stock market?

David: Yes, I think they could step in closer to the 14,000 range on the Dow. So, take another 2000 points off of a recent low and I think what you will have is the general public moving from being critical of Fed interventionism, which they have become more and more so in recent months, to being Fed desperate, and just basically saying, “Please stop the pain. Isn’t there something that you can do?” And on the basis of having political cover I think you could have another round of QE, but having it done right now would suggest, I think, too much to the global community that we’re in desperate straits, and they have to be very, very careful that they don’t send that message too soon.

Kevin: We’ve talked about velocity of money being very, very low, and in the past they have been able to issue QE in a low velocity environment. When people stop trusting the currency, the velocity can jump very quickly. Don’t you think quantitative easing, playing with that again, even though we didn’t really get much of an economic boost out of it last time – do you think that could actually turn into, down the road, a hyperinflationary scenario?

David: It’s interesting, it’s the way that people are behaving. The more concerned they become, the more desperate they are to pull funds from everything. So, it may be that the government’s attempt at quantitative easing could exacerbate a deflationary trend, not an inflationary or hyperinflationary trend, as people decide to suck money out of the system. And we will talk about that in few minutes, but it is an interesting phenomenon. In this market selloff, this is a very important dynamic to keep in mind, because again, in that same issue of something amongst investors has changed, the normal asset allocation shift when people get concerned, is from stocks which are considered high risk, to bonds, which are considered slightly lower risk. That is the consideration. That may not actually be the case, but that is the way people believe, and often behave.

In this most recent market selloff, you had just as much money being pulled out altogether, and money coming out of bond funds, and that is interesting, because ordinarily, the first shift when you are concerned is stocks to bonds, not stocks to cash. And so, the allocation shift suggests that people think that there is something severely wrong and this may not be just a 10% market correction. When people want out of the system, again, that is suggestive of a complete change amongst investors in the context of investor sentiment.

Kevin: Let’s go back to this bear market mentality, then, because there have been sell signals that have been coming across. Like you said, this isn’t a new phenomenon. The last few months we have had sell signals. But in these markets what are the sell signals right now? If a person is listening and they have a fairly broad stock portfolio right now, what should they do?

David: Well, I mentioned, on a technical basis Louise Yamada would argue we have long-term technical sell signals. I think this is consistent with what we have already seen, the price action of the S&P mid caps, your Russell 2000s, which are your smaller companies. And we were talking about this six weeks ago, as early as March, and then again in June you had signals of a market top in your smaller markets. It was the bellwethers, the S&P 500 and the Dow, which were bucking the trend. And if you recall, 2011, 2012, 2013, we also saw significant monthly sell signals – these are long-term sell signals — and they ended up being nullified by massive central bank intervention. Do you remember our conversation about the Economic Cycles Research Institute?

Kevin: Right.

David: And their call for recession. In each of those years, 2011, 2012, and 2013, those were all supposed to be years when we had another recession, looking at major business cycles, and then I think also coupling that with market dynamics.

Kevin: And like you said, that was nullified by central bank intervention. I mean, we really should have gone into recessions at those times, but the central bank just printed more money.

David: And what that has created is an interesting dynamic in the minds of investors where if things start to get bad you get a little selloff in the markets and then you have a big announcement. And the big announcement is what buoys the markets again to old highs, and maybe takes it to new highs. So, let’s go back in time. In 2011 you had the European crisis in full bloom. Draghi promised unlimited resources. Do you remember that?

Kevin: I do.

David: And so here we are with the markets not doing well circa 2011 and his promise of the sun, moon, and stars in terms of European resources – an immense promise. That was an unlimited promise.

Kevin: Right. “We’ll do whatever we need.”

David: “We’ll do whatever it takes.”

Kevin: Yes.

David: Then in 2012 you have Ben, who employed Quantitative Easing-3, which buoys the markets as it is getting to a soft patch. And that was followed by Abe-nomics which was launched that December.

Kevin: Along came Japan.

David: And then, not even a year into that you have the Bank of Japan’s QQE scheme which was introduced to underscore the commitment to market levitation. I think that was April 2013. So, the signals are telling you something important, that the markets are, in a natural sense, exhausted. And the economies they represent need to, and should, correct. You should see a natural ebb and flow in the marketplace and it’s not being allowed to occur.

Kevin: Let me ask, though, you had talked about China’s commitment to bring trillions in at some point, into the market – is that going to be large enough to maybe save the rest of the world?

David: It remains to be seen – if the Chinese can introduce a big enough check and underwrite the next quasi-recovery and market rally. So, it remains to be seen. Now we’re just talking about a question of trillions – a trillion here, a trillion there. Eventually, we’re talking about real money, aren’t we?

Kevin: Right.

David: And so, at some point people realize that this is something of a perception game. A trillion here, a trillion there. Eventually, people realize, “Why didn’t we try this 100 years ago, a 1000 years ago?”

Kevin: Maybe because it doesn’t work.

David: And that is, I think, a harsh reality that runs contrary to the narrative of central planners, which is to say, “Of course we can control this, of course we can make it happen.” When the Chinese suggest, as they have here in the last 48 hours, in fact, Saturday, over this weekend, it’s done. The downside is done. That is a massive commitment on the scale of a Mario Draghi, “We’re going to do everything.” Now, they’re either going to do everything and anything that it takes to levitate equities in the Chinese market, or they’ve just put their reputation completely on the line. And they may, in fact, be utterly discredited from this point forward. The PBOC and the People’s Communist Party in China may look very foolish in years to come because of that sort of strong prognostication. They’ve got to deliver – well, they’ve promised to already – 8 trillion dollars in spending between now and 2020.

Kevin: I think the troubling thing is, though, Dave, if it does not work then now we are in a bear market – interest rates are still at zero. This is a scary time.

David: Sure. And so, you look at the last several years in retrospect, and you can see that a monetary baton was passed from one central bank to another, which has created sufficient liquidity to assuage any panic in the markets. This has been what has kept things stitched together for the last five, six, seven years – the monetary job, the heavy lifting, so to say, first with the Fed, then with the ECB, then with the Bank of Japan, now with the PBOC, the People’s Bank of China. Is it going to be sufficient, or at some point do you have the wake-up moment when people say, “It’s nothing more than a Ponzi scheme.” It is, I guess, some form of financial success, but what is it based on, exactly?

If we are entering a bear market at this point, it is particularly troubling for two reasons. One, because, as you well know, rates are already at zero. And two, the Fed balance sheet is already at a lofty 4.5 trillion dollars. And for those less familiar with U.S. financial history, this would be the first occasion where slipping into a recession occurred with rates already at zero. This would be the first time. Then you may ask that question again, of how far you can stretch the imagination. How far will the American investor, or our foreign creditors, look at a 4.5 trillion dollar balance sheet? Will they allow it to expand to 9 before they revolt, 12 before they revolt? How many trillions of dollars in debt, implicit leverage in the Fed’s balance sheet, will be allowed before there is a currency and bond market revolt? The return of the bond market vigilante is something that gets discounted today because it looks like the central banks of the world can do what they want, and deliver on any promise they make. But at some point there may be a return, and the bond market vigilante is, essentially, the market in total voting and driving rates through the moon.

Kevin: Dave, then I think somebody is going to have to inform Wall Street about the volatility. We have looked at various investment outlooks, we have had clients send them to us and say, “Hey, what do you think about this? These guys are saying there is really not going to be much volatility and it’s all growth from here.” I think of Fisher’s analysis.

David: Isn’t that interesting? Beginning of the year, low volatility and growth ahead, and granted, they are a small player in the mix, but if you look at the estimate, say, for the S&P 500, the most conservative estimate on Wall Street today is coming from Goldman-Sachs, where we should finish the year with the S&P at around 2100. Slightly more aggressive would be Stifel-Nicholas, expecting to finish the year with the S&P around 2350. There is virtually universal agreement, in between that 2100 and 2350. You have Bank of America at 2200, J.P. Morgan at 2250, and the consensus of probably a dozen other firms, right at around 2300. In other words, the stock market is going to finish the year with a 10-15% gain, and that is what you should expect for 2015.

Kevin: And that comes from an expectation – let’s give them credit – of the central bank confidence game continuing. Over the last three to four years it really has worked. Now, what if the confidence game is falling apart?

David: And I think this is why this piece on China is so significant because, at least in terms of their market intervention, they have not been as effective as the plunge protection team has here in the United States. They haven’t worked out the machinery, what trades to put on and when, and how to execute them in a way that buoys the stock market when you need it to be buoyed. That’s a good question – what if confidence in the money mandarins is now diminishing? Let me put this out here. Here is a bit of evidence for that very thing. You have the usual defensive shift from stocks to bonds. We talked about this a minute ago. But look at it as evidence that actually people don’t have confidence in the system as a whole, supported by the central bank and monetary policies. You have the usual defensive shift from stocks to bonds. As stocks begin to sell off, people sell stocks and move into bonds, you get a boost in bond prices as demand increases.

Kevin: And you said it’s different this time.

David: It’s not happening this time. Bonds and stocks have both been sold. And it’s curious, it’s worth reflecting on, if people want to eliminate all risk from the equation, and bonds are not a sufficient safe haven, then sentiment is radically shifting, suggesting that this very well may be the big one. And what do I mean by the big one? A major correction where people just basically say, “I’m taking my marbles and going home. I don’t want any diversified portfolio, I just want to be in cash. I just want out. Get me out.” And those three words, I think, may be the most memorable words from 2015 – “Get me out.”

Kevin: And it’s not just the market people are looking at. We are coming into an election year. Politics – I would have to think it is going to be affected by this, Dave.

David: I look at Trump. I look at Sanders. I sometimes scratch my head – I still have some hair, and it’s not a flop-over [laughs]. If Trump and Sanders represent a growing dissatisfaction with the elites and the establishment types, the context may be ripe for a collapse in confidence. Think about this. It is long presumed in the currency and bond markets that the Fed and the central banks are all powerful, and yet, if they are found to be feeble you have a context where people are basically disestablishment in their orientation. Again, because Sanders is an outlier for the Democrats. The DNC has got to be very disturbed by the fact that he is getting as much traction as he is, because he just says what he wants to say, and he does what he wants to do.

And that’s not how you play politics. That’s not how power operates in the two-party system we have today. And the RNC is equally concerned, because here is, again, the outlier – Trump says what he wants to say, he’s not getting consultation as he is writing his speeches. The RNC is on the outside looking in, and he’s just saying it like it is. Again, I think that speaks to a general dissatisfaction with the elites and the establishment which has been governing things for a long period of time. And again, I think that suggests that we could have a major turn of events relating to the currency market, as well as the bond market, as we have held them up, or have had them held up, by the Fed.

Kevin: If the Federal Reserve and the central bankers are not able to keep this confidence game going, do you know what it reminds me of, Dave? Just pretend for a second the Fed chairman is the captain in the movie, Titanic. After the iceberg has been struck, do you remember he could not believe that it actually happened? He was still using an old model – the ship can’t sink. I think about the Federal Reserve here recently talking about the Phillips curve and how they are still following old models.

David: This is exactly the point. If the general public understood how old school the Fed was, not actually operating with cutting edge technologies and ideas, but very old school in their thinking, it would be disturbed. And again, I think this is a part of what makes for the undoing of the Fed in the years to come. The Wall Street Journal ran an article recently titled, “The Fed Has a Theory.” I forget what the subtitle was. But in this Wall Street Journal article it explains that one of the assumed and operating theories at the Fed is the Phillips curve. The Phillips curve links employment with inflation. And the problem is that that theory was discredited in the 1970s, and it was discredited again in the 1980s, and it was discredited again in the 1990s.

And this is the trouble with academics. There is a lot of vested interest in the theories they learned in school and integrated into their Ph.D. theses (that is with a “th” – although it might smell). I think this is the difference between a market practitioner and an academic. Market practitioners know that the Phillips curve is now a false idea. But academics have yet to acknowledge this, and in the process of delegating responsibility we have given them the keys to the kingdom. And I think the Wall Street Journal article is very important because, thematically, it complements this idea of confidence being lost, perhaps sooner than later. Think about it – when the general public says to themselves, “Wait a minute. You knew this? You knew that this didn’t work? And yet you were still operating with it as a part of your model?”

Kevin: “You knew the ship was going to sink and you didn’t tell me?”

David: And again, just imagine the look of consternation and disbelief. “I thought you knew better.” The general public, appraising the confidence game that the Fed has held in place since the panic days of 2008 and 2009, and they are still holding onto something as foolhardy as the Phillips curve?

Kevin: You know, Dave, central banks around the world, though, have just basically thrown the towel in and said, “You know what? We’re going to buy stocks. We are just going to go ahead and buy into any market, or sell into any market.” Ours has been doing it secretly, as well.

David: We know the Plunge Protection Team. We know what they do, how they do it. We also know that they can call upon Wall Street firms to buy equity index futures to influence the trends in the marketplace. We are well aware of the monetization schemes that the Fed has employed, that central banks have used to buy mortgages and government paper with freshly printed credits. These are behaviors that, amongst central bankers, are now considered normal [laughs]. I mean, think about it.

Kevin: It was shocking at one point. Now it’s normal.

David: So, the guys that are on the outside of normal would be like the Bank of Japan buying up shares of companies directly, investing in the Japanese stock market. Of course, the Fed has been prohibited from that kind of behavior by their own rules of the road, so to say. But this is interesting, as our friend, Bill King, has brought to our attention, there is an amendment to the Federal Reserve Act which was put in place in 2010. Section 13.3 allows for a loophole, which is, lending money to other entities so they can purchase shares. So, the Fed can say with a straight face, “We don’t own Pfizer, Coca-Cola, Disney, or IBM.”

Kevin: But here is a little free money so that you can.

David: So that you can buy it for us. And these are the ones that we want you to buy. So, it’s interesting, there is this possibility that we see, in the next six months, the Swiss National Bank and their balance sheet fully brought into the spotlight. By the way, all of this would be very clear if we did an audit of the Fed. We would see the capital flows and we would see in what ways they are gaming the system. I think the general public should know that, but I doubt it is ever going to happen.

If we did an audit of the Fed, I think you would see the money trail from the Fed to the Swiss National Bank, which would help us understand why the Swiss National Bank is sitting on such a large portfolio of shares in Exxon Mobil, Microsoft, Google, Johnson & Johnson, Procter and Gamble, General Electric, Verizon, Pfizer, Coca-Cola, Disney, IBM, Gilead, Amazon, Facebook, Merck. There is a huge equity portfolio sitting at the Swiss National Bank, and I think if push came to shove, the Swiss National Bank, in answer to the Swiss people, would say, “Well, actually, you scratch our backs, we scratch yours. It’s an arrangement that we have with the Fed.” I think that they would say, “Actually, it’s not our money. It’s borrowed, and the purchases were made on behalf of the Fed.”

We’re not there yet, but we ask whether or not the behavior of the Fed isn’t unlike that of other central banks, sometimes operating in the light of day, sometimes operating in the shadows. And yes, the Chinese have been manipulating prices higher, they have earmarked hundreds of billions of dollars to step in and buy shares in the stock market. As you mentioned earlier, perhaps they are going to put an end to the decline in the stock market. Well, the best way to end the decline in the stock market is to quit letting it trade [laughs] – it will never go down. It might not ever go up again, but at a minimum, we see the Fed and other central banks included continuing to attempt keeping equity prices from falling below critical levels.

Kevin: And it’s not just equity prices that people watch. It is amazing to me when you see the amount of government spending increase that is coming in here, how they were able to apply that to an increase in the GDP. Management of perception – I mean, GDP just jumped.

David: I want to go back to a conversation that I had with a Wealth Management Client of ours at the end of June, maybe it was the first week of July, and it was a frustrated conversation. The question on the table was, if the Fed has manipulated prices of the Dow to 18,000, why can’t they continue to manipulate prices indefinitely? And if that is the case, why wouldn’t we go long the Dow and own it exclusively? We know that it is a targeted index, we know that between that and the S&P 500 these are bellwethers that signal and advertise well – from a PR standpoint they advertise well the direction of the economy, and hopefully will someday also influence retail behavior – consumer behavior. So, if we know that there is vested interest in getting these prices higher, why don’t we throw our lot in with the Fed?

Kevin: Right. If you can’t beat ‘em, join ‘em.

David: If you can’t beat ‘em, join ‘em, was the gist of the conversation. And I think it’s worth right here, and right now, looking at what has been and can be a pretty catastrophic decline. I think in the case of the Chinese it is 40% off of a peak number, and I don’t think the Chinese government wanted as much as one or two percent off of those peak numbers. They liked continual progress forward, not one, two, or three steps back. In the U.S. market you see the same thing. Some of your financial firms, off of recent peaks have, in the context of 30 days, declined by 20% [laughs]. And so, again, this notion of, the Fed can keep things going indefinitely, Kevin, it is unmitigated balderdash. You can manipulate markets in the short run, but ultimately, the market vote prevails.

Kevin: So, if you can’t beat them, desert them. In other words, don’t join them because you’ll go down with them, but you can desert them. You’ve talked about being in cash and gold, over and over, and over. If you were in cash and gold through the last few weeks, you wouldn’t have been hurt.

David: Right. So, back to this issue of other numbers that are contorted and twisted. We have the second quarter GDP, which here in the last ten days was revised up to 3.7% from 2.3%, and lo and behold, as you dig into the details, we had the largest increase in government spending in five years, which was the biggest input, if you will, toward improving that number. And very curiously, if you are looking at gross domestic income, which generally tracks GDP on a very consistent basis, you had very little improvement. So, for anyone paying attention here, this is very critical. GDP and GDI usually run in a parallel track. GDP is moving up. GDI is not. Something smells. This is one of those Denmark moments. Something is fishy in Denmark.

Kevin: It is another perception.

David: Yes, it is. It is a perception issue, and you have, at the same time, the Atlanta Fed – you know, they have their GDPNow, a computer model of what the current GDP is doing? It just took another lower drop from 1.4% to 1.2%. The official number is saying, “Yes, we have improvement,” while the Fed’s own internal model says, “It’s in decline – sorry.” Do you see what’s going on here?

Kevin: We know we’re being managed, and actually, this Wealth Management client was right. If they are going to be able to manage it forever – if they would be able to manage it forever – why wouldn’t you play the game? We’re starting to see that they can’t manage it, we’re starting to see conflicting numbers. China, however, keeps coming back up in mind because you were there, like you said, when this was happening. And China seems to be the pivot point at this point. If China succeeds, we may have more growth. If China fails, then there is no one to catch us.

David: Just a brief discussion on China. It is unfair to lay full blame for the recent market volatility on China. That is what some pundits have attempted to do. We here in the West have a lot of leverage in the system. China represents a trigger. They represent a pressure point for the much greater issues which are both here and abroad – that is, too much debt. The global economy is supporting way too much debt. When I was in China, and Singapore, I spent many hours visiting with a top economics professor from Beijing. And in a nutshell, he views the current Chinese unwind as far more significant to the global markets than the subprime lending crisis was in 2008 and 2009.

Kevin: So he sees more impact to what is happening right now in China than the subprime impact in 2008?

David: And a part of that is because it is triggering an unwind of a vast carriage rate which has allowed for trillions of dollars, not only in corporate, but speculative investor money, as well, to be borrowed in three different currencies – euro, yen, and dollars – and invested in what was considered to be a better bet. So, what we are seeing now is 3-5% currency swings in a day, whether we are talking about Australia, New Zealand, Russia, Brazil, Mexico, Columbia, Chile, Turkey – these are disturbing signs of money quickly leaving markets, that is an unwind to a carry trade, and a part of this is being predicated on things that were assumed to be the case, which are proving not to be the case.

It has been assumed that China would continue to be a growth engine. Last year, Kevin, China contributed better than a third of all global growth. Looking at GDP growth, over a third of it came from China. Half of the world’s manufacturing last year came from China. And this is with them slowing down in their manufacturing and export industries and shifting toward a more service-based economy. This is causing major, major issues for the Chinese, watching concern, watching money exit the system. Watching capital flight out of all emerging markets is making it much harder for China in real time to affect this change toward a service-oriented economy.

And it is causing them to rely even more heavily on this infrastructure project that I mentioned earlier – opening up the old Silk Road and allowing for energy and trade to flow directly to Europe, reducing the timeframe involved. Currently, shipping times can be one to three months, depending on the destination from China if they’re taking “the slow boat.” But by putting things on a fast train through 26 countries, you have the ability to deliver goods within days. And this is their goal. Their goal is to reglobalize and be at the center of that reglobalization theme, cutting the rest of the world out. And if they’re wrong, China will have lost forty years’ worth of accumulated wealth, and that is what is at stake. Scholars are now squaring off against each other on what the issues are, and what the issues will be.

Kevin: Is it any wonder that people are wondering what in the world happens to the dollar during a period of time like this, because obviously, China has shown, even on billboards throughout China, that they are interested in having their own currency as a reserve currency, or as a world acceptable trade currency?

David: Yes, and the biggest issue underscoring the Chinese markets and ours is the destabilizing dynamics related to debt. If you are over-encumbered, that equals under-performance, with the possibility of failure always present. We are going to come back to that in future weeks, to not only look at some of the Chinese dynamics, this large infrastructure project that is being proposed, but also this idea of being over-encumbered, initially equaling under-performance, and ultimately, opening up the possibility of failure.