May 13, 2015; Today’s Smart Money? – “Gold, Cash & Patience”

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

“We do have a free-for-all in Shanghai and the Hong Kong markets, and that is set to continue, but for how long? To what extent? It is just curious to me, it is now ingrained amongst the leveraged and speculative community that central bank monetary policy is, in essence, paving a new way into a new kind of capitalism, and this is apparently a good thing. I guess I have to register my doubts on that.”

– David McAlvany

Kevin: Half a trillion dollars lost in the fixed income market. Fixed income – we’re talking bonds, we’re talking a lot of retired people. It’s the only income, the meager little interest that they have been getting in bonds. Now their principle is dropping and over 500 billion lost in the last couple of weeks in bonds, Dave? Why?

David: Well, and the interesting thing is, it is primarily government bonds, and as an RBS Director, Head of European Credit, said, Andrew Roberts from the Royal Bank of Scotland, “It’s pandemonium in the fixed income markets. Everybody has been trying to get out of long-duration positions at the same time, but the door is getting smaller.” And it gets to that illiquidity issue we mentioned weeks ago. It is in this two week period where, yes, we have seen close to 500 billion dollars in losses, and you may say, “Well, okay, it’s a paper loss.” Yes, that is true, it’s a paper loss. I think the issue is that people were buying bonds as if they were a sure bet.

Kevin: Sure. That’s really how they have been sold through the years, as a sure bet. But let’s face it, Dave. Our entire adult lives, the last 40 years or so, have been falling interest rate markets. Of course, bonds are going to look like they are a sure bet.

David: It is fascinating to me, I think Bloomberg has given this some very good coverage, not only in talking about the pandemonium in the fixed income markets, pointing out that 500 billion dollars in paper losses have been accrued in a two-week period, but also to point out the trend in the bond market, which is to say, there are “bargain hunters” who are stepping right back into the bond market because now things are so much more attractive. Instead of a German ten-year bond yielding 6 basis points, and virtually everything out to eight years being at a negative rate, now things are yielding closer to ½ or ¾ percent, and isn’t that a bargain?

So, what is interesting is that what we define bargain hunting by today is still categorically insane behavior. And the Bloomberg article I am referencing says this, as well: “The sharp moves have been exacerbated by a lack of liquidity as traditional dealers withdraw from the market to comply with stricter rules. The Institute of International Finance said this week that thin liquidity had become the top issue in talks with central banks and regulators.

Kevin: Isn’t that interesting timing, Dave? Because last week’s show that is what we were focusing on. Actually, it was a couple of weeks ago, wasn’t it?

David: Yes.

Kevin: We talked about there not being liquidity in the market when you need it.

David: What I thought was fascinating was this final quote from the Institute of International Finance. It said, “The new rules amounted to a dramatic revolution that had re-engineered the global financial system and pushed risk out into the shadows, storing up outcomes that are likely to be pretty painful, and certainly unknowable.” I appreciated the candor in the Bloomberg article, looking at what had, in their words, degenerated into a momentum trade. And basically, when you are talking about a momentum trade, you are talking about something that has degenerated away from fundamentals and away from real reasons to own, and now you are just doing it because everybody is doing it. It’s like a high school popularity contest.

Kevin: And you normally see that in a rising stock market or Beanie Babies. Let’s face it. When you see everybody else buying them and it’s like, “You’re kidding me. That Beanie Baby is worth $400? Give me three!” Well, there is not a lot of liquidity in the Beanie Baby market, and what is interesting though is, there is not a lot of liquidity in this gigantic thing we call the bond market. Now, let’s talk about why interest rates would rise. There is an increased risk of default; that’s one reason interest rates rise. The other, Dave, is ominous, because with all this money that has been printed, interest rates rise also because of expectation of inflation.

David: Well, that’s true. Now, granted, they are targeting inflation, so expecting it, and seeing interest rates rise, they would actually like to see it happen, and they realize that it needs to happen, and it hasn’t happened quite yet.

Kevin: But even the 2% target, Dave, you are talking about halving the value of your money about every 28 years. A lot of people don’t realize the slow creep, why their dollar buys less and less, even with 2% inflation being a target.

David: Yes. New Zealand popularized the idea of having an inflation target at all, and that goes back 25 or 30 years ago, and now you have folks at MIT and the IMF suggesting that the 2% number, while it is an interesting number, is not all that scientific. In fact, it could be as high as 4%, and that would be good for economic growth, as well. And I’m thinking to myself, 4% — 4% is devastating to a saver. If you are having your pocket picked to the tune of 4% every year via inflation, and then, as we suggested last week, as Ken Rogoff has suggested, perhaps we do away with paper money altogether so that we can apply financial repression to the entire stock of money. It strikes me as odd, to maintain this system of Ponzi finance we have to increase a certain base level of taxation but do it very surreptitiously. You could call it a stealth inflation, you could call it anything you want, but it is ultimately getting in our pockets.

Kevin: Let’s just look at the math on that. Let’s say that there is a 50-year-old person listening to the show right now with plans of retiring about age 64, 14 years later. With 4% inflation just being a normal target, that person would have to save twice what they are spending now, or what they planned on saving because their money would buy half. If you have 4% inflation, that is 14 years before your money is worth half of what it is today.

Speaking of people in their 50s, Dave, the jobs numbers took my breath away, because it looks like, in this country anyway, no one is really getting a job in normal working years, it is the people who are in their 50s and their 60s right now that are making up for all the jobs, virtually. And they are also part-time jobs, not full-time jobs.

David: Right. Just in a nutshell, the nonfarm payrolls – these are the jobs numbers out this last week – the March figures were revised lower by 32%. That was a pretty big hit because it was an ugly number to begin with and it got uglier. The April numbers, the nonfarm payrolls, those were increased by 223,000. And what is interesting is this, because we have this strange market psychology where that actually, as you got into the details of the numbers, it was a very negative report, which ended up being very positive for the stock market. The worse it is, the less likely the Fed is going to do anything.

Kevin: Bad news is good news to the stock market these days.

David: Exactly. And of course, good news is good news, as well. So, we have a one-way bet in the stock market. Well, why do we say things weren’t exactly rosy there? 223 is a decent number, and if you are averaging 200 you really have nothing to complain about, but as you mentioned, the big gains came in the 55 and older segments. You have full-time jobs, which actually declined by 252,000. So, full-time jobs are down, part-time workers increased 437,000, part-timers for noneconomic reasons were up 323,000. Then factor in, if you will, the birth/death modeling – this is a statistic anomaly, these are not real jobs created. Nevertheless, we pencil in 213,000 jobs from the birth/death modeling, you have an increase in the “not in the labor force” numbers to an all-time high, taking us back to the days of Jimmy Carter, 1977, 93.194 million people who are not in the labor force.

So, let’s just summarize all that. To summarize the health of the jobs market, and really, by means of encouragement to those who are now graduating from college, the jobs were all part-time, the jobs all went to workers 55 and older, and well, I think that just about summarizes it.

Kevin: So you had an increase in part-time jobs. That is, people looking toward retirement, but having to go back to work, and they are getting a part-time swing shift at Starbucks. That’s really what is happening, they are becoming baristas.

David: And then you have what Janet Yellen likes as one of her favorite indicators, also relating to jobs, although it is just job openings, not actually people hired, and it is what is known as the JOLTS [Job Openings and Labor Turnover Survey], or Job Opening data, and this was brought to our attention by Bill King of the King Report. It seems that when the government is seeking bids in a contract, there will, of course, be a variety of bids, many bids. But curiously, the JOLTS figures count all the posted openings from all the bidders and not just the bid that is accepted. So for instance, a contract that will ultimately employ 80-100 people will indicate 1800-3,000 job openings because of the multiple bids and the people that they will need to hire if they get the bid.

Kevin: Well, that makes no sense, but Janet Yellen likes to use this number?

David: Well, of course. Through the Yellen lens you have 1800-3,000 job openings, which are viewed as a positive economic indicator. I am just thinking to myself it’s a good thing she only runs a central bank and not something more important. (laughs) But we can all rest easy knowing that the tough decisions are being made on the basis of hard data.

Kevin: Well, what if you, as a person who runs a company, Dave, counted every inquiry as a sale? You just used that as a bottom line. Well, that would be very, very positive, would it not?

David: And then on that basis, went out and got a lot of small business loans to increase the size of our business because our sales were so good.

Kevin: Based on inquiry.

David: That’s exactly right. So, this strange incestuous relationship between the Fed and the Treasury, their information-gathering, their decision-making, and then the debt that we accrue – quite frankly, you know what it reminds me of? It reminds me of the insanity you see in Japan today, where you have an improvement in GDP statistics by dropping the deflator to a negative number.

Kevin: And the deflator is how they count their inflation, basically.

David: That’s right. So, when you are looking at GDP, which is, of course, the total scale of the Japanese economy, or any economy, you have to factor out how much growth has come from just inflation. And so you have this component which subtracts out the inflation addition. They call it the deflator. If you make the deflator a negative number you end up boosting, artificially, your GDP statistic, and now the Japanese are patting themselves on the back for an improvement, and actually saying, “Look, GDP is now growing. Abe-nomics and this three-prong approach to growth is actually working.” And they’ve gotten so close to the numbers that they have forgotten how much is just actual B.S.

Kevin: What we are talking about so far, Dave, are just bureaucrats. This is how bureaucrats count prosperity, and unfortunately for us, they don’t really need to prove out, they don’t have to meet a bottom line, because they can just print money. The type of person who has to meet a bottom line has to look at indicators that are true so that they can make good predictions. I am thinking Warren Buffet. Warren Buffet isn’t perfect, obviously, but he has developed a reputation of finding value, and one of his key indicators that he likes to look at is the capitalization of the stock market relative to GDP, relative to the economy.

David: So if you put Buffet on the back of the napkin, this is what you get. He just says, “How do I do sort of a thumbnail appraisal, a real simple sketch of the stock market being too expensive, or cheap on the other side of things. And what he draws from is the Federal Reserve quarterly Z.1 balance sheet. He takes that number and divides it by the current size of the economy. So, essentially, as your numerator, you have the value of all equities. And then you are taking nominal quarterly GDP as the denominator, so you are dividing 22½ trillion, which is the current estimated value of all stocks, according to the Federal Reserve, dividing that by GDP, and you end up with a particular number. Today it is about 132% of GDP. Well, what does that mean, exactly? How does it fit in? The highest ever recorded was in the year 2000…

Kevin: At the top of the tech stock bubble.

David: And that was 153% of GDP.

Kevin: And it’s 132 right now?

David: We are now at 132, which again, if you are looking at standard deviations, we are at 2½ standard deviations from the mean. The highest ever has been a three standard deviation. We know that over-valuation, and we do have that today, can last a long time. It can go further than expected. But this bull market began from a very different level than what you would consider normal to begin with. So bull markets, typically, using this Buffet back of the napkin indicator, bull markets typically start out at around 32-35% of GDP, and work their way toward excess, which would be above 100%. Now we’re at 132%.

In fact, if you go back in time and look at this relative to, say, 1968, or wanted to speculate as to what it would be back in 1929 or 1907 or some of these early stock market booms, what you would find is that it never got to more than about 80-100%. So these two periods in modern history, now and the year 2000, stand out. They are totally different than any other thing in financial market history. And a part of it is because we have brought in a tremendous amount of leverage into the financial system. We’ve seen the financialization of the economy, which has exaggerated the numbers in a fairly dramatic way.

Kevin: Talking about dramatic, we had talked last week about the old adage, “Sell in May,” that period of time from May up until you get to about November in the stock market. And what were the figures? I think $10,000 turned into over $800,000 if you had just put in money in the late fall and taken it out in the late spring.

David: November to April were your winning months. Well, just like you have a winning season, there are also winning years. And Doug Short lays out an interesting comparison of bull versus bear markets, and tallies the years spent in one trend or the other. If you go back to 1877 it is about a 60/40 split and that is sort of 80 years of growth, 52 years of contraction. And again, you could look at the seasons of growth, but there are blocks of time where you are just on the wrong side of the trend, or on the right side of the trend – 80 years of growth, 52 years of contraction, puts it at a 60/40 split.

Kevin: About half, or a little bit better than half the time, the market is going down. And so, you don’t necessarily want to ride through all the bulls and the bears. You need to recognize the cycle.

David: You would navigate it differently, and certainly on a more defensive basis if you recognized that you were at a market peak and moving into a period of sub-par growth.

Kevin: We talked about growth in the stock market, but how does inflation factor into that?

David: Doug Short also draws an interesting graph which looks at the S&P 500, the 500 largest companies in the country, and charts from 1870 to the present, and shows its long-term trend using an inflation-adjusted regression, and current readings are well above trend. In fact, the latest price puts the market 93% above trend, which is the second-highest level in U.S. stock market history. So, is the stock market a bargain? No. Can it go higher? Well, stranger things have occurred. And we would suggest that if the stock market does move higher, if at all, it will be short-lived, followed by several years of sharp losses. That brings us to, frankly, one of my favorite long-term measures, which also ties into that same Federal Reserve reported data, that is, the quarterly Z.1 statistics from the Federal Reserve balance sheet.

Kevin: Andrew Smithers has looked at what is called the Q ratio and really has focused on that. He has been a guest of ours on the show. It has been a very accurate indicator as to the true valuation of the stock market. Would you bring up again that Q ratio, because it is so important?

David: The Q ratio goes back to Dr. Tobin. He was a professor of economics at Yale for 38 years, winner of the Nobel Prize in Economics. This was one of his fascinating little projects, in which, again, he was trying to figure out how to value a company and determine when something is over-valued or under-valued. And Q, or the Tobin ratio, compares the current traded price of a company, or the stock market as a whole, to the hard assets of those companies.

Kevin: So plant and equipment, that type of thing.

David: Exactly. You are talking about the replacement cost of a business if you had to go out, and in today’s dollars buy and pour concrete, if you had to buy land and put in a road and infrastructure to build a plant. So yes, land, plant infrastructure. And what you are looking for, as an investor, is premiums that were discounts. Like any value proposition, the premiums are seen when you have inflated markets, and represent good times to be liquidating those assets, not buying them. And the discounts represent bargains and suggest to someone who is a value-oriented buyer that it is cheaper to buy an existing set of assets at a discount than to create the business from scratch and pay the replacement cost for the business.

Kevin: Let’s do an analogy here, then. Because for those who don’t own a business, let’s just compare to most people who own a home.

David: And this may be a little high depending on what part of the country you live in, but let’s say your costs to build a single family home are $250 a square foot. That will build you a very nice home. If that is the going rate, imagine stepping into the market, buying a used home, not for the $250 that you could build one, but for $325. Would you feel like you were paying a little too much? Would you feel like you are paying above the market for it?

Kevin: It sounds like New York right now.

David: And there you will find it is probably closer to $1000 or $1200 a square foot. But on average, again, the difference between the replacement cost of $250 and the premium you could pay of $325, now let’s go to the value side of things. Let’s say that you are paying $165 a square foot for something that you know if you had to build it today you couldn’t do it for anything less than $250 a square foot.

Kevin: So, that’s your deal.

David: That’s a good deal. So, the Q ratio is the same mindset applied to equities, and the current levels of Tobin’s Q, and again, this isn’t a new concept, it was, as I mentioned, developed by Dr. Tobin while he was teaching at Yale, and what do we see there? The current levels of Tobin’s Q are higher than all the market peaks – 1907, 1929, 1937, 1968, 2007. The outlier is the year 2000.

Kevin: That was, again, the tech stock bubble. Everything was out of proportion.

David: Exactly. Where valuations were so whacky that nothing else in financial history compares. Well, look back to it. You have selling for better than 500 years’ worth of nonexistent earnings. Is it any surprise that this outlier, in terms of a valuation spike on a chart, is there in the year 2000?, okay? So, yes, it was whacky, but what we are suggesting is that, today is only one notch off. Today’s levels are the highest in history, setting aside that one anomaly. The ratio swings – just like any price in the market, you have high ratios, you have low ratios, and it is a very helpful way, using Tobin’s Q, of gauging where you are. Are you above or below an average trading range? And 50-60% above the average level represents the typical peak. And quite symmetrically, 50-60% below the average represents the typical low ebb in the market.

Again, those two curious anomalies were 2000, with the extraordinary high peak, more than two times any other in history, and the discount in 2009, which I think is very fascinating and worth talking about. Because typically, if the discount to an average is 50-60%, we got to about a third of that, which suggested for us, stocks even in 2009 were not a very good value. Typically, at the end of a bear market you have a bloodied and beaten investor base, and they have already thrown in the towel. This goes back to 1981 when Time magazine and other magazines were announcing the death of equities. In other words, there was no one interested in owning them, and you could pick things up for pennies on the dollar. We did not see those kinds of values in the corrective phase in 2008 and 2009. The correction only went about a third the distance that it should have, in line with Tobin’s Q in the past.

Kevin: One of the things that Smithers has brought out, as well, is that for the person who is addicted to day trading their portfolio based on the speed of the internet these days, the Q ratio is not much of a help, is it? It is not a short-term timing tool, it is a long-term valuation tool.

David: That is correct. It is not a timing tool at all. It is most useful to the long-term investor who is asking the question, “Where will I be in five to ten years, and what kinds of returns can I expect between now and then?” To which, Tobin’s Q suggests, at this point, your returns are likely to be marginally positive, maybe 1% or 2% each year on average. So, you are taking a lot of risk, with very little reward on offer, if you are looking at your average returns over the next 10-15 years. To me, that is not compelling. But some, also, would argue that Smithers is too conservative an investor. Look, he moved largely to cash over a year ago, and could certainly be criticized for missing the upside, so to say. But I guess, for me, I would remind you that the last year has also seen many professionals join that on-the-sidelines category.

Kevin: We just brought that up. You got back from New York three weeks ago and the meeting of the minds of the billionaires. There was a lot of cash position at that point, wasn’t there?

David: Right. These are folks that I think, as professionals, get it. And they have done the same thing that Smithers did over a year ago. Maybe it is cash levels of 25%, 50%, 65%. Very rarely we will find somebody who has moved 100% to cash. Of course, my confidence is in ounces. That is cash to me. Gold and cash are synonymous in my book, and I am heavily weighted there. But whether it is greenbacks or gold ounces, the case against owning equities remains a significant one.

Kevin: Dave, this week we had a valued client of ours send a report from Fisher, who writes for Forbes. And he would disagree – Fisher would disagree. And our client just wanted to hear what your comments were on that report. The report was very, very optimistic about the economy, almost pushing aside any thought of risk, whatsoever. I really appreciated the response that you gave to that. Would you just give us some of the points, after reading Fisher’s report, a 14-page report, on why you should be buying stocks right now, not selling.

David: I think, generally speaking, you can categorize the bulls and the bears as those who are either fixated on risk, or fixated on reward – the bulls being fixated on reward, the bears being fixated on risk. And I think maybe that is even not a fair assessment because you have plenty of bulls who are conscientious about risk and are, in fact, somewhat paranoid about risks.

Kevin: You can be a careful bull.

David: And I think that is what was lacking in this appraisal, 14 pages entirely dismissive of risks. And I quote the Money Manager explaining, “Most risks today are either false or too small and widely discussed to move stocks materially.”

Kevin: I know that made you twitch. I could see it as you read it.

David: It immediately brings to mind – you remember Larry Ellison, Oracle CEO, many attempts with his yachting team – he put together a yachting syndicate to smash all the records in terms of the competitions for yachting – and his boats have been so effective at capturing the power of the wind that at times they do it too effectively, and they get flipped, they get destroyed, people can get hurt. The natural forces of wind and wave actually are greater than the stability of his fiberglass yachts – very expensive, by the way.

And it is the scenario where it is always impressive until his crew is in the water testing their life vests again. And then it is a little less impressive. So it is surprising to me that risks are so thoroughly and comprehensively dismissed, and by the way, this is one money manager, but I think it typifies the consensus view, which is, “Look, you’re arguing with five years of momentum.” And I want to go back to that Bloomberg article, which said of the bond market, we have degenerated into a momentum trade.

Kevin: But that was to the downside.

David: And I think we have degenerated into a momentum trade in the equity markets, as well as the bond markets.

Kevin: One of the points he made in this report was that he is looking for double-digit returns in the global equity markets. Now, what is your thought on that?

David: Okay, non U.S., global, or all-encompassing. The global equity markets – if they are going to see double-digit gains this year, with the second half of the year having surprise to the upside, again, I recall from our conversation last week that the May to October period is statistically like a windless day at sea. It is not great if you’re sailing. And then you remember Newman’s comments on that point. Again, we are talking about the dead period. So I guess we are supposed to see a double-digit rate of return accrue sometime between November and December, and thus close out the year on a high note? I think that is rather optimistic.

Kevin: So, you are skeptical?

David: My other response is that global economic growth and developing world equity markets are dependent on excess liquidity from the developed world. This is where their growth comes from. If you are going to see equity markets overseas do well, again, it is a spillover effect from liquidity in the developed markets. The U.S. is now running smaller and smaller trade deficits, which shrinks the liquidity previously depended on to fuel growth overseas, so this is a strike against the growth thesis.

Kevin: That is what Malmgren called the perfect circle – us running a deficit and creating liquidity overseas.

David: That’s right. This has already affected Asian countries. You can see it in shrinking trade surpluses from their manufactured goods, and the effects are equally felt in the Middle East. There is less revenue from U.S. oil purchases. This is very critical, because think about how that affects our ability to finance our spending deficit, which if you recall the nature of petrodollar recycling, it puts more pressure on the Fed to monetize treasury debt and allow – can we call them the gentle people of D.C. – to continue sort of their slop fest in the pig trough?

Kevin: So what you would say is the growth thesis in the global equity markets over the next six months or so is probably not going to pan out.

David: We have contracting liquidity, not increasing liquidity, so how does the developing world contribute to this global market growth and double-digit gains if, in fact, we are in an environment of shrinking liquidity? And there is the central bank liquidity. So we have trade liquidity, now you have central bank liquidity, which has not found a way out of the financial sector, and has therefore not become an economic driver, if you will – a driver of economic activity.

Kevin: It has driven the stock market, but it is not driving the economy.

David: Right. And this has occurred in neither the developed nor the developing world. So, the two forms or sources of liquidity remain absent. You have China, which has dropped its rates for a third time in six months.

Kevin: Just looking to stimulate.

David: Of course. And so we do have a free-for-all in Shanghai and the Hong Kong markets, and that is set to continue, but for how long? To what extent? It is just curious to me, it is now ingrained amongst the leveraged and speculative community that central bank monetary policy is, in essence, paving a new way into a new kind of capitalism, and this is apparently a good thing. I guess I have to register my doubts on that.

Kevin: One of the things that Fisher said was, “Get ready, because we’re setting up for a second-half surprise in the U.S. equity market, the stock market. What is your thought on the surprise?

David: We tend to agree, although we might disagree with the direction of the surprise.

Kevin: Oh, he thinks up, you think down.

David: Right. So valuations remain an issue of concern. We talked about that earlier. You have low levels of retail investor cash. You have low levels of mutual fund cash. You have very high levels of retail investor margin debt – in aggregate 474 billion dollars’ worth of margin debt. You have an adjustment to higher rates, which still has to be accommodated, and you have markets which are pricing in, as a discount, zero rate money. So any adjustment to the interest rates will affect all asset classes in question. We could go on and on. There are many other factors that, in essence, hang like the Sword of Damocles over the market.

Kevin: Fisher did say, though, initial interest rate hikes are probably not going to be enough to affect the market to the downside.

David: Again, I felt like, as I was reading the report, that is fair, but it is unfair, because for the novice investor, or for the trusting investor in the Fisher management scheme, you know what you have? You have something that is absolutely true. The first rate hike doesn’t do much. Again, it is the impact on the equity markets from the second and third, which is much more significant. And that was the point that Edson Gould, who was the famous Wall Street technician of the 1960s and 1970s made. He said, “Three hikes and a tumble, three hikes and a tumble.” And so, Fisher is basically saying, “Don’t worry about an interest rate raise.”

Well, that is true, to some degree, but if it is more than 25 basis points and they do it more than once, all of a sudden you have an aggregate effect, which may very well cause a recalibration of investors, and we talked about that weeks ago, or months ago, dealing with discounted cash flow models that many analysts use. What is the value of a company using a discounted cash flow model? You are using interest rates as a part of the equation, and with zero-bound interest rates, you have inflated stock prices. Now introduce a more realistic interest rate, and what happens to stock prices?

Kevin: Yes, zero interest rates are the best of all worlds. You have already valued in something that can’t really get any better, as far as cheap money. But I want to go back to the quote that he talked about, because you have outlined a number of risks – risks that some of the money managers are saying are just too high so they have moved to cash. But Fisher says, and I quote, and you quoted this earlier, “Most risks today are either false or too small, and widely discussed to move stocks materially.”

David: And what he is getting at is that if we know the risks, we can’t be surprised by the risks, and they are already factored into the price. So, using the efficient market hypothesis, we have the prices reflecting all known reality – good, bad, and everything else. And I think to myself, that sums up the entire 14 pages. Again, it is just dismissive of all possible risks. Look at Bear Stearns. Their first loss was only 400 million.

Kevin: I remember when that happened. Was that 2007 when they put it out there, and then they pulled it back off the market because they didn’t want to scare anybody?

David: Two hedge funds that were running into trouble, and they were too small, frankly, to move the stock materially. Now, of course, we live in a world where Bear Stearns doesn’t exist anymore, but people seem to forget that crisis dynamics take one issue and multiply it – multiply it ten times, multiply it 100 times – and the ways that Wall Street measures risk, using value at risk modeling, doesn’t account for this.

Kevin: And I think we are forgetting something here, Dave. We are talking about markets that are being fully stimulated by the easiest central bank policy in the history of mankind. Let’s say the central banks weren’t doing any of this – quantitative easing, zero interest rate policy, any of those things – the markets would still be at risk, yet the markets are underperforming, or sort of performing, yet we have trillions and trillions that have come in. Let’s face it, in the last four to five years, we have gone from 8 trillion to 18 trillion dollars in debt, and the Federal Reserve has added 4 trillion just to its account.

David: I want to qualify that, though, because it is not a new experiment, it is just new by its universal application. In other words, it is now ubiquitous. You have central banks all around the world playing by the same sheet music. And so the singular reality, globally, remains that the markets, globally, are 100% dependent on central bank promises. And we may want to normalize it. We may want to normalize rates. We may want to get back to a more rules-based type monetary policy. But if the attempts to normalize are delayed, the distortions created will carry far graver consequences in the end, and again, it remains to be seen if we can normalize and take the pain. We wonder if the markets or the people who are pulling the puppet strings for the markets can take the pain.

Kevin: When you were talking to Pippa Malmgren you used an analogy of keeping a basketball below the surface if you were in a swimming pool. And the further you push it down, and the longer you hold it, the more likely you are going to have an opposite reaction. So, what you are talking about is that if the central banks continue to stimulate the way they are, and the markets continue to eat that up and continue to grow, especially the equities market, then the reaction to the other side – talk about a momentum trade, a degenerating momentum trade to the downside – it will be startling.

David: It is the difference in information. The central bank believes that they have information which tells them very clearly what the rate of interest should be, what the cost of capital should be. And Knut Wicksell would have asked the question, “What is the natural rate,” not the rate when you are standing on top of it, like holding down that ball underneath the water, but what is the natural rate?

Kevin: Let that baby float. Let’s just see where it floats.

David: I think, whether it is Fisher or others who define the consensus view, the burden of proof is on the bulls to explain why monetary policy remains more accommodative than at any other time in global financial history, with a very embarrassing level of growth to show for it. Does that make sense?

Kevin: Yes, you know, as I think about these things – you were talking about the deflator in Japan, we’re talking about these various rates that academics use, I have to remember back to this last Super Bowl and the playoffs that got the Patriots to the Super Bowl. And now we have something called Deflate-gate.

David: (laughs)

Kevin: So, it is interesting how everyone seems to think, at this point, that they can play by changed rules, but there are consequences.

David: It is interesting. This all will work well, and work brilliantly, until some unforeseen shock or black swan takes us by surprise. And at that moment there will be a whole host of investors and people marched onto Bloomberg and CNBC who will say, “We didn’t see it coming, it was utterly fantastic, and outside of every potential mathematical model.” And you know what I’m going to remember? Kevin, I’m going to remember this quote, again, “They ignored the facts that are categorized today as risks which are either false, too small, or widely discussed, to move markets materially.” Because I think, frankly, it is one of those risks which will be the undoing of the market.

Kevin: Dave, it may sound like a broken record, but sometimes you have to have a broken record approach if you are going to stay safe, and so I want you to restate what exactly you would recommend people do, right now, with their money. What market should they be jumping into? What market should they be jumping out of? Or should they just stay cash liquid in cash, gold, and silver, what have you? Just give us an example of what a portfolio should look like right now.

David: It remains to be seen whether central banks have exhausted all of their efforts in terms of desperately controlling the financial markets. So, it is not out of the realm of possibility that this move higher in interest rates is short-lived and we see rates return to rock-bottom prices again. I don’t know that that is something I want to speculate on. I think, ultimately, this is as dangerous as playing with Latin-American bonds in the last 100 years, where rates moved lower because of a perception of risk, and thus, rates moved lower and bond prices moved higher. But ultimately, it became unsustainable and governments stepped on the rates and forced them down even lower.

The ultimate break comes when confidence is questioned, and stability is re-appraised and you generally see a spike in rates. We have a spike in rates right now. The question is, does it carry forward to 2%, 3%, 4%, instead of just moving in fractions of a percent as it has in the last few weeks. Having said all that, I’m just not comfortable owning bonds. So, I would be very, very cautious in the bonds that you own. If you do choose to own fixed income instruments, keep them very short-term in duration, and that gives you some protection, so a short-term laddered portfolio would certainly give you all the protection that you need if you are going to maintain an allocation to fixed income.

Kevin: How about equities? U.S. equities, global equities?

David: I think when you see the markets trip, you are going to see them fall in tandem. It is not going to be a great differentiator, being in the Turkish stock market, or the German stock market, or the Brazilian or Mexican stock market, as opposed to, or instead of, a more developed market like the New York Stock Exchange. I think, as we discussed earlier, from a valuation standpoint, we are pushing the envelope in terms of the extreme nature of stocks and their current prices. It doesn’t mean that they can’t go higher, and if the central bank redoubles its effort and is willing to print trillions more, the knee-jerk reaction will be to see the stock market go even higher, and that ultimately is okay with me, because those are not levels that can be sustained.

What I would look for as an investor is that five to ten-year time horizon, asking the question, “Buying today and holding as an investor classically would for a longer timeframe, have I bought well? Did I buy right?” And I think you would have to say, today, you’re not buying well, you’re not buying right. So equities today, if you can hedge them, hedge them. If you are going to keep them in your portfolio, make sure you have covered some of the downside by hedging those positions as effectively as possible. Or, better yet, would be Andrew Smithers advice, which is, begin to sell your equities and sit in cash. He likes cash, and he likes it a lot. I know a lot of people that like it a lot because they don’t understand the complications of owning gold. What they don’t understand is that gold ownership is actually not that complicated, and so some balance, for me, personally, between cash – actual cash – and gold and silver, makes a lot of sense.

So, certainly, you can maintain positions in other asset classes, but you should be defensive in terms of protecting from downside volatility. Otherwise, just get out. And if you are going to get out, then a balance between Federal Reserve notes and some measure of protection against the mismanagement of those Federal Reserve notes by the Federal Reserve, I think is warranted.

It is pretty simple, but I think this is a period in time where simple – following the KISS principle – is probably as good as the back-of-the-napkin indicator that Buffet gave you. Again, it is just kind of a rough, thumbnail sketch of what is too much, and what is not enough. I think if you took a back-of-the-napkin approach to investing, and simplified, and had that as an operative principle, you would do much better over the next few years.