Whoever Has the Gold Makes the Rules
The Golden Rule states that a person should “Do unto others as you would have other do unto you”. On May 3, 1965, young comic strip writer Johnny Hart wrote a comic for the now famous “Wizard of Iz” series that depicts a King addressing his subjects. In that comic, the King’s subjects ask, “What the heck is the Golden Rule?” The King replies, “Whoever has the gold makes the rules.” Today we don’t have kings, but we do have central banks and they have the authority to print unlimited amounts of money at the taxpayers’ expense.
Central banking made its way into America in 1913 with the passage of the “Federal Reserve Act” at the insistence of J.P. Morgan who was growing tired of bailing out the United States government every time it had a financial problem. The early iterations of central banking date back nearly 300 years to France, who was struggling economically after repeated wars, and England, who was amid a series of wars. The belief then, which was later supported by Keynesian economic theory, is that economic downturns are caused by a lack of money. While both nations attempted to print their way out of their financial difficulties, they both proved that economic imbalances can’t be solved by printing more money.
The power that comes with a money printing press can be intoxicating. While Maynard Keynes likely never intended that his economic theory would be used to control the masses, it has evolved to become a means of transferring wealth from the many to the few. One of the hallmarks of a dysfunctional monetary system is the repeated boom and bust cycles that follow each successive money printing scheme. While the masses tend to lose when economies recess, those with money see it as an opportunity to buy real tangible assets at a steep discount. It is during these times of distress that wealth is transferred to those who have cash.
Warren Buffet is a perfect example of someone who understands the central bank cycles and who has used the cycles to become one of the richest and most successful businessmen in the world. He purchases distressed companies that have a good product or service and then implements new policies to help return the company to profitability. He then takes the profits from that company and patiently waits for the next opportunity, when he repeats the process. Today Warren manages billions of dollars of clients’ money, with a large portion sitting in cash. While he has missed out on the late stages of this stock market rally, his clients know that when the next recession comes, Warren will purchase distressed companies and turn them around. It is Warren’s deep understanding of the credit cycles caused by the Federal Reserve’s mismanagement of our monetary base that allows him to create wealth for himself and his clients.
It is the mismanagement of our monetary base that ultimately causes our economy to contract into a recession or worse, depression. This happens because the money the Fed prints to fix our economic imbalances doesn’t find its way into the wallets of those who need it the most. Those who are early recipients of the Fed’s printing or reinflation attempts are the ones who benefit the most, while those at the bottom continue to struggle until they break.
Following the Great Financial Crisis, the banks were the first recipients of the $4 trillion the Fed printed. Most bank executives kept their jobs and even received bonuses, all at the expense of the American taxpayer who collectively now owes an additional $4 trillion because of the Fed. This is why banks like Goldman Sachs encourage their high-level employees to take government jobs – to ensure that Goldman Sachs remains in front of the line when the next handout comes. While Goldman Sachs came out of the Great Financial Crisis stronger than ever, many Americans lost their jobs and their houses. Nobody bailed them out.
Therein lies the problem with money printing schemes; those on the top benefit the most and those on the bottom, which is about 50% of all Americans, see very little. With each successive recession and the money printing that follows, those on the bottom receive less of this money. The evidence of this is strong, as inflation-adjusted wages for most Americans are less than they were in 1973, based on government data. This is also why debt levels for most Americans are at record-high levels because the only way they can keep up is by taking on more and more debt. Every time the Fed attempts to re-inflate or save the economy from its latest problem, they are impoverishing more people. Once enough people are impoverished, it is only a matter of time before our economy succumbs to a massive recession.
That is why the next recession will likely be the worst in our lifetime. The Fed has covered up financial imbalances going back to the dot-com bust without dealing with the problems that created those imbalances in the first place. That is why there are bubbles in stocks, corporate bonds, high-yield bonds, student loans, commercial real estate and more. When there is one problem, the Fed can come to the rescue. When the entire system is over-leveraged with too much debt, the Fed won’t be able to stop the contagion once it starts. That is why I believe the next recession will come quicker and harder than most expect.
It’s also the same reason the Fed won’t be able to prop up the stock market, even though millions of Americans are relying on the Fed as they dump all their money into risk assets. The Fed can’t buy stocks without Congressional approval. And anyone who believes the Fed can prop up stock prices doesn’t understand that stock prices are determined by expected earnings and profits. The Fed can’t make a company profitable by buying their stock.
The reason the stock market is so high is that the top 10%, who have been the largest beneficiary of the Fed’s money printing, own 90% of the stock market. While those invested in stocks are hoping for a “blow off top,” which occurs when the public buys in near the peak, they don’t realize that the Fed’s tightening of the money supply is preventing the bottom 90% from participating, who only own a mere 10% of all stocks.
Starting this month, the Fed has increased the pace at which they are unwinding their balance sheet by selling off $12 billion of U.S. Treasuries and $8 billion of Mortgage Backed Securities per month. In addition, the Fed members have been discussing four more rate hikes this year. The Fed is doing this to cool off the bubbles and to rein in the money supply to prevent hyperinflation. The problem is that the money supply gets drained from the bottom first, not the top. Meaning those who didn’t benefit much from the Fed’s money printing, are finding that financial conditions are tightening rapidly.
That is why subprime auto loan delinquencies are rising along with credit card delinquencies—those on the bottom do not have the money to pay their bills. Inflation from the Fed’s money printing is affecting millions of Americans and the problem is getting worse as rising short-term interest rates push consumer prices higher. Tax cuts may provide some temporary relief, but since the tax cuts mostly benefit those with higher income levels, those on the bottom will continue to struggle until they ultimately break.
When the public breaks under the weight of their debt and rising consumer prices, the economy will quickly fall into a recession. There is little doubt the Fed and other central banks will attempt to print their way out of this problem, just as they have every other one. But their success is not guaranteed. After all, it is the central banks that make the rules and we are merely along for the ride.
Every time the Federal Reserve prints money, they widen the gap between the rich and the poor, which explains the dichotomy in our economy. Some see a strong and growing economy and have chosen to invest in stocks to participate in that growth. Others, who haven’t benefited from the money printing, see a contracting economy with little opportunity to escape the debt they have taken on. One side will prevail, and once you know which one will, then you know how to best invest your money so you can be the one that makes the rules.
Q&A with Steve – Your Questions Answered
- Why are long-term Treasury bond yields rising when you said they should be falling?
Great question. Bond yields are a function of supply and demand. When there is insufficient supply or excess demand, yields rise. Treasury yields are temporarily rising because the U.S. Treasury is running low on money due to their inability to pass the budget. As funds dwindle, the U.S. Treasury moves money out of their account and into the accounts at the member-banks of the Federal Reserve. When this happens, yields rise because demand is higher than supply – in this case, there is no supply of new bonds. Once a budget is passed, the U.S. Treasury issues bonds and rebuilds their savings, which causes bond yields to fall. This relationship is easily seen in a chart (included in the chart pack) that shows deposits with Federal Reserve Banks against the 10-year Treasury yield.
- So, this jump in yields is temporary?
Yes, as soon as the budget is passed, the U.S. Treasury will sell bonds to raise cash. If a temporary budget is passed, then the U.S. Treasury may be limited to how many bonds they can sell. The reason yields are rising is mostly due to speculators betting against Congress and Congress’s inability to pass a budget.
- Does this rise in yields create any opportunities?
If a meaningful budget is passed, then this could be an opportunity to increase the duration of the bond allocation in the portfolios to take advantage of the next drop in yields. Higher yields should also cause gold to fall, and as I have said for some time, I’m willing to accept pain in the bond allocation to get a lower entry point on gold and silver miners.
- Are there any negative effects to rising yields?
Every stock bubble in history has been broken due to rising bond yields and rising interest rates.
- You seem convicted we are going to have the worst recession in our lifetimes. Why is that?
Throughout history, mankind has turned to printing money to solve their financial problems. There has never been one recorded time in history that it worked. Every time a government of any kind has resorted to printing money or debasing their currency, it has led to an economic collapse. The more money printed, the bigger the ensuing collapse. Maybe this time it will work, but my conviction stems from a 100% past-failure rate. I like those odds!
- Why will this one be so severe?
Because this is the largest global money-printing event in the history of the world. Every central bank in every country has been printing which never ends well.
- Why are you obsessed with gold?
It’s one of the few asset classes that outperform when paper currencies become worthless. With every central bank printing, gold should do well. Not to mention most central banks are buying gold while the public is buying stocks. That should tell us what the central bankers think is coming. I cover more of my thoughts on this below.
- Is that the same reason you like agricultural commodities?
Yes, because following the failure of every money printing scheme, food prices skyrocketed. That happens due to stagflation, which is caused by rising commodity prices and falling wages.
- What happens with bond yields?
They fall during recessions as demand falls. Demand falls because borrowers are unable to get loans during a financial crisis and because the money supply falls. If there’s half the demand because there’s half as much money in the system, then yields must fall. With every recession bond yields fall to a new all-time low. I won’t be surprised to see a negative 10-year Treasury yield.
- Volatility is rising, what does that mean?
Rising volatility is a function of the Fed selling off their Mortgage Backed Securities, which I will cover in more detail in next week’s update. What it means is that the price of stocks will have larger fluctuations, and likely lead to a sharp decline in stock prices.
- Is rising volatility a problem?
Yes!! It’s probably the biggest risk in the markets today. Nearly everyone from hedge funds, institutional money managers, pension funds and retail investors are short volatility. As volatility rises, speculators will jump on the bandwagon, which will push volatility higher. As volatility rises, it will trigger a feedback loop where volatility-controlled products and risk-parity products will start selling stocks to buy bonds. As they sell stocks volatility will rise, triggering a larger sale of stocks. If volatility rises fast enough, the entire short volatility structure could break in one day, which could lead to the largest sell-off of stocks in history. With everyone in stocks, it is a nightmare scenario, but a very real risk.
- Is the reason you like bonds because volatility-controlled products will be forced to sell stocks to buy bonds.
Yes!! There is somewhere between $2-4 trillion in such investments. When they start buying bonds, yields will plummet.
Video Topic of the Week – High Stakes Poker
It’s a high stakes game of poker and the big money just revealed their hands. Tune in this week to see why the big money is talking about a “blow-off top,” rising bond yields and shorting stocks.
Chart of the Week – Consumer Sentiment
As consumer sentiment changes, so do stocks.
Portfolio Shield™ Update
Work progresses on the new version that utilizes inverse funds, which are a type of fund that rises with the stock market falls. I’m hoping to find a way to develop a portfolio that goes up more than it goes down – I realize Portfolio Shield™ does this now, but I’m looking for a better way to hedge downside risk.
I ran two tests, one using a 3-month look back and a second with a 2-month look back, both with a weekly rebalance instead of the current monthly rebalance. As I suspected, the shorter the look back, the less the strategy works. The current algorithm uses a 6-month look back with a monthly rebalance.
It takes several hours to prepare the data to run a 90-second test to see if it works. Unfortunately, the process is slow. I’m going to step back the look back to 4 months to see what happens. I’m also isolating 2014 & 2015 for my test, as those years have both a rising and falling equity market in them. If I can make it work there, I’ll expand the test.
I can see where the strategy will work; it’s just a matter of fine-tuning the algorithm.
I keep seeing reports on how a portfolio of gold and the S&P 500 beats the market with less risk. It continues to remind me that I need to devote time to a gold-based algorithm.
2018 Opportunities – Gold Interview with Fred Hickey, editor of High Tech Strategist
I had the opportunity to listen to an interview with Fred Hickey, who has two strong interests in investing – gold (miners in particular) and tech stocks. I was very curious to hear what he had to say on both topics.
His research on gold (and silver) miners goes back to the 1920’s. He says that when tech stocks fall, gold miners rise and vise versa. While that not exactly true as I see it on my charts, there is a strong correlation.
Fred believes there is a huge opportunity in the gold mining sector. He says that American investors aren’t big on gold, but foreign investors are, as are foreign central banks, who have been large buyers of gold over the past four years.
He goes on to say that gold entered a secular bull market back in 2000 and that we are currently in a consolidation period before the next move up. The big reason he likes the miners over the metal is that corporate executives, or insiders, have been buying their own company stock. That is a strong signal that the executives see long-term value. He believes they are buying because the HUI-to-gold ratio is at the same level it was back at the lows of 2000 before gold went from $250 to $1,900/oz, a 660% return. Mining stocks went up 17 times or 1,600% over the same period. A $100,000 investment with a 1,600% return would grow to $1,700,000. Not bad for an 11-year rally.
He sees that the gold mining executives are buying stocks at the same time that tech executives, such as Jeff Bezos and Mark Zuckerberg, are selling large amounts of shares. When insiders buy or sell it’s because they know what’s coming, and if Bezos or Zuckerberg thought their stock would be going higher in the near future, then they wouldn’t be selling. Either that or they are taking advantage of all the buying so they can sell before the buyers dry up.
Fred went on to say that the executives have been working at reducing costs, so if gold was to rally, then these companies would be very profitable. Plus their stock prices are trading below book value, which is a rarity in this stock market rally.
With the bubble in tech stocks and insider selling, Fred believes we are on the cusp of a bigger rally than we saw at the bottom of 2000. A rally I fully intend on participating in.
Weekly Broad Market / Economy Commentary
Germany and France added the Chinese Yuan to their basket of currencies this week and reduced the amount of U.S. dollars they are holding. Germany has also been repatriating their gold that’s being held at foreign (to them) central banks. While American’s haven’t been big buyers of gold, foreign central banks have. For anyone interested in gold, that should be an indication of what is to come.
Recently someone asked why it is taking so long for gold to break out. The big money knows that the retail investor is very impatient. If a retail investor doesn’t see returns within a short period of time, they will move on to another asset class. Every time gold tries to break out and gets rejected, the big money is buying as the retail investor takes their money elsewhere. The fact that gold has been in a 4-year bottoming pattern should tell us all we need to know about the direction it will head when it does finally break out.
Bitcoin and other cryptocurrencies appear to be going bust. About a month ago everyone was talking about how these “currencies” were going to the moon. A month later, many of them are down 40% or more. I think cryptocurrencies are a prime example of what happens when the money supply falls. Liquidity has to drain from somewhere, and it appears to be draining out of cryptos right now. I hold that view because the public is very bullish on cryptos, yet they are falling in price. Some experts have speculated that the big money is intentionally shorting cryptos to flush the public into stocks. While that possible, most of the people who on cryptocurrencies only own a small fraction of one coin. I find it unlikely that a person who just took a big loss on cryptos will turn to stocks, but I could be wrong.
On the topic of stocks, the media is trying to sell the notion that there will be a “blow-off top” where stocks rise another 50% or more before the final top is in place. Blow-off tops exist because that is the point where the public buys in and the big money moves out. With 90% of all stocks owned by 10% of the population, the problem for the 10% who own them is that they are bidding prices up against other wealthy investors. The public or working class only owns 10% of all stocks, which is not much. The data shows that the public is nearly as broke as they have been at the peak of prior business cycles. What that tells me is that the public doesn’t have the money to push the market up that high, unless they continue to use their credit cards to fund their lifestyles. Based on that alone, I’m not overly convinced the public will throw the last of their money in stocks after getting torched by cryptocurrencies. For those in stocks, when the race to sell starts, it’s a race against a small number of people who own a large number of stocks. There will be far more losers than winners.
The trade-weighted U.S. dollar continues to slide, which should have triggered a launching point for commodities, but it didn’t. Gold held its technical levels at $1,340, which is the price point that Momentum Structural Advisors points to as a key breakout level. This still lends to my belief that there will be one last pullback in gold that confirms the upward trendline around $1,220-1,230/oz. In the chart pack this week I will go over the symmetry of the four-year consolidation pattern for gold to show you why there is likely to be one last move down. With all the bullish sentiment on gold and gold miners, I expect there to be lots of buyers lined up with us, which is always a good sign.
The elephant in the room remains the Fed and their unprecedented unwinding of their $4+ trillion balance sheet. Jerome Powell takes over as the new Fed Chairman on February 3rd. While Fed officials have waited until their press conference to announce changes to the monetary policy, many are speculating that Powell may hike rates before the Fed’s mid-March meeting. It has been customary for the Fed to wait until those meetings, but it is not a requirement. Inflation is heating up and the Fed is behind the curve with their rate hikes. Perhaps that is why Wall Street is beating the drum of a blow-off top – to get the public to buy in before the Fed increases the rate of tightening.
Bonus (34 min):
- M2 Money Stock YoY% vs Recessions
- Commercial & Industrial Loans
- Consumer Loans
- Federal Reserve Balance Sheet
- UoM: Consumer Sentiment
- Total Savings Deposits at all Depository Institutions
- Savings Rate vs GDP Growth
- Treasury Deposits at Federal Reserve Banks vs 10-Year Treasury Yields
- U.S. Dollar vs Real Average Hourly Earnings
- Empire Fed
- Philly Fed
- Housing Starts
- Net Leverage in Corporate Bond Markets
- Labor Force Participation Rate vs 10-Year Treasury Yields
- Industrial Production
- Capacity Utilization
- Commercial Property Index
- Equity Flows
- S&P 500 Peak PEG Ratio
- Stock-to-Bond Ratio
- S&P 500 vs 4Q 2017 EPS
- S&P 500 (SPY) Chart
- 5-Year Treasury Yield (FVX) Technical Analysis
- 10-Year Treasury Yield (TNX) Technical Analysis
- Gold Futures (GCZ7) Technical Analysis
- Vaneck Vectors Gold Miners (GDX) Technical Analysis
- Global X Silver Miners (SIL) Technical Analysis
- Vanguard REIT (VNQ) Technical Analysis
- iShares U.S. Telecommunications (IYZ) Technical Analysis
- SPDR Trust Utilities (XLU) Technical Analysis
- iShares 7-10 Year Treasury Bond (IEF) Technical Analysis
- iShares 20 Year Treasury Bond (TLT) Technical Analysis
- PowerShares DB Agriculture (DBA) Technical Analysis
- U.S. Dollar Index (DXY) Technical Analysis
- General Electric (GE) Technical Analysis