The Gold Report: Ian, you have been involved in the markets for 50 years. How much of today’s market is a repeat of a cycle you’ve seen before and how much is unique?

Ian McAvity: Cyclical and secular trends haven’t really changed, but each one has slightly different characteristics. From 1982 to 2000, there was a powerful secular uptrend in the S&P 500. Since 2000, there’s been a secular bear trend, sideways or downtrend not dissimilar to 1966–1982 or 1932–1949 that may run through 2016 or 2018.

The big change has been the utter corruption of Wall Street and that nearly 80% of the trading on the New York Stock Exchange now is being done by high-velocity computers. When an investor puts in an order, it’s basically one computer versus another computer operating in nanoseconds. That’s why all of a sudden the volume is up or down 10 to 1 and you get a couple of hundred points added on or taken off the Dow in minutes. To me that’s a corruption of the process. “Ethics” and “Wall Street” are words you never use in the same sentence.

The trading mechanism is broken down. Leveraged exchange-traded funds (ETFs) are designed to consume the client’s capital in leveraging and rebalancing premiums. The high velocity traders literally get the opportunity to “front-run” public orders as the order flow to “the market” is available to them for a fee. It’s outrageous in the sense that they’ve legalized front running for those who pay up for the high-speed data feed. And then there’s the initial public offering (IPO) business. Anytime the public can get shares in an IPO, they don’t want it. If they can get some, it’s only because it’s not going to be that good a deal.

TGR: Is it the corruption of Wall Street or the development of Wall Street through technology?

IMcA: It’s the culture of greed coming out of the banking system. The Street always wanted to make money. That’s never gone away. But there was a time when good clients were actually respected by a firm. A firm wanted to do well for a good client because it wanted to keep the family assets in the firm. These days a client is considered to be a mark. The system is designed to convert the client’s capital into their fees and income as quickly as possible. The public is being chased out. There have been persistent outflows from domestic equity mutual funds since 2007. A lot of people justifiably don’t trust it.

TGR: Or perhaps the public just doesn’t have the tools and the speed to become an influential member of the market?

IMcA: Let me give you an example. The average daily turnover for one gold mining junior ETF is $100 million (M). Probably $80M is day trading where there is no net investment. To call moment-by-moment trading “investment” to me is a sacrilege. There’s no way that people are making a rational investment decision in that sense. I’d rather go to Vegas where they’ve got pretty girls serving you a drink while you gamble.

TGR: Aren’t day traders just playing nagainst each other? Someone bets it goes up. Someone else bets it goes down. They wait a very short period. Ultimately, it just evens out.

IMcA: In theory it works itself out, but it creates an illusion of growth that distorts trends because it injects volatility. The majority of the billions of dollars that are trading every day is intraday noise. All the computers scalping each other for as little as a tenth of a cent.

TGR: The market was up the other day in reaction to the debt plan that came out of Europe. Is this a real increase or just more intraday noise?

IMcA: One batch of traders shorted at the opening burst, but that afternoon it didn’t sell back. All the guys that shorted in the morning got their clocks cleaned and had to cover in the afternoon. That’s why there was a second rush into the close. That trading activity is symptomatic of what’s wrong with this market. Markets are being driven by headlines. Plus, the headlines are being misinterpreted most of the time. At first, it appeared that Europe had a perfect solution for everything. Then, by the end of the day, we were discovering that there were a lot of details missing and it was unclear how many parliaments have to approve the plan. Every day there’s a leak of some unsubstantiated “plan” and later it’s denied but the cheerleaders at CNBC seem to take every wiggle as gospel.

TGR: Is it driven by headlines or the 24/7 news cycle?

IMcA: I wish the news cycle was as slow as 24/7. When people are trading on one-minute and five-minute charts, a 24/7 news cycle can’t keep up with it. It’s not healthy to have this much liquidity. What it reflects is that the bailout of the banks has flooded the system with liquidity, but none of that is trickling down to Main Street or out into the real world. It’s just sloshing around in the financial markets. The velocity of trading reflects that the system is swimming in liquidity and nobody is feeling sufficiently brave to take any risk home overnight. We’ll churn the daylights out of it, but flatten the position before lunch or the close.

TGR: How does an individual investor operate in this environment?

IMcA: Basically hide. A number of people have told me that they’ve become day traders and I ask them how they’re doing and they say, “Well, I’m not quite there yet. I know I can make money doing it.” I tell them not to blow all of their capital while they try to learn. It’s an exploitable game for somebody that has the self-discipline. But it requires a degree of self-discipline that 90% of the people that try it will never acquire.

TGR: At The New Orleans Investment Conference where you spoke in late October, many speakers talked about how junior gold stocks are essentially on sale, inferring that this is the time to buy. Should investors run and hide from a corrupt and frothy market, or go out and buy?

IMcA: You’ve got to watch the inter-market relationships. The gold stocks have been very poor performers relative to the gold price. In the last 12 months, the junior gold stocks have been particularly bad even relative to the senior gold stocks. That is creating an undervalued situation. But undervalued doesn’t mean go out and buy it tomorrow morning. Yes, there was a marvelous October rally after five down months in the S&P. However, I believe that the S&P is going to go back down and at least probe the last lows, if not break them by year end or March. The junior gold mining shares will test their recent lows and then start to show relative performance where they’re not falling as much as the stock market. I’m watching for that type of relative strength and that’s when I would be looking to buy them. I wouldn’t be surprised if the gold price came back down to $1,650 an ounce (oz) as well.

I’m looking for a point where I want to buy, where for several months I was saying I wouldn’t even think about it. A lot of the excesses have been wound out, but the best buying opportunity still lies ahead. Year-end tax loss selling and a sharp down turn in the S&P where everyone is looking for a year-end rally could provide a great buying opportunity for the juniors soon.

TGR: You’re a technical analyst who relies on a lot of charts. What are you seeing in charts that make you believe that the S&P is going to pull back to its lows?

IMcA: I’m basing that on cyclical analysis within secular trends of the Dow Jones Industrial Average. I believe the top this year goes back to February as the cyclical top of the rebound off the 2009 lows, while the S&P made its actual peak in May. On a secular basis, I view this as the second half of the bear market that started in 2007. The first half of the financial bubble was undone from 2007 to 2009. The second half will run through 2012. There could also be a final low that may be as far out as 2016.

The undoing of the debt bubble over the last three decades is not a short-term affair. It’s going to take a long time to work off. The housing market has not seen its bottom. Job numbers are going to get worse. Everything that they are doing in Washington just says that they are looking for new ways to screw it up.

TGR: You’re expecting a double-dip recession.

IMcA: It will be called a double-dip only because they’ve engineered what appeared to be a recovery, but there hasn’t really been a recovery that restored many lost jobs or did much more than temporarily slow the pace of decline in the housing market. All of the money and the liquidity that they threw into the market tweaked a few of the numbers in the gross domestic product to create the appearance of a recovery, but barely a penny of it ever got to Main Street.

TGR: Main Street is starting to spend a bit more.

IMcA: That’s like saying there is a housing recovery because housing starts went up from 420,000 to 425,000. Housing starts used to be 1 million.

TGR: When will the economy get through this mess and start on a real recovery?

IMcA: It’s going to take several years. It might start to show some signs of recovery in 2013 or 2014, or perhaps as late as 2016.

If the S&P is below 1,258 on Dec. 31, 2011, it will be the first down pre-election year since 1939. Election years don’t have as bullish a record as pre-election years. But how much fun has this year been so far? The market’s going to find a bottom for bear market rally bounces. Ned Davis Research Group created a model that I’ve modified that projects a decline in the Dow to a prospective cyclical bottom between 8,200 and 8,400 in August or September 2012 if we experience only an “average” bear market. I fear that it could be a lot worse than “average” given the geopolitical uncertainties as a backdrop.

TGR: Wow, that’s a claim.

IMcA: It’s interesting to see a cyclical decline projected through an election year. It’s not unprecedented, but it’s quite unusual.

TGR: You said earlier that you expect the gold price to pull back again. Do you expect it to pull back below its 200-day moving average?

IMcA: No. The market has come back and tested the $1,600/oz level twice. The last bounce off the $1,600/oz level was pretty credible. I’d be surprised if $1,600/oz is broken now.

TGR: You don’t believe that gold is a bubble then?

IMcA: Whenever somebody talks about gold being in a bubble, I tell them to look at the credit and stock markets. If the gold price is at $1,900/oz, it’s 2.2 times the high in 1980. However, debt in the U.S. is 12 times its early 1980 level. The S&P is trading at 10 times its 1980 level. The credit market and the stock market are about five times ahead of the gold price. I don’t forecast that the gold price will reach five times its 1980 highs, but it might. If it gets there then you can start talking about a bubble.

TGR: Do you believe that gold will replace fiat currency?

IMcA: I don’t know that it will ever replace fiat currency. The leadership of the G13, China, Brazil, and India, are probably going to push the old world to go back to some sort of a central discipline, such as indexing to a basket of commodities. It’s too cumbersome in the modern world to return to a gold standard. But I can envision an international governing body being proposed to push for some discipline such as the Bretton Woods Agreement after World War Two.

TGR: What’s in the basket?

IMcA: Gold, silver, oil, copper and conventional food.

The problem is no central banker ever wants to surrender sovereignty to some other body. The U.S. government is always going to want to call all the shots. But the U.S. government isn’t what it once was. The rest of the world is increasingly going to communicate that message. At some stage, the world needs a globally accepted common denominator. China, Brazil, India and the G13 have nearly $7 trillion worth of the debt of the old world. There comes a point where the creditor will dictate the rules.

TGR: That’s how the U.S. got to the position it’s in.

IMcA: Exactly, exactly.

My biggest concern is increasing geopolitical risk for those that are exploring all over the world, the most recent example being the Argentinean government putting in a new set of rules. The same thing could happen in African countries. If the gold price gets much higher, the South African government will be talking about nationalizing. Too many of those countries will love you while you are bringing money in, but once cash flow begins to flow out, the politics of greed and envy takes over, typically under the guise of economic nationalism.

Politically stable jurisdictions are my preference. I am most attracted to seeking deposits in conventional mining districts in Canada or the U.S. where mining laws and practices are understood and respected. Even South Carolina is coming back again. I remember the previous go-around on it.

TGR: What happened then?

IMcA: It didn’t work out because the gold price went down, as best I recall.

TGR: Any other last thoughts you’d like to leave our readers?

IMcA: The big contrast with this gold cycle and that of the ’80s and ’90s is that we haven’t really seen a big discovery that excites the world. In that last cycle there were about a half-dozen companies built on new deposits that are already mined out and gone now. Names like Echo Bay, Hemlo, Amax Gold, FMC Gold, Pegasus and several others were launched and became the darlings of the last cycle, and they have already gone from the scene by the time gold got above $1,000/oz this time around.

At some stage somebody’s going to make a discovery that’s going to turn the lights on to get the speculative juices flowing, one good, exciting discovery in a prospective new camp. It looked like that might be taking place in the Yukon with the takeover of Underworld Resources Inc. (UNDWF:OTCQB). Will there be a sequel discovery up there? One solid drill hole can transform a junior explorer, but it does need to deliver follow-up success pretty quickly to build on it.

That’s the nature of the drilling beast and discovery cycles. Others will remind you what the odds are. It’s a very high-risk and capital intensive business. That’s why I’m more attracted to the companies that are in that process of creating value out of the ground as opposed to having the political experience of dealing with environmental permitting and other regulatory impediments to getting a new mine into production. My idea is if you can make a discovery then God bless you and let somebody else have those future political and bureaucratic joys for the right price.

TGR: Ian, thank you for your time.

Ian McAvity has been involved in the world of finance for more than 50 years as a banker, broker, independent advisor and consultant. He has produced his Deliberations on World Markets newsletter since 1972. He specializes in the technical analysis of international equity, foreign exchange and precious metals markets, and has been a featured speaker at investment conferences and technical analyst society gatherings in the U.S., Canada and Europe over the past 40 years.

More fundamentally, what we are lacking is morality. To this end, the title of this post mocking Paul Krugman is meant to signal that it is the liberal (little l, not big L) flavor of morality that is what is killing us. When we begin to examine things from a moral level, this will lead us to see the proper path to peace and prosperity.

One of the principle beliefs in liberalism is that it is the job of the government to better the conditions of its people. If this were limited to protecting individuals from the harm of other individuals, this would be a noble and just undertaking. But liberals would like to accomplish this goal by going far beyond the limited scope granted to the state by the Constitution, and instead seeking to impose their brand of morality through a host of programs that in the end amount to stripping the people of their most cherished liberties, often with chosen groups benefiting at the cost of society as a whole. If we examine our system of political economy under this scope, it becomes much clearer to see that what we are living under is an entirely immoral system, in which liberals through the academia and media have used their sophistry to serve their perversely unjust agenda.

First, let’s take a look at the central bank. The Federal Reserve, a government-granted monopoly, was instituted because it was felt that banking crises in the past were too painful, and a central bank could prevent against them. With the noble goals of price stability and full employment, it would appear that the central bank would be a boon to prosperity in America. However, the central bank in fact insures that neither of its dual mandates can be met. First, the Federal Reserve has the sole power to set interest rates for the entire financial system and through this process also control the money supply. It is through these powers enhanced by a fractional-reserve monetary system and legal tender laws in which no other banks can compete with their own currencies that the government crystallizes the boom-and-bust cycle (ensuring periods of mass unemployment), inflates (destroying the purchasing power of one’s store of wealth, causing price instability and helping banking institutions at the cost of other businesses) and moreover creates through the power of law an inherently insolvent financial system. Inflation decreases debts, and so public debtors like the government benefit in being able to pay for social programs with cheaper money at the expense of the taxpayer, while private debtors like individuals benefit at the expense of the creditor. The banking system as a whole of course is technically insolvent because were there to be runs on every single bank, since banks only hold around 10% of funds in reserves, they would be unable to pay their depositors their money back in full. The FDIC further could not cover all the funds needed (unless push comes to shove they decided to ask the Fed to print money, meaning massive inflation), and in itself represents a moral hazard, but that is not essential to our discussion. The principle stands that a cornerstone political entity which is supposed to help people hurts all of us (though bankers and other people with access to artificially cheap credit may benefit for a time at our sake). Further, it stands as a fraud in its ability to print infinite money out of thin air and its insolvence. In other words, it is immoral.

Let us take a look at some other recent examples of liberals trying to help Americans through regulations. In order to protect American unions, Congress voted to stop Mexican truckers from being allowed to travel through the US, violating NAFTA. In theory, it seems like it would hurt American truckers to allow competition from Mexico. Yet what is the end result of this seemingly well-intended policy? Mexico will now be slapping tariffs of between 10 and 45% on approximately 90 US industrial and agricultural products. Are the gains from the blocking of free trade to support a specific union greater than the losses to the American people in having to pay for more expensive goods? Ask yourself whether that rhetorical question seems moral.

Another example of the fallacy that these types of regulations help would be the SEC. The Ponzi scheme of Mr. Madoff if anything should have shown that the SEC is an incompetent entity, and further one that creates moral hazard, hurting all consumers. They failed to pick up on the scheme despite repeated efforts by individuals to prove the firm to be a fraud, and in their incompetence took down investors who assumed that the operation was legitimate given the rubber stamp of the United States government. This same situation has been replayed in other fraudulent schemes as well only now being uncovered. But this is exactly what happens when you have a government entity given monopoly power over regulating companies. In a system in which private investors were responsible for their investing decisions, as opposed to having a government institution their to insure safety, these problems would be avoided. In fact, private firms have been all over these frauds in the past, but have lacked the power to stop the fraud because of the SEC’s complacence. Is it really so hard to envision a system in which firms competed against each other to provide the best oversight of companies for investors? Instead, again we see a situation in which a state agency ostensibly there to protect the public ends up hurting the public through its incompetence in stopping fraud, and in its lulling of the public into a false sense of security. Verdict? Immoral.

Another hallmark of leftists is the belief in the use of the state to promote equality and fairness. Take a goal the lefties have like shrinking the inequality gap in incomes. In order to do this, the government developed a system of progressive income taxation whereby those earning more would sacrifice greater percentages of their incomes in order to subsidize those who were worse off through various programs. This system of redistribution has led to a tax regime in which 60% of people pay income taxes, subsidizing the 40% of people who do not.

Yet leaving aside the grave injustice that such a large percentage of people get the benefits of programs paid for by others, progressive taxation ends up hurting the very people it purports to help. Since those earning more are taxed at a higher rate, this discourages productivity, meaning that businessmen will be disincentivized to generate better products at cheaper prices. This will mean smaller profits, which means lower wages for the employees, and for the consumers, worse and more expensive products. Thus, everyone loses as a result of progressive taxation.

Further, in principle, it seems immoral to my mind that people should be penalized for being more financially successful than others. Doesn’t it strike you as odd that people are punished for success and rewarded for failure in order to level the playing field? Should a dominant right-handed pitcher have to pitch lefty in order to make it more fair for opposing batters? Should a Nobel Prize winner have to incur a few concussions so as to knock his intellect down a few notches?

One can see that this principle pervades not just the tax structure, but also the way in which we have dealt with our entire financial crisis in that financial institutions that made poor decisions are being propped up by everyone, specifically at the cost of the financial institutions that were superior who deserved to gain market share as a result of the failures of their competitors, and who could use the assets being wasted by the poorer institutions productively. In addition, again all of us are paying through direct taxation, debts which will have to be paid in future taxes and/or inflation a more deceptive but equally odious tax for the failures of a given group. Forcing everyone to pay for private failure is immoral, especially when we are burdening yet-to-be-born generations of American citizens in doing so.

Another example of this perversion of morality is in affirmative action. By taking into account race and sex when it comes to college admissions or employment in businesses, we have institutionalized an inherently racist and sexist system. I find this to be degrading in that we are judging people not on their merit but on traits they are born with. I feel especially bad for someone like Clarence Thomas, a brilliant jurist who unfortunately has had his whole career doubted because of affirmative action. In other situations, an individual lacking in merit may be put in a position in which they are ill-equipped to thrive due to preferential treatment from affirmative action. In this case, the employer or school is left with an underperforming employee or student. In the case of business, the shareholder and/or consumer is left with a worse investment and/or product. And again, just thinking logically, imagine if you managed a baseball team where in evaluating a player you had to add 50 points to the batting average of anyone with red hair. Not a good way to succeed, and a pretty arbitrary way to pick a team if you ask me. This is akin to affirmative action. In sum, as a result of trying to break down social barriers, these barriers are erected and all bear the cost of falsely trying to help those seeking redress for prior injustices. Members of the “minority” and “majority” alike suffer.

Going back to the financial crisis, many people have spoken to the notion that housing is the key to fixing the crisis. Indeed, many of the assets crippling the financial institutions are those tied to non-performing mortgages. So the government, in an attempt to stem this problem has sought to keep people in their homes by allowing judges to alter contracts to lessen the debt burdens on those with mortgages they cannot afford. Again, this seems like a noble policy in which the state is trying to help out some of its people, just like the noble policy that the state pursued through the CRA and Fannie and Freddie in attempting to put every citizen into a home (note implied sarcasm here). It is this entitlement mindset however that hurts society as a whole.

Witness the collapse of Fannie and Freddie and the drain on taxpayers funding it, all of the homeowners now underwater who purchased houses they could not afford as a result of the easy credit fueled by the Federal Reserve and the inane policies that the government pushed upon lenders to put people into these homes. Then, perhaps even worse, remember that those who do not have mortgages or who can pay their mortgage are now being forced to subsidize those who can’t. This creates a moral hazard in signaling that it is okay for people to live in houses they cannot afford. This hurts renters who would otherwise be able to live in these vacant houses but who cannot because of the bailed out mortgage holders. This hurts the lenders who are being forced to take haircuts on properties that they will still probably not receive interest and principal on. This hurts people who have the desire and the means to be able to purchase these homes that should have been foreclosed. To blame the auctioneers of the homes, the ones who are helping stabilize the housing market by matching buyers with sellers makes me apoplectic.

At root and behind this by no means exhaustive and rather poorly organized list of various instances of government intervention with seemingly beneficial goals that end up having the direct opposite effects, plundering almost all citizens while benefiting small groups of others is the belief in democracy, immorality’s bedfellow. As Madison noted in Federalist #10, “…democracies have ever been spectacles of turbulence and contention; have ever been found incompatible with personal security or the rights of property; and have in general been as short in their lives as they have been violent in their deaths.” In fact it was Karl Marx himself who said that “Democracy is the road to socialism.” Not once is the word democracy mentioned in our Constitution, and the founding father’s ardently defended against it throughout the Federalist Papers. Yet everywhere today, people speak of America as a democracy, and we know we have become one based upon the previous examples. The political system has become a free-for-all in which every single group has sought to gain power at the expense of every other group through government fiat. Our prescient old friend Frederic Bastiat describes the process by which we have ended up here:

Men naturally rebel against the injustice of which they are victims. Thus, when plunder is organized by law for the profit of those who make the law, all the plundered classes try somehow to enter — by peaceful or revolutionary means — into the making of laws. According to their degree of enlightenment, these plundered classes may propose one of two entirely different purposes when they attempt to attain political power: Either they may wish to stop lawful plunder, or they may wish to share in it.

Woe to the nation when this latter purpose prevails among the mass victims of lawful plunder when they, in turn, seize the power to make laws! Until that happens, the few practice lawful plunder upon the many, a common practice where the right to participate in the making of law is limited to a few persons. But then, participation in the making of law becomes universal. And then, men seek to balance their conflicting interests by universal plunder. Instead of rooting out the injustices found in society, they make these injustices general. As soon as the plundered classes gain political power, they establish a system of reprisals against other classes. They do not abolish legal plunder. (This objective would demand more enlightenment than they possess.) Instead, they emulate their evil predecessors by participating in this legal plunder, even though it is against their own interests.

In summation, all of our problems are a result of the inversion of morality by the sophistry of leftists, and a gullible public that deludes itself into believing that the government is working for fairness, equality, charity, security, peace and prosperity, the very things it undermines through its policies. The belief in the US as a progressive democracy has aided this cause. A simple dose of true morality however would provide the antidote for all that ails us.

It is this conception of morality in the tradition of classical Liberalism that was built into our Constitution, insuring that the state solely preserve our natural rights to life, liberty and property against the aggression of other individuals, and moreover against the tyranny of the majority. It was this system of government with limited powers, in which people could choose their own form of morality over that imposed by the force of the state. This choice of what was moral could be made at one’s own peril: people could choose to accumulate as much wealth as possible or sacrifice all of their wealth to charity; businessesmen could operate for consumers at a profit or for the “public good” at a loss; soul-searchers could choose to live good Christian lives or become pot-smoking hippies or dwell in hedonistic communes.

The point is that people had choice, and they were responsible for their choices and protected from harmful choices of others by the rule of law. Until we rekindle this system of limited government standing to protect free markets and free people — a system firmly grounded in morality — we will be doomed to mob rule and the perpetuation of the aforementioned immoral follies.