Thursday, December 27, 2007

Outlook for 2008

The following was published as a six part series on between Dec 27, 2007 and Jan 7, 2008. It was written over the Christmas holidays. To view the articles inclusive with charts, please visit the following links:,-part-one,-part-three,-part-four,-part-six

It should go without saying that in the world markets, a year is a long time. Any number of events can have enormous effects on the directions of different asset prices. Sometimes these events are predicable; sometimes they seemingly come from out of nowhere. Astute investors are able to respect the unpredictability of these events and react quickly. Others attempt to predict these occurrences and position themselves accordingly. Doing so is a difficult task, and before attempting to do so, one must realize that much like in professional sports, you can be good, but never perfect (maybe the Patriots are an exception - maybe). Recognizing mistakes early and learning from them is a key principal to success in investing, much like many other aspects of life.

Therefore, I am taking the last couple weeks of the year to evaluate positions I’ve taken and attempt to find patterns in my decision making that I can improve on in 2008. It is also time to review my opinions of the overall economy and determine what needs to be changed in my outlook. Let’s start by revisiting my Themes for 2007 (

- Over speculation and oversupply in the housing market throughout the western economies will lead to a continuing decline in home values. - check
- This dramatic reduction in equity will put a damper on the engine of the US economy - consumer spending and send the economy in general towards recession by Q3 of 2007. - looks like I was a little early
- Slower growth in western economies will lead to lower prices of nearly all assets. - not yet, but some assets are coming down already
- Slower or negative growth in the US could have a disastrous effect on the banking system which is highly leveraged to future growth. - check
- In such a situation, the price of precious metals could rise exponentially. - Gold up 27% YTD - check
- Agricultural commodities will carry the torch of the commodities cycle on the back of being immune to lowering demand and due to abnormal weather. - all time highs in wheat prices - check
- Oil will trade lower on prospects for lower growth, but remain volatile due to socio-political events. - not even close
- Export driven economies dependant on US consumer spending and housing will need to find internal sources for growth before continuing their economic expansions. - not yet
- Domestic demand for cash in the US will outpace foreign demand, devaluing the dollar against other currencies - USD down nearly 8% YTD - check
- Interest rates in the US will not be lowered to inject liquidity because such a move will not be effective enough to risk dollar hegemony. - way off
- Bargains will be had in all asset classes as people liquidate their holdings to pay off debt - happening now - check

Reading over previous thoughts is always a humbling experience. It’s part of the reason I write in the first place. It provides an inescapable glimpse of your thought process. After re-reading my year-end piece from last January I found numerous holes, gaps in logic and things that plainly did not make sense. But for the most part, my thought process was correct. In the year that has passed I have learned a lot. I feel I have plugged many of those holes and have a far better understanding of why these things are happening. But I would be foolish to think that at this time next year, I will read through the following and not giggle a little at my short-sightedness. Let’s get started:

How we got here

There are two ways to view this previous economic expansion: as a result of the low interest rate policies following the collapse of the tech bubble and the irresponsible lending/government promotion of homeownership that followed. Or as an extension and parabolic blow-off of the credit boom that has been going on since the early 80’s. Either way, it is undeniable that it has been a credit fuelled expansion. Total credit market debt has ballooned to over 300% of total US GDP. This is a number that after reaching a peak of 270% during the Great Depression stayed between 120 and 150 for most of the post war period. Homeowner’s equity declined from near 90% after the second world war to 70% before actually recovering during the inflationary 70’s and has proceeded to dip below 50% this decade. The personal savings rate is nil or negative. Government debt and unfunded liabilities are off the charts. It is no secret that America has been living beyond its means. But most of these are all statistics I could have listed in 1990, 2000 or even last year. If it didn’t matter then, why should it matter now? Why can’t it continue for a few more years?

My answer is that it did matter then. And the effects are cumulative. The consequences were just postponed until a later date. This is also no secret. I have never heard anyone claim that debt is okay because it doesn’t really need to be paid back. It is the complacency with the date of inevitable payback that I am concerned with. Wall Street and Main Street seem most concerned with preventing a recession rather than focusing their attention on the legitimacy of the financial system. With every economic or financial shock experienced since the Great Depression, there has been a successful reflation of the credit markets. This string of success has been drilled into our collective conscience. Even though, if asked individually, most believe that eventually it will fail. This is an inconsistency in logic that I cannot accept.

Where we are now

As promised, the slowdown and subsequent depreciation in US home prices has caused a tidal wave of foreclosures and a crisis in the financial system worldwide. Naturally, the first properties to be foreclosed upon were the most suspect of mortgages issued, where borrowers had little room to breathe before having negative equity. Those borrowers that bought at the top of the bubble with no money down were labelled as ‘subprime’ hence the name of the crisis. But as prices have fallen further (30% already in San Diego), there are new vintages of mortgages going into foreclosure as folks that purchased in 2004 with a decent (although historically small) down payment are going under water as well. Also in this group of buyers are people who bought many years previous, but began taking home equity out of their homes or used the equity as collateral for other consumer loans. This group of people makes up for a far greater percentage of American ‘homeowners’.

Most readers probably have a decent understanding by now about why this has been such an enormous problem in the credit markets. An entirely new occupation sprung out of this latest round of speculation called ‘structured finance’. It involved figuring out ways to disperse risk to many investors and to reduce the likelihood of losses by purchasing insurance or derivative contracts. The cost of that insurance or those derivatives were all based on historical rates of defaults. Sounds like a pretty good idea. A win-win situation. Rating agencies (Moody’s, S&P, Fitch and DBRS) for these packaged debt instruments came up with their own formulas and decided on a rating accordingly. But there was a catch. Falling levels of collateral were never part of the risk equation. It was just assumed that home prices would continue rising forever.

So it should come without any surprise the reaction of the credit markets in August, nor the persistence of the issue through year-end. And it should not come with any surprise that mortgage insurers like MBIA (MBI) and Ambac (ABK) are on the brinks.

That was then. What now?

Okay, so a couple of companies do down the tubes. Good riddance. Why does this really matter? From estimates I have seen, these two companies insure combined bonds valued in the hundreds of billions of dollars. Their combined share capital as of Friday Dec 21 was $5.2 Billion. It doesn’t take a genius to figure out that is not a good situation. But they don’t even need to go completely bankrupt for the negative effects to be felt. If their credit ratings are simply downgraded, then the credit ratings for all of the bonds they insure are subsequently downgraded. That has already been set in motion with both companies being put on ‘negative watch’ by the credit rating agencies (keep in mind these are the same folks that finally downgraded Enron less than a week before it went bankrupt). Along with the insurers, 173,022 bond issues were also put on negative watch.

2008 is going to be a tough year for states, municipalities, and pension funds all over the western world. They are the ones that have been investing in these AAA bonds, that will no longer be AAA anymore. The current market for these bonds is minimal, with bidders only willing to purchase at steep discounts. Many of these municipalities and pension funds have regulations as to what they are permitted to invest in. A downgrade of the investment quality would likely force the sale of billions of dollars in bonds at those steep discounts, causing massive losses. Combined with lower tax-receipts being received by the states as fewer people pay their property taxes, I don’t see how bankruptcy by certain states, municipalities and pension funds is avoidable in 2008.

A bright spot amid the collapse in residential real estate over the past two years has been the continued strength of commercial real estate. The building of office buildings and shopping malls has generally followed that of residential real estate with a lag and so have slowdowns. This makes a lot of sense, as residential communities are built outward they require services in relative proximity. Commercial Real Estate has already begun to show signs of weakness as points out. A continuation of that weakness will begin to make headlines in 2008.

The other lone bright spot of 2007 was the apparent resiliency of the US consumer and ‘strong’ employment numbers. I don’t think that either of those things have actually been happening, but we all know perception is more important than reality - until one day it isn’t. The massively tinkered with employment numbers are in for some nasty revisions. And we know that just to keep up with population growth 150,000 new jobs need to be produced each month, a far cry from the tampered with 5 month average of 98,000. Consumers have been scrambling to support their lifestyle as home prices have been falling. They’ve resolved to using their credit cards and news of the defaults are already coming out. Rising unemployment and slowing consumer spending will be key themes to the economy in 2008.

If this all sounds too negative, don’t worry; there’s a positive to come out of it. I’ll get to that later. First, let’s take a look at how weakness in the US economy will have an effect on Canada, and why most of the prescribed cures will ultimately prove to be useless.


Part 1 of this piece was devoted to understanding the roots of the credit crisis we see in the news on a daily basis. While the mainstream media treats the issue as something that just ‘showed up out of the blue one day’, we know what actually caused it and have begun to connect the dots in what effect it will have on other parts of the US economy. But if you are a Canadian reader, you will be wondering how this will have an effect on you. Let’s take some time to review the Canadian economy.

Canada: Recession Proof?

The mantra sung by the media in Canada is that a strong economy, low unemployment rates, and rising commodity prices will prove to be enough for Canada to escape the ill effects of a recession. Much like analysis in the US, little effort is actually put in to understanding the root cause of the recent expansion. Of Canada’s $1.18 Trillion GDP, 34% of it is in exports. 27.7% of the total GDP is in exports to the US. Combined with a sharp rise in the Loonie, a slowdown in the US will lead to a decrease in the amount of exports to that market. Given that only 14% of Canadians are employed in goods-producing jobs, it is easy to see where the wealth is being produced. So even though jobs growth has been strong, future layoffs are going to be in the most critical of areas in the near term. And considering another 75% of Canadians are employed in services it doesn’t take much of an imagination to figure out the future direction of unemployment trends as we are now sitting at all time lows.

Home prices in Canada have not yet begun to decline, but as jobs are lost, price declines will come sure as the sun rises. Lending practices have not been nearly as loose as in the US, but speculation in major western markets has been rampant as the perception of perpetually rising incomes has led to much of the same insanity that occurred in Southern California and Florida with people .

Canada isn’t immune from the effects of the credit crisis either. CIBC recently announced this week that $3.5 Billion of its holdings that have been frozen since August are now without insurance as a smaller mortgage insurer (ACA Financial Guaranty Corp) was downgraded and who’s stock was de-listed. All of the other major Canadian banks have declared losses associated with subprime exposure in the US. As I type this, I hear of news that the $33 Billion in ABCP (Asset Backed Commercial Paper) that has been frozen since August has now been restructured over a longer time period. From what I can tell, unless there is all of a sudden huge demand for this paper the market value of it will still be lower, meaning markdowns on the balance sheets of its investors.

Canada will undoubtedly have a recession at some point in the near future. But contrary to how prospects of such are spun by the media and our politicians, there is nothing to fear. If we are to accept the presence of a capitalist society we need to accept the normal movement of the business cycle. Recessions are a good thing for the economy as a whole, even if they are bad for individuals. Indeed, many Canadians will have to go through the pain of losing their jobs, and I’m not trying to make light of that. But eliminating unproductive workers because a certain good can be produced or service provided by someone else at a cheaper price is not a bad thing. The rising Loonie relative to the Greenback is telling us that investors believe that the promises behind the currency are stronger. I.e. investors believe they will get their principal back when they buy Canadian issued credit notes. This is a sign that our banking system is relatively stronger than it was previously. Never a bad thing.

The consequence is that goods produced in Canada are more expensive to foreigners, so businesses are shut down that can no longer compete. Jobs are lost. The strongest businesses will survive, however. Businesses that produce something that nobody else can produce will thrive. And they will reap higher profits as the currency rises. Additionally, a strong currency encourages foreign investment and this seed capital will go to providing business opportunities that never existed before, resulting in higher wages and a higher quality of living for Canadians. But this foreign investment is finicky. It wants a human capital advantage that it cannot get elsewhere. This is why it is imperative for government to not discourage the failure of businesses by way of supportive subsidies. Canada’s most educated and productive portion of the workforce - no longer living up to their potential by designing auto parts - need to be re-educated in other lines of work, so as to satisfy the global thirst for superiorly educated workers.

The implications for investors in Canada are obvious. They need to be quick to recognize where these foreign capital inflows are being directed and attempt to be first on board when it happens. They will likely be in areas that are seen to be non-traditional drivers of economic growth in Canada, so investors here will likely be kept in the dark until the opportunities are fully understood. This makes for an explosive combination for those that are left with extremely liquid assets, who are able to take advantage of the new opportunities. But those stuck in the mindset of ‘old Canada’ - ‘the discount alternative to the US’ will be left behind.

Indeed, the future is very bright for Canada. One of the few, or perhaps the only, market in the world with abundant supplies of fresh water, energy self-sufficiency, large quantities of arable land, a modern financial system and an educated population. None of this makes Canada recession-proof, but it serves to make it less susceptible to economic shocks. Should the government have enough sense to allow the free-market to utilize and improve the country’s human capital, simply participating in the growth will be one of the best opportunities for Canadian investors.

Next, we will take a look at how effective central bank actions are likely to be in resolving the credit crisis and some of the common arguments used to play down the importance of the issue.


Are Central Bank actions helping?

One difference between this credit crunch and the previous two (Long Term Capital Management in ‘98 and the Savings & Loan Crisis culminating in ‘90) that I find most interesting is the reaction of the US equity markets. In 1990, the S&P 500 experienced a 20% decline over 9 weeks in the summer. In 1998, the index declined 21% over 10 weeks in the summer. After 10 weeks in 2007, the S&P had already recouped all of it’s losses and was back at the highs. On both previous occasions, the market overreacted as interest rates were quickly lowered and the losses were recovered in a matter of months and were followed by enormous gains the following calendar year. This time around, as interest rates were lowered by the US Fed, investors piled back in in anticipation of a similar quick recovery. They got it for a while, but as I think we will see, investors were once again wrong. Where they previously overreacted, this time they underreacted.

Why did investors not panic this summer in a similar fashion to ‘90 or ‘98? The problems this time around are certainly serious. Whereas before, they were cleared up and forgotten about quickly, this time the conditions have lingered and even deteriorated. So why are the US equity markets not dropping like a rock? Could it be that investors believe that central banks are able to make the problem go away like last time? I think so. And that begs the question: how legitimate are those beliefs? The answer lies in ‘the velocity of money’.

The Federal Reserve in the US can affect the credit markets in only a few ways. Their primary method is by setting a target overnight rate for banks to lend to each other. They do so by intervening in the market by either buying or selling and thus increasing demand or supply. They can also make loans to banks through the ‘discount window’. Recently, the Fed set up an auction facility whereby banks could bid on short term credit. This has proved to be quite successful as banks have oversubscribed to the auctions. However, understanding what the banks intend to do with these credit infusions is paramount to figuring out if it will have any trickle-down effect on the economy.

Although the spread between LIBOR and the Fed Funds Rate has closed since the announcement of the facility on Dec 12, it is still at abnormally high levels, signalling that banks are weary of lending. So if banks are not willing to lend, what are they going to do with credit they have borrowed from the Fed? They may choose to roll it into some of their holdings that desperately require funding, or may elect to use it to boost their loan/loss reserves. But that doesn’t actually solve the problem of having billions of dollars of loans with collapsing collateral values (homes), it merely postpones it until they have to repay the Fed or roll-over the debt at the next auction. Unless banks have enough free capital to start making consumer loans like they were in 2005, nothing is achieved by the Fed’s lending. A credit based economy requires an ever increasing amount of credit growth.

The velocity of money is the net effect of one dollar in circulation on a country’s GDP. If I spend $1 at a movie theatre, the movie theatre operator turns around and makes a capital investment on a new projector, and the projector manufacturer goes and spends that money on research and development of a better projector, the net effect of that $1 was actually $3 on the GDP for that year.

But if new credit in circulation only goes to serve the purpose of destroying old credit, and if businesses make no future investment and, for example, elect to buy back their own shares, there is no net positive effect on domestic production. That is, it is taking an ever larger amount of credit issuance to have an effect on growth. This is why it is possible to see the total amount of money and credit (M3) in the system growing at 17% y/y while GDP grows at a much slower rate of 2%. What this tells us, is that it is taking (approx) $8.50 of credit issuance to have $1 positive effect on the GDP. And that number is growing. Eventually, the equation runs into a sort of ‘zero hour’. Where credit growth has no effect on domestic production. I believe we are approaching that time.

This is the only possible explanation as to why all of the central bank’s efforts to stimulate the credit markets have failed to produce similar results to the ‘90 and ‘98 credit crises. And it is why I believe the Fed cannot have a similar effect in resolving this particular crisis. The Fed is not willing to hand out cash. They can encourage banks to lend and consumers to borrow, but they cannot force either of those matters.

Quantifying the Problem

Simply put, there is no way to quantify the magnitude of this situation. It is systemic. A creditor economy that could no longer keep up with developing nations and turned into a debtor economy after refusing to give up the lifestyle of the previous. But that doesn’t stop analysts from attempting to put a price tag on the ‘subprime crisis’’ cost to the economy. In a recent Yahoo! Article ( ), Ben Stein writes:

“That's a major moral problem, and the magnitude of loss because of defaults on the mortgages seems immense. There may have been roughly $80 billion in losses so far (before liquidation of the collateral, which will greatly reduce the losses). There may be another $150 billion of losses out there, and maybe even another $200 billion.”

Stein and so many others are assuming the problem is limited to the 20 per cent of home mortgages that are considered ‘subprime’. They ignore a spill-over into commercial real-estate, credit cards, option-ARM and Alt-A mortgages, prime mortgages that become underwater, consumer loans, auto loans, and the fact that this is not just happening in the US - that it is global. They ignore that states like California, Michigan, and Ohio are facing massive budgetary shortfalls, and that municipalities are going broke because of bad investments. It doesn’t take a genius (that Stein is acclaimed to be) to add up all of the already declared losses and proclaim the problem to be a speck on the face of the economy. I suggest that Stein should go back to his TV show.

Exports to the Rescue!

Among the nuttier of claims I have heard lately is that the US economy will be greatly benefited by the lower dollar because their exports will become more attractive. Nevermind that the export sector of the economy is only 7.8 per cent of the total GDP. It would take approximately a 10 per cent increase in exports to make up for every 1 per cent of consumption slowdown. The people giving this advice are either incredibly unintelligent or are giving it maliciously. I don’t know which I prefer to believe.

Coordinated Attempts

Much of the stock market’s reluctance to weaken can be attributed to the relentless onslaught of central bank and government announcements to prop the bubble up. There have been four such attempts thus far. The first was the Fed flip-flop on Aug 16th, lowering the discount rate .50 bps on an options expiry day only 9 days after deciding to leave rates unchanged. Then came the ‘Super SIV’ that was designed to be a fund that would buy all of the bad assets at face value held off the balance sheets of major banks (the plan was recently scrapped). Then was the Bush Administration’s plan to ‘freeze’ interest rates for troubled borrowers. But that only helps a maximum of a few hundred thousand borrowers among potentially 10 million plus homeowners that could soon be under water on their mortgages. Lastly, we had the US, UK, EU and Canadian central banks come together and announce additional measures - basically offering an unlimited amount of credit to anyone who would take it.

Each of these attempts caused sharp rallies in the stock market that otherwise would not have occurred. More importantly, each of these actions had the effect of ‘calming’ the owners of failing investments into believing that all would be well. Although this may seem to be a noble purpose, there are greater implications over the long term. The term ‘moral hazard’ is used to explain the phenomenon of human action being altered because of an underlying belief that they are ultimately not liable for their actions. It leads to excessive risk taking. The bank bailouts of 1990 and bailouts previous had a cumulative effect on the psychology of risk-taking. And the current actions of central banks and governments are having similar effects. I.e. “take as much credit risk as the law allows. If it turns out to be too much, don’t worry, we’re here for you.” It is an extremely dangerous concept, but one that has been thrown out as irrelevant in the face of ‘saving’ the financial system. Eventually, the problem gets to big for anyone to bail out. Eventually will be 2008.

But before you pull out the roll of tinfoil to shape a new hat, I ask that you save it to cover tonight’s leftovers. There’s plenty of good news to come. Stick with me. We’ll take a more in-depth look at investment opportunities for 2008 as we move on.


Commodities have been a booming area to be invested in for many years now. Whether that growth continues depends on multiple variables for each different class of commodities. During a credit boom, all assets generally rise in price. But during a credit bust, the same is not always true. Some commodities will diverge from others.

Precious Metals

I continue to believe that the gold market is one of the better investments out there. Either in bullion or in mining shares. The longer this credit crisis persists, the more inevitable it is for holders of declining asset prices to mark down the value of investments on their balance sheets. This destruction of credit is very deflationary. As it becomes more apparent that banks do not have nearly as much money as has been deposited, and whose assets are not liquid at prices they consider to be ‘normal,’ the potential for bank runs by depositors is becoming more likely. The uncertainty of solvency of governments and banks around the world will be a key driver for the price of gold in 2008. Gold’s inherent value is as an alternative currency in the face of threats to the legitimacy of fiat money. Times of monetary hyperinflation or credit deflation are both very good times to be invested in gold. Times of monetary disinflation or credit inflation are the worst. Understanding the difference between money and credit is imperative to this discussion. The technical picture on gold is very bullish, and it cannot be ignored that the possibility of a large run-up is in the process of happening on not only gold denominated in US Dollars, but in all currencies. A 75% increase like the one we got in late ‘05-early ‘06 gives us a price target of $1137 by the spring of 2008.

Further bullishness in the precious metals complex is being shown by platinum, which has already broken out from it’s November highs and is making new all-time highs on a daily basis as we close out 2007. Is platinum leading the way?

I also believe silver is in a good spot to benefit from another leg up in the precious metals. The gold to silver ratio is at a historically high ratio (55.6), and if people begin to buy physical bullion as I think they will, this ratio will decline. The reason is simple. Buying an ounce of gold is extremely expensive relative to buying a few ounces of silver. If I were an ordinary Joe (okay, I am an ordinary Joe) and I wanted to buy some bullion with a portion of my paycheque what would I buy? That logic prevailed during the last parabolic run in gold (1980), when the ratio closed to about 17 at its peak.

Industrial Commodities

I am wary of what the perception of an economic slowdown will have on the industrial commodities. I understand that real demand will be minimally affected by a potential worldwide slowdown, and there is relatively little new sources of supply coming on to the market like there was preceding other commodity bear markets. But perception is stronger than reality, so the possibility of large price declines remains a possibility in energy and industrial metals. It is not something that would lead me to short the market, but is enough to prevent me from taking large long positions.

With that in mind, we must respect that the traders of these commodities are, in general, far more sophisticated than your average equities trader. Therefore, the possibility remains that any future pause in Chinese or other emerging market growth has been priced in already. If those growth slowdowns don’t materialize, there is the potential for a blow off rally in these commodities as holders of US debt go on a spending spree, buying up raw commodity supplies.

The technical position of commodities like copper are interesting. Looking at a chart, I don’t see any reason for pessimism in the copper market. If I had to bet on prices being higher or lower in the next year, I would bet higher. The falling prices into year-end is looking very familiar to last years’.

Similarly, the global growth story will have great impact on the price of crude oil. Whether that is priced in or not is hard to say. But demand is only one half of the equation that leads to the price. Finding oil is becoming increasingly difficult, and alternative sources are not growing fast enough to impact the overall energy picture. I am a believer in peak oil. Although there are numerous prospects to utilizing other sources of oil (US tar sands, arctic oil, etc) the costs involved in recovering it are prohibitive. The argument is that as prices rise, these sources will become more economic. That ignores the fact that the costs in recovering the stuff (which are largely energy related themselves) also rise. Eventually, it costs just as much in energy inputs as the value of what is yielded. Therefore, I believe oil prices, over the long term, will continue to rise. In the short term oil could pullback on concerns of recession in the US, but I don’t think the drop would be too far. I foresee oil trading in a range between $80-120 in 2008. Technically, there’s not much to see. The price is moving from the lower left to the upper right. It will take a lot to change that.


Speaking of moving from the lower left to the upper right, take a look at agricultural commodities. Agriculture is also affected by high energy prices. Producing corn, soybeans, cotton, etc is very energy intensive. It doesn’t help that a large portion of the food supply is being taken to produce energy either. As more corn is being used to produce ethanol (another exercise in futility that costs as much in energy inputs as is yielded) farmers switch over their crops, driving up prices in just about everything we eat. I like agriculture in 2008 as much as I did for 2007 and for the same reasons. There is potential for massive price increases in this arena if agriculture is to catch up to other commodity prices.

Still to come are technical views on the currency and equity markets and how they will be affected by adversity in the credit markets in 2008.


We have discussed in-depth the fundamentals of the credit markets and the effects it is having on the overall economy. We know that inflation numbers are extremely manipulated and flawed in the method of their collection (by focusing on prices and not growth in money supply), so any statistic that adjusts for inflation is by extension going to be flawed and that includes GDP. Whether or not there is an ‘official’ recession in western economies is not relevant to consumers who rely on their jobs to continue spending. Regardless, I believe we will discover that the US economy is either currently in recession now - Q4 ‘07 - or will be in the coming quarters. But I don’t doubt, that heading into presidential elections later in ‘08, every effort will be made to prevent one from being declared. How will the equity markets react to such a situation both in North America and abroad?

North American Markets

- ‘If something cannot go on forever, it won’t’ - Herb Stein
As I mentioned in Part III, the US stock markets have shown an interesting divergence with the credit markets. Whereas in other credit shocks (’90,’98), the stock markets experienced swift 20% corrections, this time investors appear to have put all of their faith in the Federal Reserve’s abilities to smooth over the problem. I don’t think that faith is warranted, and when it is revealed that the emperor has no clothes, stocks will fall.

Much is said about stocks being priced reasonably on a price to earnings ratio, and therefore the market will not decline. This analysis only looks at one part of that equation - price. When the economy slows, companies will experience slowing profit growth.

From a technical point of view, the stock market is very extended in terms of a number of indicators that tend to sway back and forth over time. Moving average crosses, trendlines, RSI levels, etc have not given bearish signals for time periods unmatched in the history of the markets. In times like these, quotes like the one above ring especially true. To suggest the stock markets will continue higher from here would be throwing out 100+ years of stock market data that says otherwise. That doesn’t mean that it can’t. It means the likelihood is small. That is, ‘if something cannot go on forever, it won’t’ but there’s also ‘a first time for everything’. Whatever happens, the finance based economy has been compromised and will likely not continue. The relative underperformance of financials to other sectors will persist for a number of years as the market undergoes a sector rotation much like it did away from technology earlier this decade.

Emerging Markets

The emerging markets growth story is a real one. I’ve seen it with my own eyes. New members of the global economy are educating themselves and that is creating wealth for the people of those markets. Eventually, these emerging economies armed with their massive populations will overtake those of aging western economies. But the road there will not be without speed bumps. America had it’s fair share of bruises along the way to becoming the biggest economy in the world, and others will also.

China has a number of obstacles preventing uninterrupted growth. They will inevitably have a return to democracy. What the spark will be is unknown, but it will happen. The government has recently imposed price controls to prevent food inflation. Every time this has been tried it has led to food shortages. Hungry people are not happy people. Eventually, they will realize that their currency peg is causing the inflation and needs to be abandoned. But doing so would destroy their export based economy. A no-win situation for the Chinese Communist Party. There are also environmental disasters waiting to happen as air and water quality continue to deteriorate. All of this will be brought to the fore during the summer Olympics.

The Chinese stock market continues to defy gravity but is another one of those things that can’t go on forever. The same can be said about the Korean Kospi, Brazilian Bovespa, Indian Sensex and other emerging stock markets. A consumer slowdown in the US and rising input costs means these economies will need to re-tool their manufacturing base to maintain the same levels of profit growth. A synonym for re-tooling the economy is ‘recession’, and emerging markets aren’t any more immune to the business cycle than we are. This doesn’t mean they go back to living in mud huts. It means capital is redeployed to more efficient uses. This sudden realization of mortality will mean big declines at some point. I think that day will come in 2008.

Lastly, we will take a look at the currency markets and try to determine what the credit crisis means for folks who just want to sit things out and stay in cash until it all blows over.

In a typical credit deflation, the best investment is cash and having no debt. Unfortunately, we don’t have much to compare our current situation with that can label it as typical. We have never had a global economy with a primary reserve currency unbacked by a gold standard, while the issuer of that reserve currency teeters on insolvency. There are no parallels. Therefore, safety, liquidity and diversity are all good ideas. Investing in currencies is being made easier with the introduction of currency ETFs that trade on equity markets. Not all currencies are created equal - and some will outperform others - although, in the end no paper currency has ever ultimately survived without the backing of something tangible. With that in mind, lets look at the technicals of some major currencies.

Major Currencies

Much is made about the declining US dollar in the media, and ‘dollar doom’ has been a popular theme for many market bears over the past years. But I believe much of the bearishness on the USD is unwarranted through a magnifying glass of what it is generally measured against. The US dollar index is made up of 56% Euros, 13% Yen, 11% Pounds, 9% Loonies and the rest is shared between Swedish Kroners and Swiss Francs. In order to be a dollar bear, I would need to be primarily optimistic on the Euro. But the arguments for a falling dollar (collapsing home market, credit crunch, high inflation, etc) are also present in Europe. In fact, Europe is currently printing currency notes at a rate of approx. 10% y/y according to the ECB website. Over the long term, I think the Euro is actually in worse shape than the US Dollar. But, as mentioned before, perception is more important than reality. The perception of the US dollar as a safe currency is something that has existed for many years now, and it is impossible to quantify how much of a premium that is putting on the current exchange of the dollar to the euro. As a function of herd psychology, I am expecting a parabolic rise in the Euro as people give up hope on the US Dollar. Predicting price points on parabolic price structures is not something I’m good at, so I’ll just say that the US Dollar will drop further than most believe possible and will subsequently turn around as people understand what the alternatives are.

Of particular interest in 2008 will be whether or not commodity based currencies can keep up their momentum, namely the Aussie Dollar and the Loonie. As the credit crisis intensifies south of the border, Canadians may continue to elect to repatriate their dollars that are invested in the US. The stigma involved with the Loonie ‘reaching parity’ has faded and talk of the currency no longer adorns front pages of newspapers across Canada. Much of what happens with the currency depends on the direction of the price of oil and interest rates. Fundamentally, the Loonie is no better than the Euro. That is, monetary inflation is running at around 10 per cent year over year. This will eventually have an effect on the overall price level, but in a global economy monetary inflation can be temporarily exported. Knowing all this doesn’t do any good in predicting the movement of the currency in a time period of one year. So I rely on the charts. They are telling me that a bottom has been put in and the currency is now poised to challenge or surpass previous highs.

As an extension of the credit crisis, I can foresee a spilling over of sorts into currencies that have been artificially weakened due to their lower interest rates. These ‘carry trades’ were sources of cheap money to fund all sorts of speculation and when the worldwide equity markets decline, these currencies rise as investors pay off debts they’ve accumulated. The primary currencies involved in these carry trades have been the Japanese Yen and Swiss Franc. Japan has the highest debt/GDP ratio of any nation, so I am weary of buying the currency even if I think it will rise. Therefore, the Franc is my vehicle of choice for ultimate safety.

Summary of themes for 2008

- US economy is either currently in a recession now (Q4 ‘07) or will be in one early in 2008.
- the Canadian economy will follow
- Emerging markets will experience slowdowns as the US consumer is pinched
- The credit crisis will continue to intensify as more homeowners go underwater on their mortgages
- Commercial Real Estate declines, credit card defaults, and bank runs will be major stories in 2008
- Municipalities and States will be going bankrupt and require federal bailouts
- this situation will be a catalyst for the precious metals complex and could push gold past $1000
- there will be a time for both large declines and large gains for the US Dollar - likely in that order
- the Federal Reserve will be seen at some point in 2008 as ‘an emperor without clothes’
- US stocks will decline as lower interest rates fail to revive the credit markets
- energy and food prices will continue their upward climb due to supply concerns

The only thing I know for certain is that some of those themes will prove to be correct and others will prove to be laughably false. My New Year’s resolution is to be able to recognize the false ones sooner and profit from the correct ones further. In a world of a million variables, being correct isn’t as important as being quick to notice changes. And that is something I will always be able to improve upon.

If anyone has made it this far, let me wish you a prosperous and happy new year!

Monday, December 17, 2007

Levels Worth Watching For A Bear Market

This post originally appeared on Dec 18, 2007 on

Last week was a sobering one for bottom-callers in U.S. markets. Many (including myself) were expecting the Fed to bring out an axe and hack rates in an attempt to close the LIBOR gap and ease the pain for those refinancing their mortgages. But perhaps they have somewhat come to their senses in realizing what we have known for a long time: Lower Fed funds rates do little in encouraging borrowers to borrow or lenders to lend if they have shifted from a psychology of risk seeking to risk aversion. The following day was one of the most pathetic dead cat bounces I’ve ever seen. The market opened up 2.5% on news of a relatively insignificant coordination of central banks to “inject liquidity,” and then proceeded to tank 3% later in the day. Perhaps the market realized what central bankers apparently have not yet: The issue is not of liquidity; the issue is of solvency. Banks need cash, not access to long term credit. So the markets closed on Friday at their lows of the week, 4% off their pre-Fed-hype highs. Financials fared even worse finishing 11% off their weekly highs.

As was addressed in a previous article The Prime Credit Crisis, the problems generally talked about as “subprime” are really much broader than that. It doesn’t really matter much what the borrower’s FICO score is. If they are underwater on their mortgage the bank will be receiving jingle mail. And there are a lot of people that still might become underwater with rising home inventories and accelerating resets as we move on. The banks need cash to write these bad mortgages off of their balance sheets.

Thus far, the equity markets have managed to levitate in spite of such problems. I believe we entered a bear market earlier this summer and the U.S. is likely to be in a recession as of this quarter. This is what fundamentals have told me when I look forward. But in order to confirm such fundamental beliefs we need to turn to the charts. I like looking at multiple time scales to find important levels. Here are some indicators I’m using to get confirmation:

1) Bull market trendline from the lows of 2003. It was tested in August and November but both times bounced. Will it bounce a third time? Keep in mind this is a rising trend line. It was at 1375 in August, 1400 in November and will be 1425 by the end of the year. Staying above this will be important to convince people “we’re still in a bull market.”

2) Similarly, people don’t like seeing negative year-to-date returns on the stock market. It has happened three times this year, with buyers causing sharp rallies each time in rather short order. The S&P opened the year at 1418. The Dow and Nasdaq have outperformed however, so all would not be lost.

3) Like the rising trendline, the 200 day Exponential Moving Average (EMA) has not trended down since turning up in May of 2003.

4) Since crossing upward at the same time, the 50 day EMA has not crossed below the 200 day EMA. A cross below would be a signal of a bear market.

Click here to see a full sized chart

5) Looking at a weekly chart, there are many of the same conditions that have remained the same since 2003 and are now in jeopardy of changing. The 20 week EMA hasn’t crossed the 50 week EMA in over 4 ½ years.

6) Throughout the bull market, the 40 level on the Relative Strength Index (RSI) has held up. Any meaningful dip below it would be telling us that something has changed in the dynamics of the market.

Click here to see a full sized chart

7) Looking at a monthly chart (which I can’t post here according to my own charting provider - they aren’t available with, the 20 month moving average is a level that hasn’t been breached on a closing basis since the bull market started. It has touched it (or crossed by a bit) a few times on an intra-month basis, but has always produced a long tail candle (meaning buyers stepped in to prevent the occurrence). The rising EMA is at 1419 this month.

8) Closing lows from August and November at 1406 and 1407 respectively.

The combination of all of these indicators indicates a massive level of support in the 1405-1420 range. I suspect that at some point this month we’ll see that level tested. Whether it breaks or not is anyone’s guess. But I will offer that with Friday’s close, the market is approaching those levels from a daily RSI reading far higher than the previous two attempts. On July 27th the S&P closed at 1458 with an RSI reading of 31. On November 7th the S&P closed at 1475 with an RSI reading of 38. And Friday’s close at 1467 was with an RSI of 47. This means that it will take a further decline than the last to give the same oversold reading that caused the bounce.

It is easy to become complacent about the importance of these indicators. Indeed, many of the same indicators I’m describing now were very close to reversing in the summer of 2006. But with the extra 18 months they are now at all-time lengths in resisting reversals.

Anyone suggesting that the market is now at a bottom and we will go on to hit new highs soon is advocating that we throw out 100+ years of market data suggesting things like “mean-reversion always occurs.” For us to enter another phase of the bull market would mean we are in a new paradigm. I frown upon such suggestions.

There may be some wishing to wait for confirmation that the U.S. is in recession before selling stocks. I will leave those with some quotes from Alan Greenspan (note the dates):

“In the very near term there’s little evidence that I can see to suggest the economy is tilting over [into recession].” Greenspan, July 1990

“...those who argue that we are already in a recession I think are reasonably certain to be wrong.” Greenspan, August 1990

“... the economy has not yet slipped into recession.” Greenspan, October 1990

It was not confirmed until March of 1991 that, indeed, the economy was in recession in July 1990. The same mistakes are repeated every time.

Thursday, December 6, 2007

The Prime Credit Crisis

This was originally published Dec 6, 2007 on

Of late, one cannot read a newspaper article in the financial section and avoid the word subprime. It is everywhere. “Stocks decline on subprime concerns” is a headline used about twice a week when newspaper editors can’t figure out why stocks are going down, but have to report something. However, the average expert or analyst when asked to explain the problem would likely point to a small slice of the economy made up of people who were given loans and didn’t deserve them. As usual, the term is used in a very misleading fashion by those who don’t really understand what is going on. Some will even point to the relatively small proportion of subprime loans among the entire credit market and declare the problem to be ”overblown.”

It helps to know what subprime actually is and where it came from. Most think it is a new phenomenon, when in fact it has been around for decades. Subprime loans were normally given on a refinancing basis only. When people would fall behind on their payments for one reason or another (job change, divorce, medical condition, etc.) but could demonstrate the ability to pay back the loan in the future, they were normally sent to another institution that was willing to take on the risk at a higher interest rate. Once they became current on their payments again, they might have qualified for a prime mortgage with their primary lender. Of course, as the housing bubble in the U.S. started inflating, lenders became less risk averse and started offering these subprime loans on a purchase basis, as second mortgages, or for a variety of other purposes.

Reading the newspapers, one would be led to believe these mortgages were given only to the lower middle-class in the U.S. and that they were the only problem area of the credit markets. Many articles refer to subprime mortgages “infecting” asset backed commercial paper and thus destroying their value. Others point to SIV (Structured Investment Vehicle) bonds being “contaminated” with subprime debt. Such references are derogatory and misinformed. Many affluent people were given subprime mortgages as second mortgages or as consumer loans to be used on boats, vacations, etc. And as lending standards and risk aversion decreased, many other forms of mortgage issuance proliferated even without proper income documentation, a scarred credit history or the standard down payment amount, but still met the bank’s ”prime” requirements for issuance.

Contrary to popular belief, it is the prime mortgage market that is the biggest threat to credit markets and the financial system. And as housing prices decrease, it is of little importance the quality of the borrower, if the price of their home is worth less than what they paid for it. Prime or subprime, they will simply put the keys in an envelope and mail them in. The further prices decline, the more banks are on the hook. And this brings us back to where we are now.

The subprime lending market is now non-existent. 193 lenders have gone out of business in 2007. Most think this is a blessing. But it was actually an integral part of the mortgage market for people who still had the future ability to pay, but had fallen behind on payments. As of now, anyone falling behind on their payments has no recourse and goes straight to foreclosure, further adding supply to the market and further suppressing prices.

The banking mantra since ‘01 has been “borrow short, lend long” and for years it was very profitable. Banks would borrow money in the short term (overnight to three-month) debt markets and use it to lend to individuals and businesses in longer intervals. Subsequently, they would package the loans together and sell them to investors. But as can be evidenced by watching the LIBOR (London Inter-bank Offer Rate), short term rates are rising, making this process less profitable.

But this phenomenon is not exclusive to the subprime lending. Anyone without a pristine credit history, historically stable income and a down payment is being turned away, as they don’t meet the new risk guidelines set out by banks. And even if banks wanted to issue more loans they are not able to resell them to investors, because the investment market for such packaged mortgages is also minimal. The demand is for cash, not lending risk. Banks want cash so they can set aside reserves for loans that go bad. According to a report from the FDIC, loan/loss reserves have doubled in the last quarter alone from all-time low levels. But as a ratio to the percentage of loans that are non-current, those reserves are still lower than they’ve ever been since 1987. And with prices only starting their decline, this need for cash is not going to magically disappear.

So with that as a backdrop, we hear of companies such as E*Trade Financial (NASDAQ: ETFC, Bullboards) on the fringes of bankruptcy. Their portfolio of long-term loans had started to go bad, and as short term lenders became more risk averse, E*Trade was unable to secure cash to write the loans off. As such, they received an emergency cash infusion from a hedge fund (Citadel) that would give them the ability to continue day to day operations. The price? They sold their entire portfolio of Asset Backed Commercial Paper (valued at nearly $4 billion in June) for 26 cents on the dollar. Most interesting is that this portfolio contained 73% prime loans. So if the market is not willing to pay anywhere close to par for even prime loans, what is the implication for the credit markets? Enormous.

Most financial institutions have basically been playing a waiting game. Waiting for “credit markets to normalize” was a popular phrase in Q3 conference calls. As long as nobody sold their securities at a deep discount, the market value they were able to record on the balance sheet remained unchanged. Of course it was only a matter of time before someone had to sell. Now, anyone holding the same securities as E*Trade has also experienced a huge paper loss.

With the enormous amount of leverage taken by lending institutions and investment banks, even a small decline in the portfolio of their assets could render the company insolvent. Indeed, the entire financial system is at risk of going belly-up. And to think less than a year ago, anyone even suggesting a decline in home prices was laughed at.

This is a very simplistic version of how we got to our current situation. But it could be further simplified by stating that lenders and borrowers alike made poor decisions based on their future expectations of asset prices. They made those decisions with an incredible amount of leverage and are now getting a margin call. Unless asset prices miraculously turn around and start rising, we are only witnessing the beginning of this crisis. But simple supply and demand numbers and indicators of future supply and demand state clearly that the chances of that happening are remote. Once a credit cycle rolls over like this one has, and banks begin to become more risk averse, it takes a lot to turn it around. A lot of fundamental changes (price, sentiment), and usually a lot of time (years, not months).

Because the last credit cycle was created by favorable legislation and loose monetary policy, there is a lot of confidence that more of the same is able to ”stem the tide,” ”cushion the blow,” or ”stop the bleeding” and prevent the cycle from going full circle. I believe such confidence to be massively unjustified, and will have more on that later this week.

Best of luck to all in the final month of the year!

Wednesday, November 28, 2007

More Wine With That Turkey?

This post was originally published Nov 28, 2007 on

A year ago, America’s investment community sat down for their annual turkey gorging with smiles on their faces. The S&P 500 had risen 150 points since August without even an inkling of a correction, and economic problems were distant concerns, or only for those in far away lands.

A year later, those same folks might be asking for a little extra wine with their turkey. The S&P 500 is down over 150 points in just over a month and closed last Wednesday just below its open for the year. Most are afraid to go into the office in the morning as bad news is a daily occurrence for the same credit markets that the last five-year expansion was based on.

But still, a debate rages among analysts: Is it a buying opportunity or the beginnings of a bear market? Indicators that most use to try to forecast the outcome are currently coming up extremely mixed, and the result seems to be mass confusion, rather than any semblance of consensus.

Some point to the extremely prevalent Presidential cycle that will keep stocks buoyant until at least elections take place at the end of ‘08. Even more difficult for bears to swallow is the cycle of seasonality, whereby most positive stock market returns occur in the winter months. Some point to the P/E ratio and declare stocks to be cheap. But arguments can be made to the contrary.

Could it be that the seasonal cycle occurred early this year, with investors scooping up stocks in August and bidding them up 15% in just two months? Similar to the Presidential cycle many believe in the four year cycle. But most thought that it made its bottom in the summer of 2006, three years and eight months after the Oct 2002 lows. Now, of course cycles are not perfect or to-the-day type things. If it could happen four months early, could it not happen 12 months late? Cycles are an average result of past events. If they were 100% they wouldn’t exist.

Valuation methods like P/E became popular after the 2000 bubble when stocks went past all historical norms in the “new tech economy.” So now with stocks priced at an entirely reasonable average P/E of 15.5 for the S&P, analysts scream BUY! But could they be forgetting the other half of the ratio? If earnings fall, can that bring the price down without affecting the ratio? Yes, of course.

There are a number of other indicators available as well. Some of them, like the Dow Theory, are over 100 years old. On Wednesday, the DJIA closed below what would be considered its sell signal (Industrials and Transports both closing below a previous low - August). This should be a signal for a bear market. But again, no signal is perfect.

Hope still remains that the credit crunch was just an overblown bad dream, that everything will ”normalize” and we’ll all have a thrifty Christmas. For a while investors thought that a few rate cuts by the Fed would do the trick, but since then the credit markets have worsened and stocks are now below the level they were before they got those cuts. Psychologically, this is very bad for the stock market which assumed that lower rates meant higher stock prices. For the first time in five years investors are being punished for ”buying on the dips.” The fact that this is happening in November could in fact turn out to make matters much worse for a number of reasons. Among them, investors trying to preserve their capital and withdrawing it from the market for holiday expenditures. Additionally, institutional managers trying to salvage their yearly gains and year-end bonuses move money to cash.

It appears that the market is in bear mode and doesn’t want to leave any time soon. With the constant stream of bad news and stocks making new lows day after day it is hard to imagine otherwise. Typical bear market activity is marked by constant declining stock prices followed by enormous rallies that aren’t sustainable for more than a day or two. Bull markets are the opposite. Consistent and measured increases, met with sharp declines. Action over the last month is of the former.

To me, the downside possibilities far outweigh the possibility for a major year-end rally. But there is always the chance of retailers reporting good traffic and sales for the Christmas season. This would probably send the market back into orbit. But given current consumer confidence levels and the limited ability for consumers to take on more credit, how likely is that? Another rate cut by the Fed is expected, but how much that will help matters is unclear. It has already been revealed that the emperor has no clothes.

To conclude, the U.S. markets are long overdue for a prolonged bear market that would wash out some of the excessive speculation and return stocks to more reasonable levels in relation to realistic economic expectations. The market is at a psychological crossroads, where more selling could beget more selling. At these times, it is often better to wait until the dust settles than to attempt catching the proverbial falling knife. Markets generally move far further in both directions than most believe before they change direction.

Tuesday, January 9, 2007

Themes for 2007

“I, however, place economy among the first and most important republican virtues, and public debt as the greatest of the dangers to be feared” - Thomas Jefferson

The second half of 2006 was one that was very interesting for observant onlookers. On the surface there was little indication of anything spectacular. But digging a little deeper has created some curiosity in what the following year will bring. This entry will deal with the signals we have been given and what effects they will have in ‘07.

Where did all the liquidity go?
Westernized countries have, not just recently, but since the end of WWII, undergone a long phase of economic growth, fuelled by the monetization of assets and the positive effects globalization has had on our standard of living. This growth has been accelerating at a fantastic pace due to improvements in technology, communications and transportation. Unemployment has been historically low, even with more women entering our workforce, and disposable incomes have been rising (more for the few than the many.) This has all happened over a post-war period when our population has been young and robust. As a result, inflation has been a common theme throughout the world as the supply of money grows along with our productivity.

However, much of the inflation we have experienced has failed to show up in the balance books of first world citizens. Indeed, we have recently seen price appreciation in commodities (by extension some food products) and energy, the price of homes (rent prices have failed to follow thus far), and for Americans the cost of Medical Insurance has escalated to the point that the bills themselves can make people sick. But we have also experienced lower prices for many things like electronics (computers for $500), appliances, communication devices, transportation (Vancouver to London for $500 tax-in!), and for the most part our taxes are much lower than previous generations (depending of course on where you are from). These differences in expenses for the average western person come pretty close to evening themselves out. Wait a second though. The money supply is growing at a rate of close to 10% in much of the westernized world (and even faster in some developing countries)! Where is this money going? The answer is complex.

Debt servicing, investment in future growth, and most importantly; speculation.

The Speculative Bubbles

1) Real Estate
The mother of all speculative bubbles. In my researching of previous manias like the Tulip Mania of 17th century Holland, the South Sea Bubble, the Mississippi Scheme, the Railroad Schemes and speculative episodes in stocks through the late 20’s and 90’s of the US stock markets, many parallels can be drawn in the psychology of the people involved. That is, people falling over themselves to buy, bidding wars, people buying on insane amounts of leverage and of course the popular, media sponsored belief that prices only go up.

Calling for the housing bubble to pop now is like predicting that Pompeii will be buried by a great volcanic explosion - it has already happened, and debating whether or not it will happen wherever it has not been felt as of yet (like Vancouver) is a waste of my precious time. The only questions that pose any interest to myself are “how far will it go before hitting bottom” and “what effect will it have on our economy in general.” Any number of answers to the first question could hold water. Property is after all, an asset and holds intrinsic value. It’s price cannot fall to zero. However, with the perfect storm of specuvestors getting nervous and selling their highly leveraged properties and summer home(s), adjustable rate mortgages resetting at higher rates than during original financing, and large volumes of supply still coming through the pipeline, the RE market could become a bloodbath. Other issues could become important such as the degradation of lending standards, mortgage fraud, appraisal fraud and poor building practices. I would not be surprised to see nominal home values return to their pre-boom prices. This would involve a 60-70% correction in areas involving the most speculation and 20-40% in areas that have experienced little. How long could this take? In my opinion, the air will be let out quickly in North America, Australia, New Zealand and the UK and slower in Europe. Some will draw lines with the Japanese housing meltdown and it’s now 18 years of steady deflation. Japan is not a good comparison with much of the west; they are a tiny island nation with a relatively large population. They had a supply shortage. There is no shortage of land in Canada, the US or Australia, therefore the run up has been more speculative by nature as opposed to supply and demand driven.

What effect will this have on the economy? Considering the world’s largest economy has been literally propped up with the inflation of this bubble after the tech crash and are now propping up the housing bubble with equity withdrawals to use on spending, I foresee a sudden crash in the value of homes as potentially catastrophic for the US economy and by extension the Canadian economy (80% of exports to the US.) Asian powerhouses (China and Japan) and the Tigers (Singapore, Korea, Malaysia, Taiwan) that rely so heavily on exports to the US will also need to transform their economies to become less export driven. How able are they to make a rapid shift towards domestic growth? A sharp decrease in consumer spending caused by an equity shortfall would bring about new consumer habits in the west that I don’t believe governments, corporations or the average person are prepared for.

Knowing that the money supply includes the value of all assets outstanding, what effect will the collapse have on the now unpublished M3? In 2002 The Economist noted that 54% of all assets held in developed economies were residential and commercial real estate. At the time that amounted to 60 Trillion dollars. I don’t have the time or desire to find an accurate current number, but would estimate that it is approaching 90-100 Trillion, and is likely closer to 60% of total first world assets. Now that we have an understanding of how large this bubble is, what happens when it pops?

Contraction of the money supply is what happens.

2) Equities
Stock exchanges around the world are at or near all time highs. The inflation of the housing bubble was apparently a good thing for corporate profits. Business expanded rapidly to accommodate for all sorts of associated requirements, and consumers basked in the glory of increased equity and showed it at the new shopping mall around the corner. Is this growth sustainable? Sadly not.

The US economy has wedged itself into a tiny box. It is now entirely dependent on consumer spending to maintain positive GDP growth. And that consumer spending is entirely dependant on growing home equity. If the average worker was experiencing double digit growth on his/her paycheque, things would be different - they’re not. Current stock valuations are already a little overpriced, trading around 18x earnings. On a historical basis, stocks trade much lower. It seems that economic growth has ingrained itself so deeply into the craniums of investors, that even with earnings hanging on the balance of home equity they are ready and willing to put up their money at these valuations. Not only are stocks trading at a premium to earnings, but future earnings growth is still expected. For the life of me I cannot figure out why. Corporate executives don’t know either, because they’ve been bailing in record numbers.

Stock prices of late have been maintained for a number of reasons. First and foremost is M&A activity and speculation of activity. Contrary to popular belief this is a very bad sign. We hear lately that companies are “awash with cash”. If I was an executive, my first priority if I had a lot of cash would be to expand business internally. I would attempt to grow my market share by marketing my product/service to a new part of the population. I would invest the money in research and development to bring new products to the market. I would reward employees by paying them more and attracting more talent to my company. Only if I could not do this, would I look at taking another company over and paying a premium for the market share that they have. Failing that, I would resort to the most wasteful of all business operations - I would buy back stock to support the share price. Corporate executives are tipping their hand, and have been doing so for a few years now. There is no room for further growth.

So what happens when all artificial methods of maintaining earnings growth and stock prices are exhausted? Eventually, the market becomes aware of the change and earnings expectations are restated. As a result the stock is revalued lower. A good example would be Whole Foods, who in November restated their growth expectations from 12% growth to 6%. On this news, the market revalued the stock downwards by 30%. What would be the reaction to not just earnings growth being lowered, but lower earnings altogether? 50%? 60%? 70%? Perhaps we now have a better understanding of how speculation in future growth is rampant in the valuations of equities. And since we know that those growth prospects are very minimal for most companies, we know the fate of the equity markets in general. Not good.

So what happens when the 30 Trillion (my conservative estimate based on the same economist article mentioned above) in first world equity markets begins to erode in value? More contraction of the money supply.

3) The Derivatives and Bond Markets
Ah, yes. Where money is made. The last estimate I saw of all outstanding derivative contracts stood at 370 Trillion. To be clear, that figure is not reflective of actual money or even credit. But it gives a good general idea of the magnitude of speculation and hedging in markets that most people don’t even know exist.

I don’t believe that hedge funds are inherently bad. I don’t believe that hedging is bad either. It can be a viable way of managing risk and allows for using a responsible amount of leverage to achieve profits for investors willing to take on more risk than most. However, when funds begin to stray from A.W. Jones’ 3 principles hedge funds are meant to operate under (to utilize leverage, to short the market and manage risk of the underlying position, and to pay the manager 20% of profits) they pose a risk to the financial system with the amount of money they are playing with.

Recently Amaranth Advisors, managing 9 billion of their accredited investor’s money, got burned on a natural gas spread play. They lost 6.5 billion on the one trade. Early in 2007 we have seen some volatility in the commodities markets. Has another fund lost billions on the price of copper or oil?

Perhaps one of the most concerning signals of increasing volatility is the narrowing gap between yields on junk and A rated bonds. Investors seem to be oblivious to the meaning of the term “junk” and why a bond may deserve such a rating. For example, a Mortgage Backed Security (MBS) may be made up of a few hundred or thousand home loans whose dependence lie on the sustaining of the housing bubble. The sub-prime mortgage dealer packages these loans and sells them to Fannie Mae who repackages them and sells them to investors looking for a yield higher than ‘investment grade’ bonds. These investors may be a hedge fund manager for example, who uses the equity to leverage himself on futures contracts for oil. If the homeowners default on their mortgages, the junk bond becomes worthless and the hedge fund manager is left with a leveraged position on a volatile futures contract, potentially resulting in the loss of billions of dollars.

The incestuous nature of the debt markets will eventually come home to roost. The stability of our market is dependant on homeowners to pay off ever-increasing amounts of debt. This is what economists refer to as systemic risk.

Another matter of concern in the US bond market is the inverted yield curve. That is, short term rates being higher than long term rates. Historically, when such has occurred it has been a leading indicator of coming recessions. The more protracted the curve, the higher probability of recession. The inversion began in late summer. It’s predictive powers usually come with a lag of 6-12 months, putting a recession highly probable for Q2 or 3 of ‘07.

So what of this contraction of credit?
One may ask, what does it mean for me? Traditionally a contraction in the money supply is characterized by falling prices and oversupply of consumer goods and assets as people try to avoid bankruptcy by paying off debts. As a result, cash is generally the best asset class. Goods are cheaper and bargains are had.

Forgive me Sir John Templeton for saying so, but “it’s different this time”. To an extent anyway. With the recent advent of globalization, global wage arbitrage and the prolonged development of numerous carry trades with investors seeking higher returns, cash may not necessarily be the best investment in a deflation. Not for North American investors anyway.

Prospects for lower growth in the US economy will not be met with kind reactions from those holding the many trillions of dollars in assets abroad. These dollars coming home will not have nearly the effect of credit destruction from popping asset bubbles, but in the foreign exchange markets it’s effects could be monumental on the value of the dollar relative to other currencies and to gold. What I am suggesting is increasing domestic demand for dollars and decreasing foreign demand.

A practical example of this easily happening can be explained by the following:

A Dutch homeowner who works as a carpenter in Rotterdam is trying to pay of his debt with other means because the housing slowdown has decreased the amount of work for him in the Netherlands. He took out some of his home equity in 2004 to invest in a predominantly American growth mutual fund. He did this because of the attractive returns compared to similar European investments. Now that the US is officially in a recession, he thinks it’s a good idea sell his dollar denominated mutual fund and convert it to Euros in order to pay off debt.

Less foreign demand for cash.

At the same time, a real estate agent from Sacramento, California is also having trouble managing her finances. She quit her job as a teacher in 2001 when she bought her first home. Luckily, she got in before prices got hot. Business had been great for 4 years, and finally she took part in a condominium development near the riverfront. She bought three units in the pre-sale and they are just nearing completion. However, the values have fallen off by about 20% since she purchased two years ago. She now has over $800,000 owing on the empty condos and is trying to sell all three for what she thought would be an easy profit. To add to her problems, her husband has lost his job at Ownit Mortgage and is now working at a car dealership for a third his normal income. Since she hasn’t sold a property in 6 months, he now has the only income even though they are both technically employed.

More domestic demand for cash.

But the Fed will simply lower rates like last time…
If any economist agrees on the above information (fat chance, eh?), they will likely point to the fact that last time the US economy was at risk of deflation (2001) the Federal Reserve abruptly loosened lending rates which sufficiently stimulated the economy (and as a result put us where we are today.) Because it worked last time, they will do it again. To that I have a number of objections:

First is the Fed’s effectiveness. Since the last round of rate loosening and subsequent rescue of the economy, there has been an aura of godliness surrounding the Federal Reserve Board of Directors. If the last reinflation of the US economy is strictly a result of low interest rates (and nothing to do with cheaper consumer goods, lowering corporate expenses due to wage arbitrage and communication costs, and heightened world trade, etc) why did rate cuts not have such magical powers in preventing previous recessions? Additionally, the Fed is a reactor not a leader. Their only ability is to react to the numbers and set rates accordingly. If they lower rates too fast, too soon, they will put at risk the carry trade and will then have to deal with potential runaway inflation. Therefore, they have to wait until a contraction of credit is apparent and then ease rates. Or so people think…

Second is the bank’s willingness to lend at such low rates. What possible benefit is it to them to lend money at such low rates of return, when there is nowhere left to invest money other than in the repayment of debt (which they are already earning higher rates on). Why would they lend money to carpenters, real estate agents, or other mortgage brokers when they know their ability to post future income may be jeopardized? The answer is they won’t.

Thirdly, what American is able to take on a higher debt load? Are those that resisted the temptations of cheap credit last time going to all of a sudden refinance their home mortgage with a 200k ATM to spend frivolously? Are there a new generation of highly skilled young workers with 6 digit paycheques ready to plunge into the stock market? Are there foreigners lining up at the door to invest their money in American companies because they offer higher returns than companies operating in Sao Paulo, Hong Kong or Mumbai? No, no and a resounding no.

Lastly, is an observation regarding the health of the US dollar. In 2001, when rates were cut from 6.5% to 1%, the US Dollar Index fell from around 120 to it’s level of long term support at 80. The Index is currently hovering around 84. If the Fed were to lower rates again to 1%, they would be inviting the dollar to drop below it’s long term support line and enter unchartered territory into a proverbial freefall. To do this is to jeopardize dollar hegemony - the US government’s biggest political weapon. Won’t happen, not intentionally anyway.
Lowering interest rates will have very little affect on a contracting credit environment in the US. It risks destroying the dollar as the currency oil is denominated in and with it the only advantage the US government has left in it’s crusade against “terror”. The prospect of such an intentional occurrence by the Fed seems absurd.

So with this information at hand, I will try to explain what I feel we should expect in 2007 and beyond with respect to asset classes. I have already stated that I believe an accelerated housing crash is upon us, and as a result consumer spending - the largest driver of the US economy, will be negatively affected. Considering such a large premium for future earnings growth is priced in to current valuations of stocks, I could foresee any realization of lower earnings growth causing an outright panic in global equities markets. Here’s how I see other asset classes performing in
2007 and over the remainder of this decade:

Developing Economies
I touched on the subject earlier of the Asian economies needing to shift from export driven economies to domestic driven. Many commentators when confronted with the prospects of a recession in the western economies seem to think global growth will simply be picked up by the Chinese, the Indians and other developing economies where the west left off. They again point to Japan as an example of a growing third world country that became industrialized and eventually graduated to the status of a first world nation. However, this was done by Japan on a gradual basis. Quality of living for the Japanese was earned by consistent economic growth from the early 50s through to the end of the 80s. What they did not have to deal with was an abrupt shock to their export market. Japan’s troubles have been gradual, as increasing competition from the mainland squeezed corporate profits. Looking at a 20 year chart of the Nikkei demonstrates this.

It is true that China has made massive investments in infrastructure, education and natural resource extraction. Regardless, much of this investment has been towards maintaining competitiveness in exports. It could take years for governments and populations to shift from an export/manufacturing economy to a more knowledge-based/balanced economy. I believe that the long term trend for the Asian economies is positive and will remain intact, however there will come a time when they will be challenged to show resiliency. Only once they have demonstrated this, will they be allowed to continue to make gains that we have become used to early in this century. Literacy rates of only 60% for the Indians will have to become a thing of the past and environmental degradation will need to be reversed or at least dramatically slowed.
Although I believe a correction is in order for the larger of the developing economies in Asia, I remain optimistic on the prospects for some of the smaller ones such as Singapore and Malaysia. After traveling through these countries last year I was impressed by the sophistication of their educational institutions and the human capital that is being generated by them. I believe that in a correction in the Asian economies these will be the most resilient and will lead the way in growth thereafter.

Japan could prove to be the big winner in an Asia slowdown. Their relative safety provides a better investment than China or Korea for investors looking for global exposure.

Growth is energy and energy is mostly oil. In an environment where global growth is slowing, demand for oil will decrease. We have already seen how much the “terror premium” has knocked off the value of oil (over $20 from it’s Israel/Lebanon peak in the summer of $78 to where it sits now at $55.) How much of oil’s value lies in expectations for increasing global demand? Whether you believe in peak oil or not (I do), slowing economic growth is negative for the price of oil. There are many factors that could serve as support, such as production cuts by OPEC, the US attacking Iran, Russia cutting off supply to Europe, etc. It is useless to speculate on such issues because they are in the hands of madmen, not us. So we can only go with the information we have, and that is that slower growth pushes the price of oil down. What we also know is that our supply of oil is limited. Even with slower growth or slightly negative growth, we will be using oil at a rate far beyond even what was used 10 years ago. This will become apparent during the world’s next round of economic expansion. When OPEC is asked to increase production, but cannot deliver. Only then will peak oil rear it’s ugly head and send prices into triple digits.

It is my belief that we will see oil priced at $35-40 at some point in 2007 on lower growth prospects. This is barring any socio-political events that cannot be predicted with any accuracy.

By extension, alternative energies such as nuclear that are, in effect, leveraged to the price of oil should be affected adversely as well. The price of uranium rose in a lagging manner after oil, and I suspect it will fall in a similar manner. There has been a lot of speculation over the price of U308, which to me signals that there is potential for a major correction. Hedge fund buying of the metal in physical form could easily be released quickly causing a run to the exits. I like uranium investments with a spot price of $30 or so. Anything above that is overly speculative with today’s oil price and destined for a nasty correction.

Precious Metals
Ahh, the safe haven. Gold is money. Something, unlike anything else, whose intrinsic value has remained relatively constant over time. It is a hedge against instability in the banking system. No portfolio should be without it in my mind. But over the last decade, with investors seeking higher returns it has been neglected. Priced in currencies other than the USD it has performed very poorly. It is, however, volatile. So owning gold may be a bit of a rollercoaster for those who own it. It should be viewed as more of an anchor in a portfolio, but most try to seek reasons for it to be a great performer. Those reasons are of the speculative variety, much the same as oil. Whether they become true or not is difficult to predict, therefore I do not grant them much weight in my forecasting.

This is even more true for Silver. It’s dual utility as an industrial metal makes it not only a safe haven for instability, but a barometer for economic vigour. It’s volatility demonstrates this paradox very well.

In a period of slowing economic growth, it is characteristic for all asset classes, including PMs, to decline in value relative to cash. It must be noted that the gold sector is not one dominated by the US, like most other asset categories. Therefore, in forecasting the direction of gold during such a slowdown, the psychology of American investors is not nearly as relevant on a world scale. How will an Indian investor handle depreciating assets in India when their GDP growth is revised downwards from 8% to say 3%? Will they buy Rupees? Or will they buy gold? What of the Saudis, the Russians or the 1.3 billion Chinese? Will the Chinese hourly manufacturing worker convert his Yuan savings to gold? Unlike most Westerners, the lower and lower middle classes in the developing world have positive savings. Understanding what they will do with these savings is key in determining the direction in the price of gold over the long term.

Another thing to consider is “how are most Westerners exposed to gold?” Other than the very few gold bugs who keep coins and bars stashed in safety deposit boxes or buried in their backyards most people are exposed to gold and silver by way of mutual funds. Many of these funds have exposure to all sorts of natural resources and mining companies. The decline in copper prices last week showed us this in a very matter-of-fact way. Gold and silver were dragged down with the industrial metal as people liquidated their exposure to metals in general. Were people purposely selling gold because it was a bad investment? No. It suffered guilt by association. With this in mind, I would not be surprised to see gold trading in the $480-500 range and silver around $9.00-9.50 at some point in 2007. But I also leave open the possibility for a quick bounce upward off the lows as people clamber for safety as financial institutions and hedge funds begin registering losses on a large scale.

Industrial Metals and Lumber
If oil is tied to economic growth then a similar argument can be made for the industrial metals such as copper, zinc, nickel and others but also for lumber. These are key materials in construction and infrastructure projects and are therefore intertwined with the health of those sectors. We have already seen the prices of these metals and for lumber drop substantially in response to the housing slowdown experienced thus far. How much further will they drop when it is fully apparent that very little building will be necessary for a number of years? We must keep perspective of the fact that just as little as 2 years ago the notion that copper prices could surpass $2/lb was preposterous. 18 months later we had copper prices at $4. We’re now sitting at around $2.50, a half dollar above those preposterous levels.

I could legitimately see copper reaching a low of $1.50 in 2007 with the other metals depreciating by similar percentages. I am a believer that we are in a cyclical (supply shortage driven) bull market for commodities, so this kind of a retraction will prove to be a fantastic buying opportunity for those with capital left to spend.

Agricultural Commodities
Because of the cyclical nature of our commodities bull market, there will be times when metals and energy perform well and there will be times when agriculture products perform well. This is one of those times. Unlike industrial metals, demand for agricultural commodities like wheat, soybeans, corn and sugar are constant. People need to eat. They can eat less (some places this is more true than others!), but people will buy food over getting their patio redone. This much we can all agree on. Additionally, we have a growing world population - at a rate of 1.14%. That may not sound like much, but it adds 74 million people to the world every year - roughly the population of Germany. And they’re all hungry.

To add to that, we have a little phenomenon called global warming. And she is causing all sorts of trouble with the weather. Droughts, unseasonable temperatures, flooding, typhoons are just some of the curves being thrown at farmers over the last few years. Meteorologists are expecting 2007 to be the warmest ever year on record. This may be great for your tan, but not so good for John A. Farmer who relies on rain in the 3rd week of March to produce a decent yield for the year. Whether you believe Global Warming is caused by humans is frankly not something I concern myself with (for the record I also don‘t concern myself with those that think the Royals will make the playoffs this year). The fact remains that temperatures are rising and they are playing havoc with our crops. The prices of agricultural commodities could easily double in 2007.

As a debt instrument, bonds of low grade or junk grade should not be considered in an environment with heightened systemic risk such as today’s. Furthermore, any company or institution that purchases these bonds and uses them as collateral for other speculation should be avoided like the plague. Because I believe that interest rates in the US, Europe and most western countries will be at most left alone and quite possibly raised, I don’t believe long term treasuries are a particularly good investment. If you are looking for a fixed income source I would suggest foreign bonds over domestic (from a US perspective that is). The best way to invest in these that I know of is through mutual funds. They generally carry a high management fee, but offer sufficient protection against currency volatility and quite often provide a better yield than US bonds. Specific recommendations would be the Investors Group Global Bond Fund and the Templeton Equitable Life Global Bond Fund.

Foreign Currencies
Over the long run, the value of all currencies will inevitably decline against assets with intrinsic value. The logic is simple: currency can be multiplied infinitely; hard assets cannot. If you were to go live on a deserted island for 20 years, I would not advise to put your money in a savings account until you got back. You would surely be poorer on a relative basis than when you left. Having said that, all currencies are not created equal. Some will perform better than assets and other currencies, while some will perform much poorer.

I have already outlined my opinion on the US dollar. To summarize, I feel it will become more valuable domestically and less valuable internationally. The amount of dollars it takes to buy a Ford truck will be less than it is now, and the amount it takes to buy a bottle of ice wine from Sweden will be more.

The Euro will continue to gain value against the US dollar. But slower economic growth in Europe will also be a negative on the value of the currency relative to hard assets. European economies could suffer from competitiveness issues with a depreciating dollar, making aerospace, pharmaceutical and high-tech industries more attractive for business in North America. There is an outside chance that the Euro could fall out of favour with some populist leaders in Europe, however this is again mere speculation. One should only be aware of the risk.

As I mentioned earlier, a slowdown in Asian economies could prove to be buoyant for the Japanese economy and by extension the Yen. However, any nation sitting on a Debt ratio of 194% of GDP has a currency that I want no part of. Any value in the Yen is short term and only if other Asian economies crash.

The UK does not seem to be phased by it’s strong currency. That could change if the housing crash affects England as much as it will the rest of the west. I am neutral on the pound sterling.

I like the position of the Canadian economy over the long term, however they face great challenges in diversifying their export markets, much the same as China. If the government can manage to stimulate the economy by utilizing it’s vast natural resources effectively and exporting energy efficiency technologies worldwide, Canada could become an economic powerhouse into the second quarter of this century. Until progress is made on that front, the Canadian Dollar will inevitably be tied closely to the USD and the price of oil. For 2007 I am very negative on the CND.

Currencies I like include the Scandinavian Kroners, the Australian and New Zealand Dollars, Swiss Franc, the Ruble, and the Singaporean and Hong Kong Dollars. Resource based economies with a low debt to GDP ratio make for stable currencies and will eventually outperform currencies whose governments need to increase the money supply to service debt and import raw materials.

Most other assets like automobiles and consumer durables should become even cheaper in 2007. The common theme will be “wait because it will be cheaper next month.” Manufacturers have been producing based on unrealistic expectations of future growth in sales. They will continue to do so until it is painfully apparent that sales will be slowing dramatically. This means oversupply and oversupply means bargains for those with money to spend. I know nothing about the art market so cannot comment on it’s potential as a store of value.

In Summary
- Over speculation and oversupply in the housing market throughout the western economies will lead to a continuing decline in home values.
- This dramatic reduction in equity will put a damper on the engine of the US economy - consumer spending and send the economy in general towards recession by Q3 of 2007.
- Slower growth in western economies will lead to lower prices of nearly all assets.
- Slower or negative growth in the US could have a disastrous effect on the banking system which is highly leveraged to future growth.
- In such a situation, the price of precious metals could rise exponentially.
- Agricultural commodities will carry the torch of the commodities cycle on the back of being immune to lowering demand and due to abnormal weather.
- Oil will trade lower on prospects for lower growth, but remain volatile due to socio-political events.
- Export driven economies dependant on US consumer spending and housing will need to find internal sources for growth before continuing their economic expansions.
- Domestic demand for cash in the US will outpace foreign demand, devaluing the dollar against other currencies
- Interest rates in the US will not be lowered to inject liquidity because such a move will not be effective enough to risk dollar hegemony.
- Bargains will be had in all asset classes as people liquidate their holdings to pay off debt

How the inevitable could have been prevented
Many western economies are on the cusp of a sea-change in their demographics. The Baby boomers of North America are retiring now and the effects will be felt gradually throughout our economies. No longer do western economies have the human capital advantage over their third world counterparts - at least not to the same extent of the boomer generations. Had they used the technological advantage achieved through the 1990s to adequately fund future development via education, R&D and efficiency improving infrastructure a cost advantage may have been maintained. Had they used this capital to adequately fund social security and medical programs for their growing needs (they saw the census data after all), our younger generations may have had the opportunity to compensate for their lack of strength in numbers. The excess capital was instead used to fuel wars, tax cuts, and wasteful asset bubbles. Future generations will have to pay the price. The proportion of GDP needed to fund pension and medical programs will relentlessly increase for the next 20 years. This is less capital being available for positive return investments.

Evidence for this change can be witnessed already, albeit subtly, in some unusual areas. Unemployment levels have been incredibly low. Abnormally low. So low that rates of this level would normally be bringing large wage increases and alarm bells for hyperinflation would be going off. Governments are not surprisingly taking credit for these low unemployment rates as a result of their superb planning and they are being interpreted as a very good sign of a healthy and robust economy. Sadly, this could not be further from the truth. The first wave of baby boomers has now reached the finish line and they are being replaced by a younger generation who are not so numerous. Unfortunately, at the bottom end of these employment numbers are those that are normally seen by society as unemployable - for whatever reasons that may be. They are now members of our workforce. As fantastic it is for them to be able to support themselves and their families with a decent paying job (or not), productivity will inevitably start to bear the brunt of this.

It is never too late to begin saving for the future. The average American and western governments all over will eventually come to realize this. This realization will come through a long period of hardship and a back to basics approach to growing our economies. I.e. investing in education, sponsoring innovation and through hard work. Today’s excesses in society will at one point in the not too distant future be looked at with disdain, and people will change their spending habits to reflect a new set of social values. The longer we continue to spend wastefully and borrow from the future, the necessary correction will become sharper and more severe. The sooner this excess is eliminated, the better off we will all be.

“Economics is not a subject that greatly reflects one’s wishes.” - Nikita Krushchev

Let me wish you a prosperous New Year and Happy Investing!

Matt Stiles

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