Thursday, July 3, 2008

Mid Year Review: 2008

This was originally published as a four part series on between July 3 and July 8, 2008. To view the articles with charts, please visit the links below.,-part-I--A-look-back,-part-II--World-equity-markets,-part-III--Precious-metals-still-stro,-part-IV--Currency-roundup

With half the year behind us, the rollercoaster ride that are world asset markets have definately given many cause to stop and think. Sadly, many of my more dire forecasts have reached their comeuppance. Shortly after writing my end of year marathon article over Christmas, equity markets worldwide went in the tank. Conversely, commodity markets have skyrocketed. And despite a spring rally off the March lows, many equity markets are hitting new closing lows for the week ending Jun 27. It has now become obvious to most that the imbalances many have been harping on for years have finally come home to roost. And they aren't going away. Without further ado let's take a look at last year's predictions:

- 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

I'm not the "I told you so" type, so I'll try to take a more critical view of these last 6 months. Much of what I expected to happen did in fact happen. However, the dollar's bounce was definately weaker than I had expected (something I will expound more on later). I was also caught off guard on the precious metals' relative underperformance to crude oil. And perhaps I shouldn't be surprised by this anymore; But the lengths central bankers and politicians were willing to go to manipulate the markets in their favour have surpassed even my lofty expectations.

If the first half of the year was so wild, the second half promises to be just as much so. With presidential elections occurring in the US, the Beijing Olympics, a rekindling of war rhetoric toward Iran, and the weakening economy, it's not too late to reposition your investments for what is likely (or unlikely) to come.

It is easy to extrapolate what has occurred through the last six months over the rest of the year. Just like it is easy for the most well-paid economists to rely on a “second-half recovery”. (Sidenote to referenced economists: the second half starts this week.) So I will attempt to take a more constructive view of matters and hopefully find some truth behind the obfuscation, misrepresentation and outright lies perpetuated by most of the mainstream media.

In doing so, I will offer my usual caveat. With hindsight, some of my thoughts will be way off base. Some of them will be way too early. And hopefully, most will enable myself and my readers to accomplish what they hope to: better than average returns on their investments.

I stress “better than average” because in a bear market those chasing large returns will likely end up in tears. Now, more than ever, is the Wall Street axiom “bulls and bears make money, pigs get slaughtered” most applicable. With high volatility becoming the norm rather than the exception, it is easy to let the allure of quick profit stand in the way of time honoured investing principles such as:

reduce and avoid all debt – including leverage
keep positive savings at the expense of a higher standard of living (ie. Live within or below your means)
diversify your asset base
expect the unexpected – job loss, societal acrimony

Those are just a few of the widely accepted ways to ensure you come out on top once this all blows over. Yet it is not something I see many people taking seriously. In fact, of the few people I know who do understand this, my octogenarian grandfather knows best. Perhaps growing up during the Great Depression is the root of this. It aligns perfectly with the logic William Strauss and Neil Howe extolled in their '97 book The Fourth Turning. Human expectations usually only encompass the range of occurrences throughout their lifetime.

What this means is that anyone under the age of 85 has not experienced deflation in their adulthood. All they have known is that the best way to get ahead is to go as far into debt as possible, use that 'free' money to buy assets, and after 10 years they'll be further ahead than when they started. Wash, rinse, repeat, and you'll be rich! It also means that for anyone under the age of 45, stories of a 16 year bear market in equities (1966-1982 inflation adjusted) are just that: stories. Their perception is that markets go up over time and that if you buy the dips, you'll be rewarded. But what happens when recent historical trends are broken? What happens, for example, when complex mathematical models fail that determine a certain occurrance to be 99.95% unlikely to occur over one year? What happens when they fail 3 times in one week?

My intention is not to out-bear the bears. But to provide possible outcomes for both sides of the coin. One side of that coin tells me that it is very possible for a multi decade depression to occur in western economies. This is consistent with generational cycles (see: Strauss and Howe) and the much respected Kontradieff cycle. Until proven wrong, these theories are in play. The societal impact this would have is unnerving. Previous depressions have never been resolved without terrible loss of life. This is one potential outcome among many. There is much that can be done to prevent the worst case scenario. And I'll touch on that later. But keep in mind that cycles are circular for a reason. Just because we are entering an economic/demographic winter does not mean spring will never come.

Together, I hope that my readers and I can prepare for what is to come in the short term, and thereby position themselves to have a head start when spring arrives. In the following installments I'll touch upon the equity, currency and commodity markets.

Since my writing last December, most economies and equity markets alike have taken a turn for the worse. As expected, the continued credit tightening by lenders, asset depreciation, and a more frugal consumer have resulted in lower profits for major corporations. Consumer confidence readings are in territories not seen in decades. As are wage growth expectations. Combine this with spiralling higher prices for food and energy and it boggles my mind how there are still economists out there claiming the economy is 'robust'. I used Ben Stein as my whipping boy in December when he claimed the total fallout from the credit crisis would not exceed $280 Billion. That number has already been long surpassed. But Stein has now in effect doubled down on his bet with this latest excerpt from a debate with economist Paul Krugman on CNN (, where Stein stated, “I think it is largely a media mirage that is depressing people and making them feel terrible.”

It is scum like Stein that have promoted the latter stages of this credit bubble, so it's no wonder he's trying to cover his behind. He better hope he has some good lawyers.

Regardless of what so called 'economists' are saying, the US, the UK, Canada, Spain, Italy, and a growing number of other western states are in a recession that is deepening by the day. The economic numbers used to officially declare a recession in most countries are both falsified and laggy. The issue of inflation in determining these numbers is a hotly contested one and I'll touch on that later. But as can be seen by equity markets worldwide, the only ones believing the numbers are the bureaucrats making them up. From a technical perspective, the markets don't believe them either. Let's take a look:

North American Markets

In part V of my year end writing, I outlined my reasons for being bearish on equity markets with the S&P sitting at 1497. Six months later we are 15% lower and I remain cautiously bearish.

I believe there is a very good probability of the S&P reaching a downside target of 1075 before the end of the year. If that were to happen, it would likely occur in the next few months (a function of seasonality) and would be driven by panic or forced liquidation selling. This is not a prediction, it is a mere statement of probability based upon the technical, fundamental and psychological inputs I take in on a daily basis. Just as likely is a phase of muddle-through. As presidential races heat up and promises of stimulus are given out by both Obama and McCain, who knows what the reaction to this could be.

But this is very short-term thinking. Let's expand our horizons a little. I have long questioned the validity of the entire bull market from 2002-2007 on the basis of dollar devaluation. Productivity gains made through technology, and globalization through the 80s and 90s are undeniable. That was a bonafide bull market based on our standards of living increasing through greater economic efficiencies. The last five years of economic 'growth' are due to gains in financial innovation and it's ramifications. Unnaturally low costs of credit kick-started a spending spree by consumers that is now known as the housing bubble, but is really just a blow off of the credit bubble started in the early 70s when Nixon booted the gold standard. Nixon was lucky, in that the aformentioned advances staved off a near hyperinflationary meltdown in '79-'81. The natural deflationary forces of greater efficiency postponed the problems for two decades. But they again began to manifest themselves in the form of a lower rate of exchange. Here is what the US markets look like for a European investor over the last two decades:

This chart looks similar when the S&P is compared with almost any other major currency (other than Yen). What it says to me is that much of the gains from the 2002 lows have been dollar devaluation driven. And this has the fingerprints of “easy” Al Greenspan all over it. So this latest bull market may be a mirage, and is simply a correction of a far longer bear market that started in mid-2000. If so, it is not unreasonable to assume that this time we will surpass the 2002 lows. Just for fun (yes, this is my idea of fun), let's review the entire last 100 years of Dow performance:

1903-1929 – 1200% gain – 26 years
1929-1942 – 70% decline – 14 years (adjust for increased purchasing power, closer to 50%)
1942-1966 – 1100% gain – 24 years
1966-1982 – flat prices – 16 years (adjust for decreased purchasing power, closer to a loss of 50%)
1982-2000 – 1700% gain – 19 years
2000-2015? - wanna argue for higher prices?

This is, of course, quite a small data sample. Anything is possible. But it is again consistent with generational cyclicality. The Baby Boomer generation who have been the main investment drivers for the last 30 years are retiring and withdrawing their assets from the housing and equity markets to pay for their retirement. The pieces fit together like a giant jigsaw puzzle.

Plenty of discussion is centred around the Canadian Small-Cap index, the TSX Venture. And the chart of that index over the last few years shows fantastic growth, but has come to a sort of crossroads. I use the index as a proxy for commodity related sentiment. Right now that sentiment is extremely negative in relation to the price of commodities.

I'll talk more about commodities and what that means for the Canadian indices more later. First, let's look at some important international markets.

Foreign Markets

In December I wrote in Part V:

“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 U.S. 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.”

That day did come, and the onslaught is continuing. Shanghai stocks were down 56% at their lows, in Seoul investors had lost 27% from the highs, Indian markets are tanking with Bombay shares down 36%. Brazilian markets are relatively unchanged year-to-date, although they are off nearly 12% in the month of June. The same can be said about Russian markets, which are up 6400% from their lows during the Ruble crisis of '98. Too bad we couldn't have been in on that one, eh? (Now we know why Moscow is the most expensive city to live in the world.)

Again, the point of this is not self-congratulatory. If I made huge bets on this happening, I'd have better things to do than write to you! As a rule, I don't bet against parabolic price structures. Valuations of these markets were absurd two years ago, and that didn't stop them. Put it this way: If I were to drink 12 beers in the next few hours I'd be sloppy drunk, would pass out and have a hangover the next day. So what if I were to drink 24? It might take me longer, but the end result is basically the same.

That these fantastic bull markets would end so terribly was no surprise to many others than those directly involved who thought they had found nirvana. Now consider that this has all occurred while official GDP estimates have not yet slowed. They will. No country grows at 12% y/y without eventually encountering a recession. But that doesn't stop market pundits worldwide from hailing China as the next global superpower by 2020. It didn't stop them from giving Japan the same label in the 80's (Japan was supposed to overtake the US by the turn of the century). And it probably won't stop them from doing it again in another decade. Don't get me wrong. I fully believe that the rest of the world is trying to catch up to a western standard of living, and that over centuries, they will. But extrapolating recent trends over the distant future is the dumbest game going.

So if the BRIC countries can't grow at over 10% per year indefinitely, what does that mean for commodity markets that are rising because of the enormous demand from these countries?

That is the single biggest question on my mind. I'll hash out the possibilities in the next installment.

The single biggest issue now on the minds of most people worldwide is the skyrocketing price of energy and food. I hear people in Vancouver whining on a day to day basis of how high gasoline prices are (at last sight $1.484/litre). If these people weren't my dear friends, I'd be inclined to whack them upside the head with some perspective. Total food costs for a large portion of the world population range from 40-80% of their already meagre incomes. The price of many basic foods like rice, maize, wheat and corn have risen as much as 100%. Do the math. This puts that large portion of the world on the brink of starvation. It is with this heavy dose of perspective that we should all be viewing this minor inconvenience (an average of a 6-12% increase on OUR cost of living).

In part IV of my December article, I stated:
“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.”

It appears that international buyers and sellers of commodities are indeed turning their eyes away from demand fundamentals, and increasingly focusing on supply. In this case, reality trumped perception. The uncertainty of supply has far outweighed possible demand destruction from a slowdown in the BRIC economies. In other words: “Peak Oil” is here. This is still a phenomenon that is apparently new to market pundits and politicians who seem to have no idea as to why prices are rising.

The first scapegoat was, of course, the evil speculators. Driving up prices for their own personal gain. If this is true, then answer me this: If these speculators are paying such an exorbitant price for commodities, why aren't the producers of said commodities selling forward their production? There are three possible answers to this question. 1) they don't have the supplies they say they do, and therefore CAN'T sell them forward. 2) They have the supplies, but know the costs of extracting it will continue to grow, and so will prices – therefore they wait. 3) It's all a giant conspiracy between the Saudis, Russians, Texans, Venezuelans and their capitalist enemies (the speculators). Only two of the above possibilities are legitimate. If you need help identifying them, please click 'back' on your browser window, for you are a lost cause.

I'm sure most readers have seen enough charts of oil's parabolic rise to make them puke, so let's look at something else. For many westerners without a Chevy Tahoe or Ford F350, the majority of energy costs come from natural gas. It is, unfortunately, also a luxury that we will one day have to do without. Our reserves of gas are dwindling and costs of extraction are increasing.

When prices of natural gas nosedived in 2006 after the Amaranth hedge fund blow up, I made an educated bet that prices would rise above $9 (via call options) in the hurricane season of 2007. Myself, and a few other people I respect lost on this bet. But the price of natural gas is now approaching it's all-time highs and we are still months away from the thick of hurricane season 2008. If something does cause supply interruptions, I would not be surprised to see the Henry Hub trade above $25 or even $30 per btu. (Note: I am not making the same bet this year.)

I am the last person you will likely hear say “it's different this time”. This phrase has usually been accompanied by numerous other asset bubbles over time – and to great loss. But all these other instances have revolved around asset markets that are not static in supply. Our main sources for raw materials are static to a large extent. And our sources for raw materials that are economically viable for extraction are absolutely static. Sure we can drill the arctic and we can mine the ocean floor. But at what cost? The term 'bubble' has been applied to oil as early as $80. No other bubble in history has been termed as such until it has already burst. The very fact that oil rising is a negative for politicians and their minions in the media is enough to make me sceptical of this term.

A number of years ago I read a book by Jim Rogers called Hot Commodities. The most important fact I took away from this book was that the average length of commodity bull markets was 18 years. Jim has been bang on about commodities for many years now, so I respect him greatly. I also respect the ability of a worldwide cataclysmic financial meltdown to dilute the value of even supply sensitive commodities for a number of years.

So, is it possible that this is the shortest commodity bull market of all time? Of course. Anything is possible. Is it possible that we are only halfway through a terrible rise in commodity prices that will destroy much of the world's population through starvation? Sadly, this is statistically more probable. But, as always, there is one area that outperforms others at any given time. So although crude oil and fertilizer may retrace their parabolic rise at some point, we can still play the bull market with 'commodities' that have relatively underperformed.

Precious Metals

I refuse to label myself as a 'gold bug'. Were all tech investors 'dot-bombers' in the mid 90s? Of course not. The term gold bug is used by those who proliferate paper currencies and see it in their interest that the general populace have no savings and therefore no wealth. Gold is the achilles heel to central bankers and their quest to impoverish us all and destroy our wealth (and therefore power) through gradual inflation.

It is for this reason that I have been correctly bullish on precious metals for many years. As my readers know, gold and silver are money. And when the financial system is on the fritz, money performs best. There is also a static supply of recoverable precious metals, and the cost of extracting it is extremely dependant on energy costs. A number of high profile gold mines have delayed production due to the increasing cost, and even my local bullion dealer says his supply of metal is already in jeopardy. Can a lid be kept on precious metals despite all this? I don't think so. The charts don't think so either:

As can be seen from the charts above, there is no reason to be bearish on precious metals from a technical perspective. The relationship of gold to the price of crude oil I find particularly interesting. Note the uniform 9 year intervals in the oversold conditions. This is a small data sample, but for that trendline to be broken to the downside, something very abnormal would need to occur.

On multiple occasions I have made my reasons for being bullish on precious metals very clear. That the risks to the financial system we have enjoyed for all of our lifetimes are in serious jeopardy. And as this enormously leveraged system contracts, people will be liquidating their assets and looking for a place to store them. Faith in fiat currencies is at an all time low, so the relative safe haven of tangible assets like oil, gold and land will outperform until this deleveraging ends.

The common reasoning for gold rising is that inflation is rising, that the dollar is losing it's value, and therefore people (err, speculators) are buying gold. That argument literally falls apart with the next chart I will show you, which is the ratio between the price of gold and the long treasury yield. What this chart is telling us, is that the risk is of deflation and not inflation.

Every once in a while I hear the question asked, “what happened to the bond vigilaties”? This last chart tells us that instead of selling bonds, they're hoarding them. Those who have been betting on higher inflation numbers have had their heads handed to them on a silver (pun intended) platter. I don't have the exact data in front of me, but a rough glance tells me that even in the hyperinflationary scare of the late 70s/early 80s, gold way underperformed treasury yields. Now they're outperforming.

In my relatively short experience with the markets, one thing I have noticed is that bond and futures traders are far more sophisticated than equities traders (this logic can be extended to 'analysts' and 'economists'). Betting on inflation accellerating from here is likely a losing one.

The Federal Reserve has set up numerous auction facilities, swap arangements, and other measures that amount to doling out free 'money' in the short term. None of this appears to be working. Credit destruction is unstoppable as collateral values continue their relentless decline. The emperor has no clothes. The Paul van Eedens of the world continue to harp on growth in M3 as signs of looming hyperinflation, yet a closer look at credit markets suggest otherwise. What van Eeden is missing is that commercial banks are bringing off balance sheet assets back on to their balance sheets, and they show up as loans, and therefore more credit inflation. Mike Shedlock is far better than I at explaining such matters, so I urge my readers to read one of his latest entries detailing this point. You can find that here:

This ties in very well with my next installment that will focus on currencies.

I can see the responses already to Part III even though they aren't there yet: “Are you blind?” “Energy and food prices are skyrocketing! How can you be talking about deflation?” “You're nuts!”

Yes, I am very aware of rising prices of the essentials, yet it is important to remember that rising prices are a symptom of inflation, not inflation itself. The prices of oil and agricultural commodities are also very supply and demand sensitive. Ultimately, prices will only rise as far as people are able to pay for them. In this respect, we are seeing falling prices in many other things that people are no longer able to afford (homes, RVs, boats, and almost any other discretionary item). As credit tightens in the US and around the world, it's deflationary effects will reverse many of the rising prices we have experienced in all asset classes. Of course, those assets that are very supply sensitive will outperform those that aren't. Gold is the ultimate supply sensitive asset, and it is my belief that it will perform best. But what else?

In a credit crunch, you want to avoid anything that has traditionally been purchased with credit. The gradual social acceptance of this act, brings about an increase in the rate of savings (“why buy now when I can pay less later?”). So in effect, a credit crisis usually brings about a rise in the relative value of cash. Banks also require cash to write down the depreciating values of their bad loans, and considering the leverage most banks have used, this could be a lot of cash.

Central bankers will always try to counteract this process via making debt easier to acquire, by bailing out unsuccessful banks (ex. Bear Stearns), or by making short term trades of bad credit for good (for a price of course). These actions will not be sufficient to reinflate the economy, which is why I believe the US Dollar is in a position to rally. I'm not bullish on any fiat currencies, so let me stress that my relative bullishness on the dollar is more a function of being bearish on the Euro, which makes up a large percentage of the dollar index.

The European Monetary Union is not without it's own problems. In the lead-up to the formation of this union, much scepticism arose over what would happen when the economies of individual countries ran counter to that of the union itself. This situation has not been tested until now, as the Spanish, Italian, Greek and some of the Eastern European economies are slowing at a greater pace as that of Germany, Holland, etc. The former governments have been running up huge defecits at the expense of the latter, and people are now going as far as to reject Euro notes that are issued by mediterranean central banks. This is not a good situation for the Euro. Combined with the failure of the Lisbon treaty as Ireland voted against it, there are some serious disconnects in Euroland. It could be said that the Euro is climbing a wall of worry – just waiting for disaster to strike. How high is that wall able to go? I don't know.

I remember when I started following the markets, being a dollar bear was extremely contrarian to popular investment culture. The tables have now turned. It's rare to find anyone who believes in the dollar, hence my bullishness.

No, the Greenback and the Euro aren't the only currencies out there. What about the others?

In Canada, it was widely assumed that the currency tracked the price of oil. As oil rose, so did the Loonie as companies reaped higher profits and foreign capital poured into the country. Not so fast. The last $45 of appreciation in the price of oil has not resulted in any upward movement in the Canadian Dollar. In fact, the currency is about 4% lower since Christmas. Evidently, investors were caught off guard by the Canadian economy's apparent lack of resilience, something I warned of in December. The combination of a slowing economy and lower interest rates has turned away currency speculators from 2007's darling. From a technical perspective it still looks to be in a solid consolidation phase. However, I have my concerns about what a protracted retracement in the price of oil would do. Perhaps that's already priced in. Perhaps not.

I remain fundamentally bullish on the Swiss Franc, as it is one of the safer currencies around. Along with the Japanese Yen, it was used as a carry trade (borrowing at low interest, and investing abroad). Whether that has been suficiently unwound is hard to tell.

As most know, the Chinese have been pegging their currency to the USD. Combined with the massive trade surplus with the Americans, this is causing enormous inflationary pressures in China. The possibility of the Chinese Communist Party doing something crazy like upwardly revaluing their currency overnight is not something I would bet against. And the gradual manipulation of it upward may be reason to own the currency which can be done through new currency ETFs traded on the NYSE (CYB and CNY).

Overall, I'm not enthusiastic on any of the major currencies. The fundamentally stronger ones have already enjoyed large gains and may need to retrace a little before continuing higher. The weak currencies are weak for a reason – their governments are overindebted, their economies are weakening, etc. However, in an economic environment where asset values are plunging, owning one of these currencies (like the USD) may be the lesser of many evils. Generally, if I need to hold cash, I elect to hold precious metals (unless they're hugely overbought). At least that way I have some hope of retaining my purchasing power.

So if there is any one theme that I hope my readers can take away from this series, it's that in this investment climate, return OF capital should be the name of the game, not neccessarily return ON capital. Or you could just take the advice of Annie Logue (

As always, it's your choice. Best of luck!

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