Tuesday, October 28, 2008

Say Yes to Deflation, No to Tyranny

I responded to a post on a message board that cited this article by Eric Janszen. I was asked for my response and will reprint it here for my readers:

I have been a "deflationist" for a few years. I was previously a "inflationist". I am also a student of Austrian Economics. Generally, we believe the Dollar is unworkable in it's present form and from an ideological perspective, we despise the confiscatory nature of inflation that a fiat currency naturally perpetuates. We want a gold standard, and as a result we want the dollar to implode so our goal can be realized. Therefore, any notion of the dollar rising is typically rejected as nonsense to most of my colleagues - Mr. Janszen included.

Unfortunately, most Austrians (not all) share the myopic view that because the Fed and Treasury are growing certain areas of the supply of money and credit that it will have the same effect it did every other time they did the same thing. i.e. - the creation of another asset bubble, and a rise in general prices.

John Xenakis at Generational Dynamics, Kevin Depew at Minyanville, Mike Shedlock at Global Economic Analysis, myself and a few others all understand that the conditions in existence now are different from those in the past 80 years. For one, we have an aging boomer population that need to liquidate their assets for retirement. Second, we have a heavily indebted Gen-X and Gen-Y population that desperately need to save money, eliminate debt and spend less money overall. Third, we have banking institutions worldwide, whose balance sheets are so impaired, that they are not ABLE to lend money, even if they wanted to.

It takes two people to make a transaction. And just because there is someone (central banks) providing a nice cozy environment to make one, doesn't mean it will happen. Banks cannot lend. Consumers and businesses see no reason to borrow. That is, in essence, the argument for deflation. "You can lead a horse to water..."

If businesses and consumers rapidly started saving, slashing expenses and re-educated themselves in new lines of work. And if banks allowed for a far higher level of transparency into their balance sheets, marked all assets to market and reduced their leverage ratios - we could potentially see a mid-cycle hyperinflationary boom, that if allowed to grow out of control, would lead to the destruction of the dollar. But that is a lot of "ifs". And the destruction we would see along the way would be breathtaking.

It "should" have been done by now. Balance sheets of westerners "should" have been repaired after the dot-com bubble. Banks "should" have reduced leverage and improved their balance sheets in 2002. And responsible government officials "should" have told us to reduce consumption and debt. Society in general "should" have, at that point, retrenched and to put it bluntly - started making more babies. But we were told to do the opposite. And like good little sheeple, we obeyed. Now we are being forced to do all of the above from a far tougher starting point. It should be noted that there was a recession in 1927 also, and the easy money policy of the Fed at that time greatly extended the boom which undoubtedly made matters worse in the depression.

Essentially, we are making the same mistakes that were made in the 20's and 30's. We're trying to prevent asset prices from falling to where savers are willing to buy them (i.e. much lower). And we are depleting the pool of available savings now, by going further in debt to prop up these prices. This means that when the opportunity arises for a new technology or infrastructure project to be advanced - we won't be able to. We'll lose the opportunity to some other, more frugal nation. And the jobs that would 'normally' be created will cease to exist.

From 1932 to 1937 the Dow Jones rose nearly 500%. Yet very few people managed to participate in one of the greatest bull moves of all time because there were no savings. The employment rate barely budged during this time first because there were few legitimate business opportunities, and later because the skills of most workers became obsolete after years of underemployment. As a result, the economy died again in '37 and eventually led to America's reluctant participation in WWII.

There is simply no way to make this crisis go away as our central bankers have promised us they can do. And we certainly cannot simply 'go back' to the way it was. To me, it is very clear that what they are doing now will be to our severe detriment 5, 10 and potentially 80 years down the line. Whether they are doing this maliciously with some ulterior motives (aspirations of the banking elite for a one-world government, justification for another war) or out of ideological ignorance is not a question anyone knows the answer to.

The outcome is already pre-determined. Asset prices will go far lower, many people will lose their jobs and there will be widespread civil strife. What is not pre-determined is the path we take to get there, and our relative position to emerge from the crisis stronger than other nations. Will we give our liberties away in favour of comforting reassurances from authoritarian leaders (like the Germans did for Hitler) or will we return to our roots? Will we have the courage to jump at new opportunities in efficiency technology and health care or will we retreat to the comfort of old and tired industries? Will we embrace diversity, new ideas and trade, or will we persecute, attack and protect?

Those are the real questions. Arguing about why the stock market went down yesterday and what it will do tomorrow are such minuscule issues in comparison, yet nobody is willing to address any issues more than a few days out. That unwillingness leads me to believe our society is so blinded by their own waning narcissistic materialism that they will be willing to sacrifice anything to get it back.

It's not coming back. And unless we come to realize that soon, the only question remaining will be, "what form of tyranny will we accept under the guise of it's promised return?"

Monday, October 27, 2008

Time and Price

US markets finished down in a major way over the last week. Trading curbs had to be put in on the futures market in overseas trading Thursday night. Fear was in everyone's eyes and voices at the opening bell. Somehow though, buyers showed up on the open and we 'only' finished down by 3.5%. Both the Dow and the S&P 500 were able to stay above their October 10 lows. The Nasdaq, Russell 2000 and many foreign markets all made and closed at new lows.

So the capitulation that everyone was confidently proclaiming had been reached, is obviously still absent. As readers of this site know, 'capitulation' is not possible in an environment where everyone is looking for it. When it comes, we will only know about it with many months of hindsight and very little fanfare.

One aspect of this crisis that I completely underestimated was the strain it would put on developing nations. Already we hear of Iceland, Argentina, Hungary, Pakistan, Belarus and others needing assistance from the IMF. Two weeks ago it was rumoured that Russia was to bail out Iceland. Now we learn that Russia itself may need to be bailed out. So if all of these developing nations start defaulting, what's going to happen to all of the yield-chasing pension funds that had invested there? I suppose we'll just have to bail them out too.

In the meantime, people keep piling in to US Treasuries as they are, paradoxically, the safest place to hold money. But at some point that perception will change too. When? Who knows. Regardless of which way all these currencies are moving, the fact that they are moving by such large margins on a quarterly basis makes it nearly impossible for businesses to conduct trade.

Everywhere we look, the financial construct of the entire world economy is breaking down. No corner of the globe seems to be untouched. This should come as no surprise, given that this construct has been based upon a ponzi scheme of debt. Coming to grips with this shocking reality is happening slowly. Policy makers are still grasping to their security blanket of "what should work." Unfortunately for them, it hasn't worked and still isn't. No matter how much they blow, the bubble won't get any bigger without springing another catastrophic leak.

Austrian economists have known this as a "liquidity trap." It's also commonly referred to as "pushing on a string," or "pushing water with a fork." The cost of credit is eased by central banks, yet borrowers still have no incentive to borrow and lenders need cash to write down the inflated values of their balance sheets. So credit is not expanded as per the ponzi schemes demand. It is contracting and rejecting debt at every opportunity.

So what's the next domino to fall? Judging by the massive layoff announcements last week, it will be unemployment. Unemployed people don't tend to spend very much money, so although the financial recession may find a respite, the consumer recession will be hot on it's tail. At some point there will be a legitimate buying opportunity. But unless my time horizon was 10 years or more, I wouldn't consider buying at these levels.

Time and price are what is needed to cure our dependancy on debt inflated asset valuations. Trying to desperately prop up the value of those assets is guaranteed (by the principles of Austrian Economics) to be the biggest failure in the history of modern monetary policy.

Wednesday, October 22, 2008

Beware the Value Trap

It's happened to everyone. A stock on your watchlist just took off on good news but you recently chose to buy something else. Now you have no cash and would have to sell that something else to buy it. It's hard to justify buying a stock for $55, when you did all your research on it at $40. So you wait. "Maybe I'll get it on a pullback," you tell yourself. But it doesn't come back. It just keeps going. $80. $100. $150. You take it off your watchlist. It's too damn painful to watch anymore!

You did everything you should have in researching the company, saw the value but failed to capitalize. You have a certain emotional attachment to the stock. It was "the one that got away."

But now, lo and behold, the stock is all the way back to the price you wanted to pay for it 2 years ago! It has fallen 70% from it's highs. The selling is quite apparently overdone and you want to buy that precious gem everyone seems to be throwing out with the bathwater.

But is this a rational decision or an emotional one? It's hard to argue that a 70% decline can be just an aberration. There's obviously some reasonable cause for concern.

Yes, I'm talking about the big commodity producers. EnCana, Potash, Freeport McMoran, Teck, Goldcorp, and BHP have all been taken behind the woodshed. I'm also talking about financials, retailers, and big techs like RIMM, Apple and Google. They've all fallen victim to the credit crisis, the perception of slowing global growth and the decreasing desirability of debt. In other words, they've fallen victim to deflation.

So if I think this selling is overdone (I don't, but that's not the point of this article) why shouldn't I try and pick up some of these great companies at bargain prices compared to just a few months ago? After all, they are trading with P/E valuations below 10 and some of them pay out dividends of 10-15%!

Well, here are a few good reasons:
1) Lower profits are implied and will drive that P/E ratio higher
2) The dividend could come under pressure if profits start falling. This could drive the stock price even lower.
3) Profit taking will be rampant on any bounce in the stock price

This is what is commonly referred to as a 'value trap.' And anyone trying to pick up bargains should be aware of the potential pitfalls in value investing. For the long-term investor, these companies may not produce the steady income desired and to the momentum investing community their 'stories' are old, so capital appreciation is not guaranteed.

On the other hand, finding an intermediate term bottom could be quite rewarding for someone with a shorter time horizon. The commodity producers especially, could double from their bottoming prices. But capturing that would require catching the bottom, the subsequent top and withstanding all the volatility in between. Not easy.

But instead of looking for companies that have been beaten mercilessly, I find it far more constructive to look for sectors that haven't been sold nearly as much and have the potential to be market leaders if and when we have a mid-cycle recovery.

Chief among those candidates are some of the high-flying biotechnology stocks. These companies have just started making money in the last few years and have the demographic tailwinds in their favour (aging populations). They don't care about no stinkin' credit crisis. And their share prices prove it. Some are still in distinct uptrends. Others still are making new highs (remember what that feels like?) On my watch list are GENZ, GILD, IMCL, ILMN and EBS.

These companies generally have desirable characteristics like low debt levels, consistent profit growth and diverse product lines. They may be off 20 or 30% from their highs a few months ago, but their uptrends are still in place. Why don't investors looking for capital appreciation look here first?

Simple. It's not nearly as satisfying to catch a stock half-way through it's uptrend as it is to catch a stock at it's bottom price.

I'm also looking at some others in the technical instrument space like WAT and ABI. And if we are to have a productivity revolution of sorts, where better to look than companies like FLS and CIR?

My intention in this article is not to give stock recommendations. And to be clear, I do not own any of the stocks I've mentioned. I still think I can buy them cheaper. My intention is to try and pry you away from the common trap of buying old ideas. Everyone knows the China story. Yes, they'll keep consuming copper. But that doesn't mean copper miners are a good buy. When the dot.com crash happened, the internet didn't disappear - but the best of the internet stocks took 5 years to recover. Most are still way below their highs.

Try to look beyond today's ideas and think about what we need over the next decade. My answer to that is higher efficiency, more sustainability and an answer to many of the diseases plaguing mankind. Others have different answers. But the key is that they are new ideas.

Monday, October 20, 2008

Best of the Net - Monday October 20, 2008

Kevin Depew was talking about liquidity traps and an era of the new American saver. Here's an excerpt:
A Liquidity Trap occurs in a low-interest rate environment with stagnant economic conditions and high savings. During this environment monetary policy becomes ineffective. Why? Because under these conditions people believe that they will not receive an adequate return for the risk assumed in owning other financial assets, even bonds, so they prefer to keep cash in short-term bank accounts. In other words, they hoard cash. Sound familiar?

Mike Shedlock had a piece on a similar topic titled, "The Age of Frugality. An excerpt:
Those wondering why the Fed and Treasury liquidity measures are failing, need look no further. Greenspan had the wind of consumption at his back. Bernanke is on the backside of Peak Credit with a breeze of frugality blowing briskly in his face.

On the other hand,

Calculated Risk was mentioning that "a few of the key signals in the credit markets are responding favourably" to the trillions of dollars being thrown at them by central banks and governments around the world.

Bennet Sedacca, one of the better credit analysts I've come across had this to say in his buzz today,
No Virginia, the credit market hasn't thawed. One would think that given the amount of intervention/interruption that bonds would be trading much better. But sadly, they are not. Until this changes, we stay cautious, although I must say that if I had a 10 year time horizon and never had to mark my bonds to market every day, some of these are appealing.

Ben Stein, who I've been picking on for a long time had this to say:
In any event, we now know a lot we did not know before. Credit default swaps are way too dangerous. Derivatives generally are dangerous. There is much that Ben Stein does not know. I hope this explains some of how we got to this precarious place, I apologize for not seeing it sooner. But I am still optimistic that the government will save us from the CDS, and we will go on to renewed prosperity. In other words, I am still buying.
And Warren Buffet says we should buy American stocks because he sees the inflationary impacts of all these government interventions we've been promised will fix everything.

Not a day goes by without either the President of the US, the US Secretary of the Treasury, or Chairman of the Federal Reserve coming out to speak on how bullish they are on America.

I can't get over the striking similarity in some of the words being spoken now and those following the months of the panic of October 1929. Here's a few good ones:

"I see nothing in the present situation that is either menacing or warrants pessimism... I have every confidence that there will be a revival of activity in the spring, and that during this coming year the country will make steady progress."
- Andrew W. Mellon, U.S. Secretary of the Treasury December 31, 1929

"I am convinced that through these measures we have reestablished confidence."
- Herbert Hoover, U.S President December 1929

"The end of the decline of the Stock Market will probably not be long, only a few more days at most."
- Irving Fisher, Professor of Economics at Yale University, November 14, 1929

"...despite its severity, we believe that the slump in stock prices will prove an intermediate movement and not the precursor of a business depression such as would entail prolonged further liquidation..."
- Harvard Economic Society (HES), November 2, 1929

These were the most respected names in finance at that time. They were all wrong. Does that mean all the optimists are wrong now? I don't know. But there are a number of very smart people who told us exactly how this would play out and have been doing so for years. Are you going to bet against them or against the world's richest man?

Despite the fact that we have incredibly intelligent people with wildly different expectations about the future, nobody really knows the rules anymore. Do we believe in free markets? Or are we socialists? Can a financial system that was never legitimate in the first place be patched over one last time to effectively screw every last saver that remains? What happens if it can't?

Why play a game if you don't know the rules? That's the question I fear most people will start asking themselves.

Thursday, October 16, 2008

Opportunity Still Plentiful, Regardless of Outcome

I received a question from a reader wanting me to explain in detail what I thought would be required for me to believe in the hyperinflation scenario as opposed to my long held belief of a secular deflationary outcome. Here was my response, in detail, as requested:

Dear Reader,

It is partly a psychological issue and deflation is being forced upon us by structural changes that are out of the Fed's control. One such issue is the retiring boomer generation. They all need to sell their assets over the next 20 years to fund their retirement, this will create lasting downward pressure on real estate and equity assets. The younger generations have terrible balance sheets and those need to be repaired before they can even think about making major purchases or investments. This could take quite a few years.

As has been discussed, much of the credit creation by the Fed and the expansion of the government balance sheet is not making it's way into the economy. It is all being pushed on financial institutions to keep them solvent. But credit is being destroyed at the same pace. Events like Lehman's bankruptcy caused $400 Billion in CDS obligations that most could not pay. The ripple effects on the derivative markets are enormous. There are $1 quadrillion (thousand trillion) in notional derivatives and counterparties to some of this are disappearing, meaning insurance that a lot of companies may have had against falling asset prices are now non-existant. Banks are still not in a position to be lending money. Not until they can hedge their risks properly in a functioning market for derivatives.

The assumption is that once the credit markets heal and banks are able to lend, there will be lineups by consumers and businesses to borrow money. This is a dangerously flawed assumption. Asset prices are rising nowhere in the world. There is absolutely zero motiviation for anyone to borrow money for expansion at this time. In other words, the engine for the velocity of money is broken. Why buy something now, when you can almost assuredly buy it later for less?

In a normal market, prices would be falling much faster right now and 'later' would arrive with quite a bit of pain, but in a short period of time. There is still quite a large pool of capital waiting to be deployed, but it is waiting for a price that accurately reflects a realistic economic environment in the next 5-10 years. So yes, in a normal market we should expect to see buyers come back to the market and pick up bargains. This would cause the inflationary pressures and if borrowing costs were left too low for too long, hyperinflation would be a realistic expectation.

But this is not a normal market. Government is actively intervening to ensure 'later' doesn't arrive for those who are waiting with their savings. So the savers will wait. We also have economists, analysts and pundits spewing rediculously rosy expectations about the near future. Analyst expectations estimates have been missed by the widest margin ever. It's only until the last week that a recession has been priced in to markets for the rest of '08. Analyst expectations still need to be slashed considerably for '09 and '10.

There is an incredible amount of debt out there and an incredible amount of leverage, but there are also a lot of savers, and they are to be found all over the world, now that we are globalized. They will come back to the markets if they feel like they're being paid to take the risk. But the key is the balance sheets of our younger generations (under 50 yrs). They need to be repaired in order for consumption to reignite the economy. Unfortunately, without jobs, they can't fix their balance sheets. And good paying jobs cannot be created until there is appetite for investment. A Catch-22.

So those are a few of the things that need to be addressed before we can 'beat' deflation and for the velocity of money to start moving once again to a point where we start seeing inflationary pressures in the asset markets. I have been on the deflation side of the trade for quite a while now, and still believe it is in the future. It is the natural way out of this. But government could try some things that could result in the inflation scenario playing out longer term. I don't advocate they do this by any means, but as socialists they will likely try. Here is what I think would be required to happen in order for some sort of a recovery.

- some sort of aknowledgement that we are in for a very long period of economic contraction and for forward estimates to reflect this outcome so it can be properly prepared for
- more transparency of bank balance sheets including level 3 assets being marked to market. Governments are attempting to encourage this now, by giving banks billions of dollars to write off bad assets. They will likely need twice as much as they've been given to accomplish this. At that point, they'd be able to lend again
- government would need to make significant infrastructure investments in transportation, energy and water thereby ensuring job creation. Re-education programs would also be required for former autoworkers and other marginalized American manufacturing workers
- government would need to dramatically reduce spending in social programs and accompany this with significant tax cuts for businesses and individuals
- barriers to foreign investment should be eliminated without exception
- consumers need to tighten their consumption habits, eliminate debt and ensure they have current education
- at this point, consumers would be far healthier and be able to again borrow money
- the combined effect of all the above would be devastating for asset prices - they would likely need to fall another 50% from current levels to throw out an arbitrary number
- banks would again be able to lend, consumers would again be able to borrow, and the appropriate infrastructure would be in place to provide positive investment opportunities in new efficient industries

If all this were to happen, I could see potential for a legitimate recovery by mid 2010. But I must stress that doing this would not fix most of the larger underlying problems, and would actually make some of those problems worse. It would likely be met with another, equally as difficult period a number of years later when some of those other problems start manifesting. What are some of those problems?

Problems that would be left unaddressed include our dependence on government spending, that while out of control now, would be even further out of control by the time they attempted something like the plan above. Related to that problem, our confidence in paper currencies would be seriously shaken by then if perception of government’s ability to repay their debts deteriorates. It would also be fair to assume the central banks would be too slow in raising interest rates (they’re always too slow on both sides) and speculation could grow wildly, causing another bubble to be inflated and subsequently popped a few years later. So the issue of interest rate micro-management would not be addressed. Neither would the issue of fractional reserve lending, which naturally causes instability in the banking industry. We will also have a litany of moral hazard problems coming home to roost as people will surely abuse the government guarantees currently being handed out worldwide.

This would then look very similar to the outcome of the 1930’s depression, where between mid-1932 and early 1937, the Dow Jones Average actually rose 473%. Only again to lose 50% of that in the next 15 months. See chart here.

So there you have it. Under the right set of circumstances, our elected and unelected officials could guide us toward a mid cycle recovery. But ultimately, the structural problems need to be dealt with, and knowing the ideological background of those officials, they will not be dealt with. There is too much debt, yet none of the decision makers see that as a problem. Essentially, we’re making the exact same mistakes that were made in the 30’s, and of 90’s era Japan, so expecting a repeat of the 30’s or Japan would not be out of the question. Just for fun, were the current crisis to play out like the 30’s, it would look something like this:

- continued deflationary pressures until Q2 2010
- this would correct some of the imbalances and bring investors back to the market for a very large rally into Q1 of 2015
- continued volatility, yet essentially flat prices for another 5 years

Unfortunately, there is little chance things happen ‘just like last time.’ It is even possible that our rally from the lows in 2003 until 2007 was the equivalent to the ‘32-‘37 rally and our current crisis is more like 1937. Comparing the Nasdaq now with the Dow of the 30’s would confirm this, yet using the S&P would not. It is all so subjective that drawing any conclusions based on this would not be advisable. For me it is a useful exercise to help remember that even if we do enter a second great depression, there will still be opportunities regardless of inflation, deflation or something new we’ve never seen before.

I hope that answers your question.

Wednesday, October 15, 2008

Some Random Thoughts

How is this possible? How could governments around the world spend trillions of dollars to fix the markets and then have the markets post their worst day in 21 years?

Could it be that these same governments have absolutely zero clue what is happening? Judging by the comments of the last few days, I'd guess so. So how could these clueless bunch of bureaucrats possibly come up with a solution to a problem they can't even explain?

We've had nearly 20 government interventions in the last 14 months. Every single one of them has resulted in enormous rallies followed by even more selling. And the duration of those rallies has been shorter and shorter even as the interventions get bigger and bigger. Is it time to officially declare the Federal Reserve as obsolete? They're clearly not helping. I mean seriously, if they can't bail out the world with "unlimited funds," what can they do?

How many buyers will we see on a retest of Friday's lows? Or will there even be a 'test'? Will it just blow right through it? I draw support at Dow 7,500 and 6,000. If you're in 100% cash and expecting this to last for years, rather than days, does it matter?

In market environments like this one, it's difficult to make concrete statements about anything, so I prefer to ask vague and open-ended questions. But what I can tell you is this:

The problems are as follows:
- fiat monetary system
- fractional reserve lending
- governments and corporations too cozy with eachother
- too much debt
- too much leverage
- a complex derivative structure of $1 Quadrillion (a thousand trillion) that even our smartest number crunchers can't make sense of
- unfavourable demographic situation

The falling stock prices, frozen credit markets, collapsing real estate values and economic weakness are all symptoms of the above problems. They can not and will not go away by throwing money at them. The only possible solutions are:
- time
- price

It's just that simple.

Sunday, October 12, 2008

Is This What Capitulation Feels Like?

Everyone seems to be looking for it. Panic is in the air. Was that it? No? How about that? Will it be the volume that tells us it's here? What about some trusty technical indicator? Will there be some sort of extraneous event that marks it? Is it going to come this afternoon or tomorrow? Or maybe it came yesterday and we'll only know for sure tomorrow? Do you agree with that, Bob? You agree right? Well, don't you? Man, if it doesn't come soon, this could start to get really crazy!

It's the capitulation game. Whoever finds it first wins. Unfortunately, nobody seems to know what 'it' is or where it can be found. So instead of looking aimlessly, most have just resolved to screaming at the top of their lungs, "I GOT IT" and hoping others believe them. The search for The Holy Grail comes to mind.

Meanwhile on planet earth, far removed from this Orwellian nightmare, people seem to be slowly coming to terms with the fact that what most are looking for is only a longing for something that used to exist - steadily rising asset prices.

I've heard it all this week. But the story usually goes like this: Some indicator used by some reputable person in the business is at 'historic' oversold levels. For as long as we have data on the markets, nothing like this has ever happened before. Therefore, it shouldn't be happening and most certainly cannot continue to happen.

That is about the extent of the logic people use to proclaim that markets should go up again. Will it? Probably. The odds are certainly in their favour. Nothing goes in one direction without pullbacks. And when prices do start to move higher for a few days, prepare to hear that the bottom has been reached and we've found capitulation.

But what is capitulation in the markets? Really, it is the universal belief that prices can only go in one direction. So if everybody is looking for capitulation, is it actually possible to find it? In my opinion, no. Capitulation can only be found, by definition, when people stop looking for it.

To think of it another way, the market has been trying to tell us something for about a year now. In the last two weeks it's been screaming in our ears. It's been trying to tell us that our financial system, based on fractional reserve lending and compounding debt structures, needs to come to an end and something needs to replace it. Every day that the market has moved lower, more people come to understand the problem and stop looking for a bottom. Eventually, enough people hold this view that there are no longer enough people to convert. Meanwhile, the market is starting to tell us something else and the market slowly starts to move higher. Then it starts to scream in our ears about this something else. But it never starts with screaming and people buying in a panic out of fear of 'missing something.'

That is something called a "dead cat bounce." Or what the media commonly refers to as "a bottom." When the real bottom comes, I can almost guarantee the media will miss it completely.

Confronting Your Inner Pessimist

I've been a bear for a long time. It's not as fun as it looks. Even when stock prices are falling faster than they have in 90 years. There's very little satisfaction one can derive from the utter destruction of nearly everyone's wealth. But I'm trying to look past the numbers and determine the bigger picture. Yes, prices of every asset worldwide are falling and people are losing their livelihoods. That is the easily seen. But what does it really mean? There are changes in social mood and in the acceptance of what was once conventional wisdom. There are changes in time preferences and in the valuation of certain objects. That is the hidden shift that is taking place under our noses. And it is far more important than the Dow falling 2000 points in a week.

I operate under the pretext of, "what everyone knows isn't worth knowing." So while everyone keenly watches the price of stocks tumble, foreclosures accelerating, credit markets closing and leaders of the world amassing to agree on a "solution," I am looking at something else entirely: The acceptance of a new reality - Deflation.

But are inflation and deflation merely a representation of prices or of the total supply of money and credit? No. They are psychological conditions.

Inflation encourages the "instant gratification" aspect of our society. Materialism in general, is rooted in inflation. So are political apathy, narcissism, environmental degradation and a host of other ailments that have plagued us for decades. Inflation represents a transfer of wealth from the poor to the rich. "Use it or lose it," is the phrase than could be used to describe one's savings.

Deflation is the cure to these unsustainable problems. It forces people to live within their means and to focus their energy on what is really important to them. That can only be a good thing.

So while I have made a living over the last couple of years being what some might term as a "professional cynic," I see opportunity in the sudden realization of this new reality. Even if that realization is not conscious, it is happening and it is a massive step in the right direction.

But in talking with others over the last few weeks, there seems to be only a vague understanding of this new reality. They only sense the shifting mood as an unfortunate symptom of falling stock prices, not the other way around. But I suppose that is to be expected. So many people have constructed their lives around the expectation of future inflation, they simply cannot see it's end as a good thing. Very much like a drug addict having to attempt being 'strait' when being 'high' was the new normal. To some it is the "end of days." To others, merely a frightening revelation that much of the 'old' reality wasn't very real in the first place.

To me it is the first step toward recovery from our addiction to debt.

Thursday, October 9, 2008

Best of the Net - Thursday October 9, 2008

I sit silenced by the ruthlessness of the market like most of you I'm sure. It's one thing to expect stock prices to fall, another to watch the utter destruction of our capital markets day after day with no sign of abating. Quite often I don't know whether to laugh or cry. And now that I'm firmly sitting in cash, having taken all profits possible from my short positions, I'm hardly consoled by the knowledge that I am a lucky unemotional spectator to this carnage.

As the last days have unfolded I can't seem to shake the notion that what we are witnessing is a once in a century event in slow motion. An inherent characteristic of most of these major panics of the past has been that the market systems malfunction due to the increasing volumes. During the Crash of '29 the ticker didn't finish printing trades for hours after the market had closed. People had very little idea where their stocks were trading throughout the day. The South Sea Crash and Tulip Bubble were rife with examples of mass confusion and misinformation. Additionally, most of these panics were accompanied by market closures. We have been seeing these elsewhere in the world, like Russia and Iceland, to absolute disastrous consequences, but not yet in Europe or North America. What this usually causes is a psychological fear of "not being able to get out." So instead of the enormous declines of 15-20% in a day, we're getting the Chinese Water Torture of 4-7% declines daily. For that we should be belatedly grateful.

The biggest problem I have with the way things are unfolding involve the perpetually terrible advice being trumpeted for the last year by our major media outlets. All along they have been telling the average person that they should be buying for the long-term, even as the economic data were pointing toward far more troubling times. It was entirely predictable. But I suppose that is the nature of the psychological beast we call our capital markets. Chris Puplava had a good chart showcasing one analysts terrible calls over the last year. It is truly amazing. See it here.

Another thought I can't seem to shake is that the Chinese have been sitting quite patiently with their massive reserves, and I think the possibility of them doing something crazy have heightened since I wrote about it in early July. I moved a portion of my cash position to the Chinese Renminbi currency ETF (CYB) in anticipation of a revaluation scheme of some sort.

But I'm still very careful about trying to pick up bargains here. It has become quite apparent that this is a beast that cares not about historical extremes. For days now, I've had some of the best technical traders in the world showing me examples of "something that has never happened before." Oversold extremes that have not happened since the statistics started being compiled (usually the early 60's). I've always held that saying, "it's different this time" is one of the most dangerous statements an investor can make. The probabilities of any event being completely different from a fair number of previous data inputs is indeed small.

But quite apparently, it's different this time.

Tuesday, October 7, 2008

Best of the Net - Tuesday October 7, 2008

I've been a little short on words lately (rare). And considering I'm not the victory dance type, there's not much that has changed over the last two weeks to merit mention. Governments around the world are doing their best to ensure this crisis lasts as long as possible. The Canadian government hasn't succumbed to this madness as of yet, but I'm not holding my breath on that.

Overvalued stocks are being sold by panicky investors and as a function of forced liquidation by hedge funds. There appears to be no bottom for the markets, as profit forecasts are being lowered at the same speed that prices are falling. What was overvalued last week is no less so today as growth expectations get slashed. There will be a bounce sometime soon, but without the credit markets and the overall economy bouncing with it (not likely to happen) it won't be sustainable. And considering there is a far lower amount of shares short to be squeezed out (due to the short selling ban), a rally may not be as manic as it would otherwise. Exceptions to this may be the commodity sector that have been hammered mercilously despite trading at very attractive valuations.

But I'm not at the point yet where I'm willing to risk my precious capital on an asset that everyone agrees is difficult to put a price tag on. Furthermore, a bottom is not a bottom if there are still people all over television telling me to buy. I am starting to get phone calls from people who I normally wouldn't asking me what I think they should do. That is one contrary indicator. But I want to start hearing folks tell me that, "buying stocks is a one way ticket to the poor house." That, "NOBODY makes money in the stock market!"

Then I'll buy.

Monday, October 6, 2008

Sunday, October 5, 2008

Best of the Net - Weekend Edition October 3-5, 2008

Mike Shedlock was talking about the coming contraction in employment that should serve as yet another indication of the expectation for lower business profits in the coming quarters.

Jeff Cooper was talking about market periodicity (aka Gann Theory) and gave his take on how long it could take for us to reach a bottom in his Friday article, Snowball from Hell

I recommend reading Kevin Depew's Five Things You Need To Know: Bailout Passes, Stocks Limp

It appears the credit crisis has finally consumed Europe as much as the US. And those arguing that all the terrible economic data would result in a weaker dollar are still left scratching their heads. The dollar is strengthening vs. the Euro again tonight, and that is a trend I expect to continue. It remains to be seen how the EU and the ECB handle this crisis together. I have very serious doubts as to them being able to do it without bickering with each other. I doubt the Euro makes it out of this crisis in one piece. That makes for a stronger dollar, and will likely also be an upside catalyst for gold. Welcome to deflation.

Saturday, October 4, 2008

Asset Class Analysis - US Equities

I, like most others, find myself paralyzed by the recent volatility in the markets. I've never experienced anything like this in my very short career. But surprisingly, that doesn't put me at any disadvantage over those who have been following markets for 30 or 40 years. They haven't experienced anything like this either. I understand that statement might raise the ire of those who have cut their teeth in this business for decades. So while I'm at it, I may as well go one step further. I suggest that economists, investment professionals and others who have been around for decades are at a massive disadvantage to others like myself, explicitly because they remember events like the S&L Crisis, 1987, LTCM, or the Asian crisis of '98. It is ingrained in their collective conscience that these crises naturally resolve themselves, and the stock market will naturally resolve upward.

For further evidence of this mindset, take a look at this excerpt from the Vancouver Province Newspaper from Tuesday, September 30,

Samir Kulkarni, 31, a personal trainer, was working on his computer on a restaurant patio. "Today would be a good day for them to hide," he said of the high-rollers. "If people are worried about their investments and their money, it's bad for me because they're going to be spending less money on things like me for example - that's disposable income. "I've seen stock-market crashes a lot of times in the past and it always goes back up," he said.


Mr. Kulkarni was obviously not around during the 1966-1982 period when stocks (adjusted for inflation) lost 50% of their value. Nor was he around during the Great Depression. His attitude is typical of Gen-Xers who think that because something hasn't happened in their lifetime, it is therefore impossible.

Luckily, the folks from which I took my early instruction on investing taught me some very valuable lessons about market psychology. For example, this Galbraith quote is one that has lingered in my mind, and has saved me quite a bit of money:

A common feature of all these earlier troubles [referring to the Panic of 1907 and the depression of '20-'21] was that having happened, they were over. The worst was reasonably recognizable as such. The singular feature of the Great Crash of 1929 was that the worst continued to worsen. What looked one day like the end proved on the next day to have been only the beginning. Nothing could have been more ingeniously designed to maximize the suffering, and also to insure that as few as possible escaped the common misfortune.


He went on...

The man with the smart money, who was safely out of the market when the first crash came, naturally went back in to pick up bargains. The bargains then suffered a ruinous fall. Even the man who waited out all of October and all of November, who saw the volume of trading return to normal and saw Wall Street become as placid as a produce market and who then bought common stocks, would see their value drop to a third or a fourth of the purchase price in the next twenty four months.


The Great Crash, 1929 by John Kenneth Galbraith
(from which this quote originates) and Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay (published in 1848) were the first two books I ever read on the topic of economics. A common theme between the topics covered in these books (Mackay's book covered the Tulip bubble in Holland, the Mississippi Scheme in France and the South Sea Bubble in England) was that the crashes were generational in nature. None of the participants in any of these examples had experienced either such prosperity nor such destitution in their lifetimes. The principle of maximum ruin was executed to perfection.

So the question confronting investors of today is: "Is this one of those generational crashes, or is it simply another crisis to be quickly resolved."

I've already made up my mind that it is one of the former for a number of reasons.

1) The natural selling pressure of Baby Boomers in preparation for their retirement.

2) The psychological reactions I am seeing. Every analyst I see on TV is looking for a bottom. Some say today is a bottom. Some say next week will be a bottom. But it is implied that because prices have been falling for so long, the bottom must be near.

3) The amount of debt and leverage in the financial system that was all created on the assumption of perpetually rising prices. Selling begets more selling. And each round of falling prices consumes even more of the pool of savings as the buyers Galbraith refers to are sucked in.

I take no pleasure in witnessing the demise of so many people's personal savings, nor am I any longer able to profit from it. Nobody gains in an environment like I describe. Everybody loses. Some more than others, however.

In addition to the typically unorthodox methods I use of generational studies and mass psychology to forecast the long-term direction of the market, I also use some other measures. I have been tracking the earnings forecasts of S&P 500 companies for a few quarters now. For the second quarter of this year, analysts surveyed by Thomson Reuters had forecasted positive earnings 4.7% higher than that of Q2 '07. Estimates fell to -2% on April 1st, and then continued to fall every week as earnings reports started being publicized. This all happened while analysts and pundits were screaming "stocks are cheap!" They were all looking at expected earnings. In November of 2007 I wrote:

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.


Indeed, earnings have started to fall. Q2 earnings ended up negative by over twenty percent. Q3 estimates have already fallen from modestly positive a few weeks ago to -4.8% on October 3rd. Analysts are still expecting Q4 '08 earnings for financial companies to be 200% higher than their terrible earnings of '07. They're also expecting Q2 2009 to register all-time highs in profits. This kind of optimism is already priced into the current valuations of stocks. And it is where I think things can come apart at the seams for the stock market if it doesn't transpire.

On Thursday I was talking about how last year's credit markets reflect on today's economy. And how today's credit markets will reflect on next year's economy. With the condition of our credit markets now, I cannot legitimately see how these analysts are making these predictions. It defies logic that companies will be able to post record profits only 6 months from now considering the credit markets are now closed - and for many companies they have been for a while now.

What I am trying to get across here, is that despite the pessimism in the media about the present, there is still unbridled optimism about the future. If that optimism were to change course - or worse, turn to pessimism - it's effects on the stock markets could be catastrophic.

Perhaps there is some hidden advancement that will come to light and allow these companies to put up big numbers. Perhaps the financial wizards will find some sort of way to turn water into wine. But I just don't see it. The engine for growth has been the credit markets for many decades now. And since that engine is broken, and unless another engine comes quickly to rescue us, there is only one direction for the stock market and that is down.

I say this, and at the same time I'm very tempted to buy in to mining companies like Freeport McMoran, BHP Billiton, or Gerdau. I'm tempted by shipping companies like Genco, Dryships and Diana. I'm tempted by telecomms companies like Brasil Telecom, France Telecom and Vodafone. I'm tempted by infrastructure, tobacco and utility companies. All of these are international in scope, provide juicy dividends and trade at very reasonable sub 10 P/E valuations. This is to say nothing of the junior stocks on the TSX-Venture that trade below cash value with great assets.

But I'm still waiting. These stocks are all owned by the same people that own other ones. They're owned by mutual funds and pension funds. They will be met with the same forced selling as those companies that ran themselves into the ground.

As I mentioned on Thursday. This is not about bailouts. It's not about "irrational market behaviour." And it's not about some insidious plot by 'financial terrorists' to bring about the destruction of civilization as we know it. It is about too much debt, too much leverage, and a far too optimistic vision of the future. Until those problems are realized and begin to be resolved, stocks cannot find a bottom. Debt needs to be destroyed. Overleveraged companies and individuals need to go bankrupt. And realistic expectations of global growth (or even contraction) need to be what we value earnings potential on.

The more government can stay out of this process, the faster it will come about. And the faster I can put my money to work again. Until then, I wait.

Thursday, October 2, 2008

Best of the Net - Thursday October 2, 2008

Today had an eerie feeling of complacency with US markets tumbling another 4% and closing near their Monday lows. Canadians weren't so lucky with their markets blowing past Monday's low. Other foreign ETFs like Japan and Germany indicate they will suffer a similar fate when their markets open tonight. Yet most newscasts are still mesmerized by the allure of political 'debates' scheduled for tonight, the search for Steve Fossett's body, and baseball playoffs. C'mon Angels! It's about time we show those high-pitched Bahstonians how things are done! 2002 Style Baby!

Oh, sorry about that. I got distracted.

The markets seem to agree that none of this crisis has anything to do with the largely irrelevant (other than the dangerous precedent it sets) bailout bill. This is about a secular shift in risk adversity that has gradually destroyed our credit markets for the last 18 months and are now evidently spilling over into the everyday economy. This gradual realization of spillover from the credit markets to the real economy was shockingly easy to predict because the credit markets have been the entire basis of the real economy for nearly four decades now. The only complication is that there is an inevitable lag between credit availability and the time it takes to to put that money to a practical use.

Credit started seizing up in January of '07, 21 months ago. Some people might remember stock markets falling in unison on February 27 of '07. That was the shot over the bow. And about a year later, the real economy started to feel it. Most economists I respect acknowledge that a recession began early this year. And now, our economies appear to be in free fall as the credit market of 12 months ago shows it's colours in today's economy.

This is such a simple concept, yet so few are able to understand it. For most, history begins this morning. No event of the past could possibly have any effect on today. As long as we don't make any mistakes with our actions today, we can sweep all of our past mistakes under the rug. Where things go from there are well documented to end very poorly.

People need to step up to the plate and hit a grand slam off Papelbon to win the game!! Err, sorry, got distracted again.

People need to step up and acknowledge what the problem is; that something needs to be done to ensure it doesn't happen again. People need to understand that trying to patch over a financial system is impossible when the psychological catalyst for that system (risk-taking) is absent and moving in the opposite direction for many reasons that are uncontrollable. People need to understand that the credit markets of today will be reflective of next year's economy, and that preparations need to be made for that slowdown, not wasteful malinvestment in doomed financial institutions.

Until those basic facts are widely understood by the average person and our legislators, we are in for a very long economic depression. And at this point, the financial literacy of the average person and our legislators does nothing to convince me that is about to change any time soon.

People listening to others that have zero understanding of the above and are buying stocks should be very careful at this point. Yes, the market is oversold and the probabilities of a bounce are high. But the structural integrity of the economy is in such shambles that 'probabilities' of the last 60 years of statistics could be rendered as meaningless.

I have very few positions, long or short, right now and am hugging my near term US treasury bills like a toddler's blanket.

Wednesday, October 1, 2008

Best of the Net - Wednesday October 1, 2008

Most markets looked directionless on a day when most people had their eye on tonight's Senate vote on what some are calling 'Bush's New Deal.' Some sort of crazed optimism seems abound in the mainstream media. Almost as if they're trying to will the market higher. I'm still trying to do less and watch this insanity unfold.

In my opinion, this bailout is more an attempt to boost confidence, rather than 'support' or 'rescue' anything. The sheer size of this global credit contraction is far bigger than can be bailed. This $700B will be like a drop in the bucket. Of the little it will accomplish, only a few things are certain:

1) Moral Hazard will be fostered further. Investors and executives of poor companies that have blatantly if not fraudulently run their companies in the ground will be taught that no mistake actually goes punished, and will attempt to take even greater risks.

2) Banks will be 'Zombified'. Their business models destroyed, and no legitimate way to make money, these travesties of business will continue to suck on the taxpayer's balance sheets for a decade or more.

3) Price discovery will attempt to be delayed. The value of homes in the middle of nowhere will be propped up to prevent foreclosures. People that borrowed recklessly benefit and those that saved and stayed away from the 'bubble economy' get punished. This teaches ordinary people who live responsibly that taking insane risks are the only way to 'get ahead'.

4) It will drive all of our smartest minds (those that would normally clean up this mess) offshore, where they can earn higher wages.

5) The pool of savings that would eventually be used for re-investing in a recovery is greatly diminished. People will be manipulated into believing that buying financial companies now is a good idea and will lose their savings. This will prolong the eventual recovery.

6) It will put a further tax load on the younger generations, who will most likely try to rebel and be spiteful for the burden they are made to bear for their ancestor's gluttony.

All in all, it may briefly boost confidence in the equity markets. The credit markets have already given a thumbs down. Only General Electric is able to raise money and that is at 10%!

Kevin Depew had a hilarious analogy on the subject in Five Things You Need To Know: Bailout Keeps the Drunk Staggering

Mr. Practical was talking about Too Much Debt. The ticking time bomb of a quadrillion notional derivatives is also covered in a, uh, practical manner.

Michael Ivanovitch just said on CNBC that if the Fed spent $200B a year ago when this was still a 'Subprime Crisis,' we could have stopped the problem altogether. It is apparent that these people still do not understand the problem.

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