Tuesday, December 30, 2008

Themes for 2009 - Part 4 (Commodity Outlook)

For years, commodities were the biggest "no brainer" investments in the world. And the reasoning was logical and easy to understand: Third world countries were playing catch-up and needed more "stuff" to build their infrastructure, feed their populations, provide basic utilities, etc. There were 3 billion Asians who all wanted a western style of life - higher protein diets, their own car, a refrigerator. Commodity prices "could not go down" because of this relentless demand.

I was always very skeptical of this argument. What I understood was that this foreign demand was contingent on ever increasing amounts of US consumer debt to buy the goods they were manufacturing. Knowing that the consumer consumption binge was itself a bubble, it was easy to conclude that this could not go on forever. As a result I sold out of most of my commodity related holdings long before the blowoff top in the summer.

But where I went wrong, was to assume that because these commodities had a certain intrinsic value, they would relatively outperform the massive collapse in the western debt-based economy. That has not happened. They simply lagged the financial economy by about one year, and proceeded to collapse like everything else. Producers of those commodities fared even worse. I should have seen this coming. But the one year lag lulled me into complacency even though signs were everywhere (ie. negative divergences between stocks and commodities). Thankfully, not much was lost other than the opportunity cost of missing one of the best shorting opportunities I'll likely ever come across. Others weren't so lucky.

The inevitable question is, "what now?" Other than the best answer of "nobody knows," there are a few things I have observed. First and foremost, is that those who were previously bearish on commodities are still bearish and those who were previously bullish are still bullish. I was watching a BNN interview with some talking head who had been a commodity bull for years. They went over his past top picks (as is customary on this show) - Teck Cominco, Potash, Rio Tinto. He explained that he hadn't sold any of his positions because his firm, "always felt that the fundamentals were still strong." And naturally, he still advised watchers of the show to buy those stocks. I try to avoid listening to these analysts as much as possible. They have such an emotional and financial bias toward their favourite sector that they cannot possibly give impartial advice. They will always find an argument to suit their bias. You can confront them on things like "demand destruction" and they'll counter with "production cuts." If prices go higher, they were right, "but it's not too late to jump aboard." If prices go lower, "it's a great time to buy!"

To me, commodities and commodity producers are a crapshoot at this point. A prerequisite for much higher prices is for global economic growth to show some signs of returning - which in previous sections I've made clear is something I don't foresee for quite some time. However, with producers announcing production cuts and geopolitical tensions increasing risk premiums, supply disruptions are a definite possibility. This could cause some short term rallies in individual commodities, but unless global growth really gets going, these rallies will not be sustainable.

One potential wrench in this outlook is not just geopolitical tensions, but all out war. War is very commodity intensive. For the commodities themselves, this may prove to be what sparks the second half of the commodity super cycle Jim Rogers has been talking about for a decade. Do keep in mind though, that even in this undesirable situation, commodity producers would likely not benefit. Their mines and oil fields would be nationalized as part of the war effort as is usually the case.

In short, I do not see much of a case for investing in the industrial commodities. If I wanted to buy something because of the intrinsic value it holds and it's wealth preserving qualities, I would buy gold. Gold has massively outperformed all other commodities, and all other assets with the exception of Japanese Yen and US Treasuries.

This chart shows how dramatically gold has outperformed the CRB (which it is actually a part of, so the chart understates the divergence):

However, if you were an investor holding another currency (Canadian Dollars, for example) the yellow metal has performed even better in '08 and is actually sitting at all time highs right now:

As I mentioned recently in "Update on Gold," I do expect the price of gold (denominated in US Dollars) to revisit and likely fall below it's October lows. This would coincide with another round of deleveraging in the global economy. However, I am mindful that one set of expected resistance (the 200 day EMA) has been breached, and if the declining trendline from the March highs is also breached, I would have to re-evaluate this thesis. Gold is one of the few assets that can claim it is structurally still in a "primary bull market." Therefore, surprises will come to the upside, rather than the downside.

The opposite is true when discussing the broad equity markets, which I will attempt sometime later this week.

Monday, December 29, 2008

Themes for 2009 - Part 3 (Currency Outlook)

The recent volatility in currency ratios has made life difficult for even risk-averse investors who have fled to the relative safety of cash. Those holding the wrong currency have also been punished, although not as badly as equity or commodity investors. For example, Japanese investors who have been holding British Pounds, Korean Won or Australian Dollars are down ~40%. At times they have been down even more. People who thought they could garner a few extra points on their savings accounts by putting it all in Iceland are now finding out the hard way why those banks were offering higher rates.

I mention this to illustrate an important point: A currency only holds value relative to that of another currency or asset.

That's not exactly a page turner, but for those incessantly screaming about the coming demise of the US Dollar, it should be. This is something I have been harping on for years now. The US Dollar Index is only a measurement of other currencies, primarily Euros, Yen, Pounds and Loonies. Most of the arguments made from the "Dollar Doom" crowd (think Peter Schiff, Jim Rogers, Doug Casey, etc - all of whom I respect very much) are along the lines of "too much debt," "fiat currencies always fail," "poor economic management," or something of the like. None of those statements are false. However, they are correct for all of the major currencies. Therefore, expecting the US Dollar to go down simply because the US is in too much debt is not a rational argument unless it's competition is actually saving. They're not. It is a global race to the bottom.

The above logic was the rationale for one of my 2008 themes: "There will be a time for both large declines and large gains for the US Dollar - likely in that order." I thought that the expectation for the credit crisis to be contained to middle-class America was absurd. And once the realization hit that the problem was global, a major rally would occur in the US Dollar. Indeed it did:

click image to enlarge

I view the recent reversal as a technical correction of a larger bull move for the USD. My outlook is that it will continue to strengthen throughout the course of '09. Again, the primary reason for my views on the US Dollar have very little to do with the US. It is my extreme pessimism on the Euro and British Pound that I see as the potential catalysts for this action. In my opinion, the EMU (European Monetary Union) is not stable. What was workable during a boom economy during the last 10 years or so is not necessarily workable during the bust. Protectionism and busts are nearly synonymous. Already we're starting to see signs of infighting among the member nations. For years, the southern countries (Greece, Italy, Spain and Portugal) have been very opportunistic in the running of their finances. Whereas the northern countries (especially Germany) have been very careful. Now as the entire Eurozone plunges into recession, the fingers are starting to be pointed. I don't see how the northern countries can avoid the urge to blame someone else for their economic problems. The logical evolution for those sentiments are to favour going back to their pre-euro currencies. My eye is specifically on Germany this year. They have a general election coming up and I'm wondering if any of the major parties will create a stir by advocating a return to the Mark. Mal sehen.

The British Pound may be in an even worse situation. Home prices are crashing all over the UK, putting even more pressure on the already ailing financial system. The pound lost 25% of it's value to the USD over the course of 2008. I can see that happening again in 2009. I would not be surprised to see the pound trade at par with the USD.

I wish I had something positive to say about the Canadian Dollar. But I don't. The Conservative government's handling of the developing crisis has been pathetic. I had thought that, if anything, they would at least try to keep the country out of deficit. Instead, it has become a virtue of sorts, in the minds of Harper and Flaherty that deficit spending is somehow "proactive." It has become apparent that the only direction for any government in Canada, be it Conservative or a coalition, is toward bigger deficits, private sector bailouts, etc. As a result, the only direction for the Loonie is down. The Loonie also underperformed on the latest correction in the Greenback. This does not bode well for the next leg down.

The Swiss Franc and the Yen were the best performing foreign currencies in 2008. Even though interest rates are at or near zero, that was of no concern to investors stranded in carry trades. I'm a little concerned with the absolute tanking of the Japanese economy. They have got to be getting desperate. But like the US, I don't see how they can do anything that will be effective in reversing the trend. Currency interventions never work. But that might not stop them from trying. Like last year, I'd be more willing to put my money in Francs even though the upside might be more limited. But that's just my personal preference. Not even the Swiss have avoided economic turmoil.

In summary, I think the trend toward more saving and the paying back of debt will prove bullish for the US Dollar. But that is no glowing outlook for the future of the currency. It, like all other paper currencies, will eventually become worthless. If you are planning on saving money for a long period of time (ie. more than 5 years), gold is the ultimate currency in my mind.

2009 looks to be an interesting year in the Forex markets (okay, I could probably say this every year). I'm expecting to see more dramatic collapses in minor currencies (Hungary, Pakistan, Argentina, Vietnam - I'm looking at you) and wild swings in the majors. What effect will this have on gold and other commodities? I'll attempt to tackle that question tomorrow.

Tuesday, December 23, 2008

On Holidays...

I will be spending the holidays in Amsterdam. The remaining parts to the "Themes for 2009" will be posted in the days before and after the New Year.

Let me wish all my readers a happy holiday season!

Monday, December 22, 2008

Themes for 2009 - Part 2 (Macro Outlook)

A few years ago I attended a resource and investment conference in Vancouver where Dennis Gartman was one of the major speakers on a panel with some others. As is customary at these conferences, those who are known as “Gold Bugs” are the majority, while anyone else is a decided minority. Gartman dislikes gold bugs. But he was a gold bull for many years because he thought it was undervalued – hence, his invite to this conference.

But the topic of gold was not what stuck in my mind from that panel. The gold bugs were ganging up on Gartman on the issue of government and consumer debt. “It's all at record levels,” they claimed. “That can't go on forever!” But Gartman was a veteran. He'd been around commodity markets for decades. He'd heard these arguments since the 70's. “Consumer and Government debt has been at record levels for 20 years. Each time I hear that it can't go higher, it does. Why should now be any different,” he responded. (paraphrased)

To an extent, I agreed with Gartman. But surely, it couldn't go on forever. Eventually, all those years of debt not mattering would catch up to us. All of a sudden it would matter again. Cracks started to show in February of 2007, when subprime lenders started going under. Fremont General, New Century Mortgage, etc. The list began to grow. I remember being one of the first 100 visitors to the mortgage lender implode-o-meter website back in 2006. 37 million have since visited.

What began as a collapse in a tiny portion of the mortgage market started to spill over to the incredibly leveraged balance sheets of those who had invested in their securities. Credit was tightened. Home prices reacted by falling further. We learned that it wasn't just subprime paper in trouble. The market for all mortgage securities dried up. Hedge funds collapsed. Forced liquidations caused a further acceleration in all of the former. What we thought was a common cold turned out to be pneumonia. Pretty soon jobs started to be lost. Stock prices plummeted. The same problems emerged in Australia, New Zealand and Spain. Then the UK and Ireland. Then it was nearly everywhere.

All along we were told that the problem was nearly over and would not get worse by the most respected economists in the world. Just as we were told by the CEO's of major financial institutions that their financial conditions were “solid” mere days before going out of business.

“At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained.” Ben Bernanke, March 28, 2007.

“Clearly, no one’s got a crystal ball. So there’s always a possibility that there will be a downturn, always a possibility,” Paulson said. “But I don’t see it. I think we have a healthy economy in the U.S. You know, a year ago, when the growth rates were much higher, I was concerned. I said, ‘Is this going to be sustainable?’ Now I’m looking at it and I’m seeing a situation where it looks like we’re successfully making the transition. We’ve got a very healthy labor market.” Hank Paulson, March 5, 2007

Those were just two of the more appalling examples. But the idiocy was widespread. Even as 2008 rolled on, people were still debating whether or not the US would enter recession. Well respected TV personalities ruminated over “soft landings” and “cinderella economies” (low inflation, positive growth.) Even pessimistic economists tinkered with their 'probabilities of recession' forecasts (think Roubini). We found out a few weeks ago that the recession actually began in December of '07.

What couldn't go on forever stopped.

To me, the most important manifestation of this worldwide crisis is in the change in psychology and the resultant change in consumer behaviour. Previously, saving money was of no real use. Everybody “knew” that buying assets was the way to get ahead. Assets always rose or at least held their value. But that psychology has changed. Prices have begun falling, and people would far rather save their money or pay back debt than buy something that is falling in price. Banks appear to be operating on the same premise. Interest rates are so low, that lending money to someone makes very little sense. Additionally, banks are skeptical of what consumers intend to do with their loans. If they plan on buying a depreciating asset, then the banks see a higher risk in lending the money, because the collateral behind the loan may be less if and when the consumer were to default.

In other words, deflation seems to be self-perpetuating itself. The US Federal Reserve, Government and Treasury Department have already injected 3 Trillion dollars to the financial system in 2008. Foreign governments have added to that total substantially. Yet whether or not they give it to banks on loose terms or whether they give it to consumers directly doesn't seem to make much of a difference. Nobody can find an economic use for the extra money.

It is difficult to comprehend how much 3 Trillion Dollars is. Robert Prechter did an interesting analysis of previous government expenditures adjusted for inflation to try and grasp how big this 3 Trillion is. He concluded that 3 Trillion would have been enough to pay for all of the below:

The Louisiana Purchase
The Marshall Plan
The New Deal
The Korean War
The Race to the Moon
The Vietnam War
The S&L Crisis
The Gulf War
The War on Terror

World War II cost 3.6 Trillion in today's dollars.

Okay, so 3 Trillion is a lot of money. But it doesn't appear to be working. It just gets sucked up by the balance sheets of banks who hold hundreds of billions worth in derivative contracts that now, apparently, have little or no value. Don't fear. There has been an additional 5 Trillion earmarked for the same purpose.

Most believe that eventually banks will start lending again and people will start borrowing again, and the game will start all over. To me it is clear that this will never work. My reasons are that psychology has already been impaired and will not be repaired until two preconditions have been met:

1)Enough time has elapsed for people to forget about the crazy speculation of the past
2)Asset prices fall by a large enough degree that they reflect the average person's ability to purchase them with the fruits of their labour

To the first condition, there is nothing government can do. To the second, the best thing government can do is nothing.

Therefore, it is my belief that the deflation I have thus far correctly anticipated will be a continuing theme in 2009. Asset prices will continue to fall and credit will continue to contract – all against the wishes of our central bankers and despite their efforts.

This will have further implications for struggling businesses that have too high a debt burden. Airlines, commercial property operators, utility providers, and retailers are all going to have enormous pressures put upon them in 2009. General Electric is one company that I do not foresee surviving in it's current form.

Unfortunately, one of the easiest ways for these companies to buy themselves some time is to cut staff. We have already seen mass layoffs on a terrible scale. I believe it could get worse. Specifically, I have my eye on the US non-farm payrolls number for January (scheduled for release on February 6th.) January and July are months when the BLS (Bureau of Lies and Shenanigans) restates all of their numbers for the previous 6 months. Their continued usage of the birth/death model has made recent numbers look far better than they actually are.

The rapid decline in asset prices, slowing business activity and subsequent unemployment is going to have grand implications for the overall economy. As the year wears on, the “D” word (depression) will start to become more widely accepted. The consensus view for a second half recovery will be pushed back yet again as it becomes apparent that monetary stimulus is having little effect on the credit markets.

As can be seen, I am still pessimistic on the US economy. But also on the economies of it's trading partners. I was previously optimistic on the prospects for the Canadian economy, even though I thought we would see a recession. But the dramatic decline in commodity prices along with the impending decline in real estate prices will be developments that will weigh on the economy for all of 2009.

The European manufacturing sector seems to be suffering as well. Real Estate declines are accelerating which is likely to put even more strain on the troubled banking system. I am seeing increasing signs of civil unrest here in Europe. The nightly news in Germany is often filled with instances of mass demonstrations in various cities throughout the EU. Most notable of these can be seen right now in Greece. But as joblessness increases and budgetary strains occur at a disproportionate level across the EU, I wonder how the proverbial cookie can avoid crumbling.

Another problem area I see for 2009 will be China. Europeans and Americans will not completely stop buying cheap stuff, but they will buy less of it – regardless of the price. And that translates to job losses in China. We have already seen enormous declines in Chinese manufacturing growth, but further declines have been seen in electricity output. For the economy that was slated to “overtake America by 2020,” I am expecting the unthinkable for '09: economic contraction in China.

But perhaps more notable than the worldwide economic contraction will be the social aversion to materialism that is it's original cause. This is one area I see becoming readily apparent to most in 2009, as it was only something one would notice if they were looking for it in '08. A vehement avoidance of any outward expressions of wealth, excessiveness and risk-taking will be one of the major themes for the coming year. I see the average person, who will undoubtedly start to feel the effects of the contraction (if they haven't already), as setting their sights on who they perceive as the perpetrators of the crisis (anyone in large amounts of debt, bankers, real-estate agents, stock brokers, etc.) The social witch-hunt of sorts will result in lower executive salaries and, less discretionary spending, increases in the savings rate and surely other unforeseen consequences.

In subsequent parts I will discuss what implications this economic outlook may have on equity markets, commodities and major currencies.

Sunday, December 21, 2008

Themes for 2009 - Part 1 ('08 Review)

That was just one year? Really? Fannie and Freddie, AIG, Lehman, Bear Stearns, Merrill Lynch all went belly up or were bailed out in one form or another. The entire auto industry collapsed. Unemployment began to skyrocket. We learned the US was in recession for the whole year. Foreign markets collapsed. Commodity markets collapsed. Oil fell 73%. Shipping rates fell 90%. Central banks cut rates to 0%. Governments bailed out private corporations, sent tax rebates to consumers, went into massive budgetary deficit. Iceland became insolvent. We learned of the largest ponzi scheme in history. Russia invaded Georgia. Civil unrest in Tibet. Political unrest in Pakistan. Terrorist attacks in India. Obama elected president.

A year is long time.

Indeed, another year has passed and it is once again time to evaluate my performance over the previous year and start making rough sketches for the next. I typically go through this process on a bi-annual basis as I find it helps me “turn the page” on the past and look toward the future. This is why I began writing in the first place. I found that without writing my opinions down, I was liable to unconsciously change them to suit whatever was emotionally less painful. It is common knowledge that learning from past mistakes is the ticket to future success. But a prerequisite to that is for a person to be able to recognize and admit those previous failures. This goes for traders, investors, or anything for that matter. Publishing my thoughts gives me an inescapable glimpse of my past thought process.

At this time last year I wrote a 6 part series outlining my thoughts on what would happen in 2008. Some of it was laughable. Much of it turned out to be fairly prescient. Let's take a look.

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

Nearly all of this transpired according to plan. Some of it unravelled mid-year. However, if I were to only show you that, I would not be fully honest. Some of my opinions from last year were false. I did not foresee the precipitous drop in commodity prices, and I thought junior mining companies (TSX-Venture especially) would hold up far better than they did. To be fair, I was not a raging bull on commodities. I was expecting lower prices. But to say I was not surprised by the CRB index falling by 40% y/y would be a lie. Here are a few quotes from last year's preview:

“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.”

“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.”

(in regard to the CDN Dollar charts) “They are telling me that a bottom has been put in and the currency is now poised to challenge or surpass previous highs.”

Commodities were something that I had been bullish on for years. Therefore, I had attributed their rapid assent in price as a logical development. So while I rightfully felt that the debt bubble would come unglued at some point in '08, I wrongfully assumed that what was logically high in price would relatively outperform what wasn't. Gold behaved in this manner. Nothing else did. I was not able to make the distinction between the commodity bull market and the commodity bubble. As a result, I left some profits on the table, wasted more of my profits trying to “catch the falling knife” and in the meantime, I missed one of the better shorting opportunities we've seen in decades. I will try and learn from this experience and will hopefully not allow it to happen again. Where else could it manifest?

One area I have my eye on is the US Treasury market. I have been bullish on treasuries for a couple years now. The move over the last few weeks has been stunning. The US Fed has announced that they may start buying these securities as part of their Quantitative Easing programs. Are treasury traders and investors using the same logic as they were for oil in July? Are they using the Fed's intervention threat as justification for believing “prices can't go down?” Just the same as we were hearing “oil can't go down because of peak oil.” Will we all look back at the seemingly bizarre recent occurrence of the US Dollar falling/Treasuries rising as a very obvious hint of irrational exuberance?

What would that mean for the inflation/deflation debate? I've been firmly on the side of deflation. Would a sell-off in treasuries be signalling that the deflation trade is reaching it's end? I've also been very bearish on equities for years now. With stocks down 40% from their highs, am I overstaying my welcome on the dark side?

It all boils down to one question. Do the trends of 2008 continue, accelerate or reverse in 2009? In the subsequent parts of this series, I will attempt to attack that question.

Thursday, December 18, 2008

Extraordinary Arrogance From Central Bankers

I think Minyanville's Jeff Macke put it best yesterday when he said that Tuesday's Fed statement made Bernanke look more terrified than Matt Damon out of ammo at the end of Saving Private Ryan.

But not to be outdone, Bank of Canada Chief Mark Carney stepped up to the plate and specifically told banks to start lending more and to stop hoarding cash. Never mind that Canadians' job security is waning. Never mind that home prices in most major Canadian cities have started falling dramatically with still more supply coming on line. Never mind that our natural resource sector is contracting faster than anytime in recent memory. Forget about all of that. “What is clear to me is that there is unfilled demand for credit," said Carney.

I read this bit of news first thing in the morning. I had awoken from a strange dream where I was on a safari in Namibia - only the Jeep was being driven by a Lion and navigated by a Zebra. I wanted to go back to the dream. At least it was entertaining. The real world is disturbing.

What disturbs me the most, is the incredible amount of stupidity being displayed by Mr. Carney. Here is the man who holds more sway over the Canadian economy than anyone else. And he is advising more of exactly the same policies that got us into this mess in the first place. Perhaps it's not just stupidity. Perhaps it's arrogance. What Mr. Carney has essentially done is label the collective knowledge of every Canadian mortgage professional as worthless. That is stupid and arrogant.

Look at it this way. There are thousands of mortgage brokers around the country. They are all making individual decisions (more or less) about whether a certain credit applicant, be it consumer or corporate, is capable of paying back their loans. They all take in their knowledge about the applicant, their knowledge about the underlying economy, the amount the bank can make with interest rates at current levels and they make a decision. Currently their answer is no.

Maybe if Carney hadn't gone on a slash and burn campaign with interest rates, the banks may have found it more worthwhile to lend. Maybe not. We'll never know. But that's the point. No one person can ever know. Nor can some shadowy committee. It is the market that needs to be in charge of what interest rates are, whether banks lend, whether corporations borrow, etc. Only then can we expect some semblance of efficiency. When you put an entire economy in the hands of one person, is it any wonder that they will make mistakes?

Isn't that why communism always collapses under it's own weight of poor decisions?

Back to the article:

What Mr. Carney advocates is almost a Keynesian approach to banking, in which a buildup of capital in good times is used to fund lending in bad times. The argument is that it's similar to the government practice of using deficit spending to prime the pump in a recession.

Props to the Globe business journalist who actually knows what Keynesianism is. But I have to correct them. It's not "almost" a Keynesian approach. It is Keynesianism. Full stop.

In a speech to a business audience in Toronto, Mr. Carney warned about the “paradox of thrift,” which economist John Maynard Keynes coined to refer to destructive behaviour of individuals during a recession. At an individual level, people want to save more and invest less in a recession. But collectively, this makes things worse. Banks may decide to stop lending because they fear losses, but their behaviour exacerbates the downturn.

This is where Keynesians lose their marbles. Keynes always mentioned the "paradox of thrift" as the problem, yet never addressed the "paradox of extravagance" that inevitably precedes it. People and businesses can and do get too far into debt. And their paying back of debt - equivalent to saving - is the cure to this problem. To Keynes and his banking buddies, debt is a fantastic thing. The more the better. And the best cure for a debt problem is more debt. The Irish think the same way about drinking.

Keynesians have a problem distinguishing cause and effect. To them, history begins this morning. Nothing done in the past could possibly have any effect on today, and by extension, nothing done today can possibly have any effect on the future.

This kind of backward thinking is subscribed to by every central banker on the planet, every finance minister, and most economics professors. The credit crisis is not just about some bad loans. It is a reflection of the biggest ideological experiment the world has ever seen in economics. And it has failed miserably. One by one, these people need to be removed from public office and replaced with people of competence. There are thousands of Austrian economists waiting in the wings to clean up the mess the Keynesians have created. Mises.org is a collection of many of the brightest.

It's time people started listening to them.

Monday, December 15, 2008

Madoff Scandal A Microcosm of Social Mood

The controversy surrounding Bernard Madoff and his hedge fund scandal is a fascinating one, and I simply can't let it go without throwing in my own two cents.

For a backgrounder, take a look at Losses in Madoff Case Spread from the Wall Street Journal.

It seems like nearly everyone was in on the action. High profile charities, investment moguls, funds of funds, and major investment branches of European banks. Santander, BNP Paribas and the Royal Bank of Scotland are some of the bigger names taking hits. The total estimates of losses range from $17-50 Billion Dollars. This isn't chump change.

But what I find most amazing is the sheer stupidity and ignorance that investors in Madoff's funds displayed even as they knew that he couldn't possibly be providing the advertised returns with the published investment strategy. They all just trusted him, shrugged their shoulders and said, "Let the money keep rolling in." They didn't care where it was coming from. Please consider: I knew he was cheating. That's why I invested with him.

What could possibly bring a person to such incredibly flawed logic? Greed is the easy answer. But inflation is the real culprit. Desperate to provide a rate of return higher than inflation, investors were willing to do anything. They would give their money to the most undeserving people who could simply write a good proposal. No further investigation was done. Not even by the fancy investment bankers and their 6 (or 7) figure salaries. The higher the risk, the higher the return. That was the only language they understood.

But what interests me most about this recent development is how it aligns perfectly with socionomic and generational theory. In an unravelling or a period of high social mood (early-mid 80's until 2007) people are characteristically willing to take on higher levels of risk. They are willing to do anything to impress their neighbours or their friends. But as social mood naturally begins to ebb, and as a new generation rises to prominence, something changes with these attitudes. A rising level of skepticism of the previous era takes hold and it's values are rejected.

These kinds of events feed off each other. From personal experience, I know that when you see a cockroach, you have cockroaches. There will be many more Bernie Madoffs. It was not his incredible arrogance or greed that allowed this to go on for so long. Rather it was the social atmosphere of neglect that led nobody to question it. Until now. Now people are starting to ask questions. Is my mutual fund invested in what they say it is? Are they invested in the real asset, or in a derivative of that asset? How else did they manage such great returns?

This type of questioning leads to the inevitable social contempt of the entire investment world. "Ah to hell with it. They're all crooked," says the average investor as he writes his letter of withdrawal. Increasing political pressure will be put on pension funds to invest in "risk-free" securities only. Astute investors are graded on the proportion of their cash holdings, rather than their investments. This is the backdrop to the next leg down in the stock market that socionomic and generational theories are telling us will be coming with absolute certainty. Such a drastic change in social mood cannot be reversed quickly. It takes time for old wounds to heal. Disgruntled perceptions to forget. Balance sheets to be repaired.

This is why all efforts by government to "get credit moving again" or to provide "economic stimulus" are guaranteed to fail. Our collective social mood is not in a position to reverse. It wants blood. It wants to clean out the old excesses. It wants people like Bernie Madoff to point fingers at.

And that is precisely what we will get. But in the meantime, we have a Santa Rally to tend to. People are still willing to pretend that our problems are all behind us and that "the news is worst at the bottom." They're willing to ignore horrible reports like:

Corporate, Government Borrowing Drops 75% in 3rd Quarter.
Chinese Industrial Output Growth Slowest Since 1999; Electrical Output falls by 9.6%
Japan Business Sentiment in Biggest Dive Since 70s

After the New Year, I wouldn't be surprised to see these negative reports start to make an impact again. Combine that with Q4 earnings that are going to be terrible (note estimates were reduced from +10% to +5.9% last week) and a slowing optimism that Barack Obama will be able to make it all better, and we will have a recipe for another January swoon. But we'll have to see. I'm typically early to major turns in the market. I'm watching a few technical levels to see what kind of legs this rally may or may not have.

All the best,

Thursday, December 11, 2008

Time for a Santa Rally?

As negative as I've been on the markets in the intermediate to long term time frames, I've been more constructive over the short term for the last 3 weeks. While in transit to Germany I took a flyer on UYG, the double long US Financial ETF. Seeing it double over the next few days, I booked the quick profits. Additionally, I've been trying to take my own advice on some of the relative strength plays that I mentioned back in November. The only one of those I managed to take was EBS, but some of the others have performed well also. It should be a further reminder to those looking for bargains the next time the market swoons: Buy what isn't falling, not what is (depending on your time frame, of course.) Here's the performance of those stocks since the morning of Nov 12:

S&P 500: +2%
EBS: +26%
ACM: +67%
INSU: +47%
TSP: -4%
ECH: -12%

Clearly, a basket of relatively outperforming stocks continues to perform better than the broad market on sustained rallies.

I'm expecting this current strength to continue, but am not really confident enough at these levels to be adding more long exposure. Nevertheless, there are a few factors that suggest to me that this rally could continue. First, the plethora of bad news has not been met with further selling (ie, last week's employment number). Usually when that happens, it is a precursor to a stronger rally. Second, the "performance anxiety" factor among institutional fund managers could perpetuate a rush into year-end to make yearly performance numbers not as bad as they otherwise should be. Third, there is still a large amount of optimism toward "our saviour, the messiah," President-Elect Obama and what he will do to "fix" the economy. This is, of course, laughable as we know that economic policy cannot fix the world's derivative mess, debt addiction and consumer excessiveness. Nor can it prevent the cures of bankruptcy and risk-aversion from taking hold. But perception is greater than reality in a world of flashing numbers. I'm always mindful to never underestimate the irrationality of masses, rather to use it to my advantage.

As such, I will be using this rally to lighten up my long exposures. When it feels right, I'll start raising cash and even begin establishing some aggressive short positions. I'm looking at the levels of S&P 500 954 and 1008 as resistance levels. It is my feeling that once this rally exhausts itself, the ensuing leg down will be shocking in it's magnitude.

On another topic:

Some readers have been asking me to address recent comments by some high profile people about a coming "crisis" on Jan 21 or 22. For more information, listen to Colin Powell: "There's going to be a crisis come along on January 21st or 22nd that we don't even know about right now. (About 2:40 in) Or Joe Biden: "Mark my words. It will not be 6 months before the world tests Barack Obama like they tested John Kennedy...Watch, we're gonna have an international crisis, a generated crisis, to test the mettle of this guy...I guarantee you it's going to happen"

Now, when crazy scientists tell me an asteroid is going to crash into earth and kill us all, like they did a few months ago, I tend to disregard it. When some obscure historian tells me the world is about to end because of a Nostradamus text written 3000 years ago, I pay it no mind. But when a former Secretary of State and General, and the Vice-President Elect are both warning of some societal crisis with no details, I tend to wake up at 3 A.M. in a cold sweat.

I must say that I am not encouraged by the sights of the growing unemployed. I just saw footage on German News of last night's simultaneous presence of riot police in Athens, Rome, Madrid and Copenhagen. Our leaders are constantly encouraging the creation of "global financial regulation." This entails the creation of a global governmental organization to which we are expected to yield our sovereignty to. Perhaps that is what British PM Gordon Brown refers to when he mentions the "New World Order" 9 times in 2 mintues. He's not the only one.

But these things are not new. Riots have been happening for centuries. Leaders have attempted power grabs since the beginnings of civilization. It is our collective negative social mood that subliminally makes us more aware of it now. And it is the same subliminal nature of this change in social mood that has encouraged past societies to accept all manners of tyranny to stem it's effects. Hitler, Mao, Lenin, Pol Pot, and countless others have been accepted in times of economic crisis. It is imperative that we learn from our mistakes of the past. We cannot allow our leaders a blank mandate to "fix" our problems. Even the most well-meaning leaders have been corrupted by this power (ie. "absolute power corrupts absolutely.") Whatever acceleration of this crisis awaits us, we must resist any proclimations of, "desperate times call for desperate measures." We've been there. We've done that. And we've seen the destruction that inevitably results from it. Will we learn from history, or will we be just another example of "history repeats itself" in the textbooks our grandchildren will read?

"Societies willing to trade their freedom for temporary security deserve neither and will lose both." - Benjamin Franklin

Saturday, December 6, 2008

On the Cusp of a Deflationary Depression

A year ago, you would have to be a 'sociopath' to even consider the possibility of a Great Depression-like downturn in the economy. Now, you must merely be a 'negative person.'

Staying consistent with my imperviousness to other's opinions, and more with my interest in being correct and it's associated wealth benefits, I must be perfectly honest with you, Dear Reader: We are on the cusp of an economic calamity that rivals only the Great Depression in modern history, or the near simultaneous bursting of the South Sea (Britain) and Mississippi Scheme (France) bubbles of the 1720's.

To such a statement, there are, doubtless, many popular objections. Unfortunately, most of those objections are baseless. They rest on nothing more than the author's underlying wish that it weren't true. That it was all a dream, soon to be forgotten. And who can blame them? Don't we all wish that it weren't true? Even I wish it weren't, and I am personally benefiting from the carnage (relatively and nominally). But if I expand things a bit, to see family and friends losing their wealth and livelihoods, society crumbling around me, and heightened geopolitical issues - I still lose.

So please keep in mind that I bring you this most dire news not out of personal interest. But rather as a messenger of truth in a world of misinformation, obfuscation and outright propaganda.

Also keep in mind that this will not be "the end of the world," or "armageddon." We will not go back to living in caves and hunting and gathering for survival. The world will still go 'round and 'round. The same places will be beautiful. Children will still laugh. There will still be gatherings of friends and family for weddings, birthdays, anniversaries, etc. Making love will still feel good, food will still taste good, fresh air will still smell good. If anything, we will learn to appreciate these things more, as our obsessive materialism is what is really under attack.

There are many objections to my views. Most of them involve manipulating statistics to give a result their perpetrator is looking for. Let me disassemble them one by one, rather than addressing them all at once.

Stocks Are Cheap!

The first mantra sung by many analysts is that "stocks are cheap" on a historical basis. One example of this came from a UBS analyst this week reported by Bloomberg.:

Global stocks will withstand a “full-blown” recession and surge in 2009 as cheap valuations and efforts by governments to restore confidence in the financial system lure investors back to equities, UBS AG said.

The Standard & Poor’s 500 Index, which tumbled 42 percent to 848.81 this year, may rally 53 percent to 1,300 by the end of 2009, David Bianco wrote in a note dated yesterday. The New York-based strategist, who a year ago predicted a 2008 advance of 16 percent for the S&P 500, is now forecasting a gain that would exceed the index’s best annual performance on record.

The U.K.’s FTSE 100 Index may increase 41 percent from yesterday’s close to 5,800 in 2009, while the FTSEurofirst 300 Index may climb 25 percent from current levels, Zurich-based UBS said in separate notes.

“The consensus outlook for 2009 is a full year of gloom,” Bianco, 33, wrote in his 2009 market outlook. “We believe 2009 will bring signs of a dawn in confidence with the first faint light appearing earlier than most investors expect.”

UBS, Switzerland’s largest bank, is more bullish on stocks than some of its Wall Street rivals. Citigroup Inc.’s chief U.S. equity strategist Tobias Levkovich last month cut his 2009 forecast for the S&P 500 to 1,000 from 1,300. New York-based Morgan Stanley said this week that European stocks are likely to be little changed in 2009.

My first objection to this article is that it is self-contradictory. On the one hand Bianco claims "The consensus outlook for 2009 is a full year of gloom." Yet in the very next paragraph, two of the biggest financial institutions in the world give their expectations for higher or little-changed stock prices in 2009. The consensus view is absolutely NOT for a full year of gloom. The consensus is for a second half recovery - as evidenced by forecasts by central banks, governments, and financial institutions around the world. Right off the bat, this 33 year old hot shot (am I allowed to say that yet?) is talking out of his arse. The only gloomy consensus can be found on the internet from realistic bloggers such as myself - hardly big players.

Next, Bianco claims "cheap valuations" for his reason to see a 53% rise in stock prices. I suppose those cheap valuations were the same reason he forecast a 16% rise for this year, but that's besides the point. Where is he getting that information? What multiple is he looking at to determine that stocks are "cheap?" Where else, other than his own forward earnings estimates.

Analysts like Bianco are still expecting earnings increases for the fourth quarter of 2008 and for all of 2009 to draw these conclusions. Yes, you read that right. Analysts are still forecasting higher profits for the current quarter Oct-Dec compared to last year, and are doing likewise for every quarter of 2009. Don't believe me? See for yourself. These are the same people that forecasted 25% higher profits for every single quarter of this year and proclaimed the whole way down that "stocks are cheap" based on those massively flawed assumptions.

So they are making up the "E" portion of the P/E valuation to reflect their own wishes and dividing it by today's price. This gives them a valuation somewhere around 11. They then use that in comparison to a ridiculously short historical time sample (5 or 20 years) of which is itself historically high (around 19) to determine - are you ready? - stocks must rise 50% to get back to "normal."

It is simply unbelievable that these "analysts" are allowed to apply their circular logic and still be afforded the airwaves to spread the message. Ancient societies had a name for these types. They called them "alchemists." And if they weren't first imprisoned for their blasphemy, they usually ended up poisoning themselves by trying to turn lead or mercury into gold. We give them six figure salaries and monthly TV spots.

The Statistics Show That This is Nothing Like the Depression

Earlier this week, Chairman Bernanke gave another speech Let's take a look:

Federal Reserve chairman Ben Bernanke said Monday the current economic situation bears "no comparison" to the much deeper crisis of the 1930s Great Depression.

"Well, you hear a lot of loose talk, but let me just ... say, as a scholar of the Great Depression -- and I've written books about the Depression and been very interested in this since I was in graduate school, there's no comparison," Bernanke said in a question period after an address in Austin, Texas.

Bernanke cited "an order-of-magnitude difference" in the current situation compared to the 1930s.
"During the 1930s, there was a worldwide depression that lasted for about 12 years and was only ended by a world war," he said.

"During that time, the unemployment rate went to 25 percent, at least, based on the data that we have. The real GDP (gross domestic product) fell by one-third. About a third of all of the banks failed. The stock market fell 90 percent."

Bernanke said the situation at that time represented "very difficult circumstances," because "we didn't have the social safety net that we have today. So let's put that out of our minds; there's no -- there's comparison in terms of severity."

To start on this, we must qualify Bernanke's own qualification. Bernanke is a student of the Keynesian version of the Great Depression. Other, far more legitimate economists, have differing views as to what caused the Great Depression. Bernanke holds that it was caused by a lack of quick response by the Fed in pumping the money supply, the gold standard and an "ill-advised" defense of the US Dollar's gold reserves by raising interest rates in 1931. He outlined his view succinctly in a 2002 speech to Milton Friedman and Anna Schwarz that can be found here. He finished his speech with this line:
Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.

I, and many other notable economists disagree with Bernanke's (or Friedman's) assessment of the GD. Indeed, it was caused by the Federal Reserve, but not for the reasons they state. Rather their very existence and manipulation of interest rates through the 20's caused the bubble. Socionomists would argue that it was simply time for a contraction because social mood had begun to reject the previous decade's excessiveness. Generational patterns would suggest that anyone old enough to remember the pain of the 1850's depression was dead and gone - allowing for the crazy levels of speculation. In my opinion, those arguments make far more sense than Bernanke's "We didn't do enough and being restricted in our abilities by gold is the cause" mantra. But I digress.

Bernanke confidently proclaims that because unemployment statistics, production statistics, or growth statistics are not as bad as they were at the worst depths of the GD, then we can't possibly be in a similar situation today. Bernanke could have added one word to this proclamation, and I would have left him alone: "Yet." But he doesn't appear to understand the severity and continuing weakness in economic indicators. Indeed, I can be reasonably sure that at some point in 1930, unemployment was nearing 10%, GDP had just started to contract, etc. That didn't mean a depression wasn't on the way. Just because our economy is bad, does not preclude that it cannot become worse. Bernanke seems to disagree, instead pointing to his own superpowers in being able to stop the oncoming train.

Let's review the current situation:

Retail Sales Suffer Worst Drop in Four Decades
Manufacturing Contracts to 26 Year Low
Philadelphia Fed Index Drops to 18 Year Low
Non-farm Payrolls Fall to 34 Year Low

I don't think anyone is arguing that the current situation is similar to the worst years of the Great Depression. But this is what Bernanke is saying is erroneous. What the "loose talk" Bernanke refers to is actually saying, is that the current situation and the dismal prospects of improvement suggest a similar event is possible.

In 2002, Bernanke promised Milton Friedman that nothing like the Great Depression would ever happen again. Six years later, Bernanke's entire life's work as a GD historian is being tested.

Anyone want to bet against him defending it do his death? Why should we listen to someone who has so much personal and ideological interest in a rosy outcome?

Coordinated Intervention Will Soon Trickle In/ Hyperinflation

Next up in defense of continued prosperity comes the argument that Trillions worth of global government initiatives, interest rate cuts and asset purchases by Central Banks will soon start to make it's way into the economy, and the next boom will closely follow. This argument is closely associated with the "imminent hyperinflation" that is set to lift asset markets as the currency is devalued.

This is nonsense.

Hyperinflation cannot and will not occur under the current set of circumstances. In order for expansion of the money supply to occur, there needs to be an effective use for that new capital. The central banks can issue all the new money or credit they wish. They can give it to banks for free, or "drop it from helicopters" on street corners. But if consumer's and bank's best idea of what to do with that capital is to either "save it for a rainy day" or to "pay back debt," then the net effect on the money supply will be, effectively, nil.

Consumers and banks are reacting differently to the same old (and many new) policies of economic stimulus. This is happening because asset prices are falling simultaneously around the world without exception. This asset price deflation is not something we've experienced since the late 30s. As a result, lenders have no good reason to lend, and consumers have no good reason to borrow. They'd rather save, pay off debt, fix their balance sheets, and wait for prices to fall further. But what is causing it?

Why would this happen? Neither consumers nor banks have acted like this for decades. They've always just spent their way further into debt or loaned out money without much care. Why would they stop now? Why has this crisis not just blown over like the oil shocks of '74 or '79, the inflation scare of the early 80's, the '87 Crash, the S&L Crisis, the Asian Currency Crisis, LTCM, the Dot.com collapse, or 9/11? This is where things get a lot more complicated and we need to dig deep to find the root causes of this shift. In order to understand why people make the decisions they make, we need to study people. And that is what I think I do best. It is how I first became interested in economics. I was a people watcher. I would watch and compare how people acted and reacted in the different corners of the world that I traveled to.

There are two theories I have encountered that explain economic cycles in a very unorthodox manner. They both revolve around the study of people, and how they act in groups in a very long-term cyclical manner. It can be argued that both theories feed off each other.

Socionomic Theory: Socionomics revolves around the study of social mood, and how that social mood eventually manifests to asset markets, social preferences, political preferences, willingness to go to war or befriend other nations, etc. Common ideology says the opposite is true and that social mood is a reflection of events. The amount of evidence in favour of the former is overwhelming. The theory holds that social mood oscillates between optimism and pessimism over many decades, sometimes reaching levels of extreme. According to adherents to this theory, social mood in the western world reached an apex during the dot.com boom and proliferation of "new paradigm" thinking at the turn of the millennium.

The resultant dot.com crash, and heightened "terror" paranoia, were evidence that a first wave down in social mood had begun. We then had a "correction" in social mood, during which all manners of speculation, "make it or break it" mentality, and materialism ruled the day. And we are now in the midst of a second wave down where those old social values are under attack. The reflection of this social shift is the credit crisis. Not the other way around.

For more information on socionomics, visit:

Generational Theory: Generational Theory also holds that this type of panic was completely foregone. As all of the old hands of the Great Depression moved out of the front offices of financial firms and government, younger generations moved in and began making the same mistakes the older generation had promised they would "never again" make. There are 4 different generational archetypes that typically behave similarly based on the conditions they were raised in: either a "crisis era," a "high era," an "awakening era," or an "unravelling era." Each era and each generation typically last between 15-25 years, and every person will inevitably live through every type of social change in their lifetime. Each era has a lasting effect on their respective generations.

According to the theory, people's actions (in groups) are incredibly predictable when looked at through this lens. The theory checks out with over 500 years of backtesting and only one aberration during the US Civil War. It has been successfully applied to many other civilizations as well, suggesting further that human action is more pre-determined that we may think. And it has been found that ancient civilizations used this same method to anticipate social changes.

For more information on Generational Theory, visit:
Generational Dynamics
The Fourth Turning

Combined, these two theories provide enough evidence to convince me that no amount of "government stimulus" or "pumping of the money supply" will be enough to overcome our enormous social revulsion of indebtedness and consumerism.

"You can bring a horse to water, but you can't make him drink."

Currently, central banks around the world are trying to force society to drink. That is a keystone to their Keynesian economic doctrine. That when the economy becomes so overburdened with debt, giving it a little bit more will fix everything. And indeed, that works for quite a long period of time. If social mood is at a point in it's cycle when it is willing to, and if there is a willingness among the current generation to go further into debt, they will. And then there is situations like today's where they won't.

To put everything another way, our older and more numerous generations need to sell their assets to younger, less numerous generations. This natural selling pressure is driving prices down to where younger generations are willing and able to pay for them. But there is a sudden affliction among this younger generation toward unsustainable homeownership, of symbols of wealth, and of anything that epitomized what they saw as a crazed scheme to get rich quick.

So prices will continue to fall, the psychology of deflation will entrench itself further, and an economic depression will be the result. Until enough of the excessiveness has been bled out of the system for it to regenerate itself.

How Should Policy Makers React?

The single best piece of news on the economy I could find was this headline: "Parliament in Canada Prorogued" I don't say this because I was a supporter of the Conservative Party - far from it. But I am of the opinion that the less government tries to stop the unstoppable, the better for the long-term health of the economy. In fact, my initial response to the news was, "Can we make it permanent?"

This may seem mean-spirited toward those that will inevitably be losing their jobs over the next few years, but those job losses are foregone. They will either come now or later. And if government funding is the only thing lending them legitimacy in between, society is no better off in the long-term. Think of it this way: If you were marooned on an island and only had a small amount of food with you, would you eat that food right away, or wait until you were nearly starving to start pecking away at it?

We only have so much "capital" that can be used, just like the stranded person in the wilderness only has so much food. A smart outdoorsman would immediately start looking for alternate food sources, make a strategy to survive through rainy season, and maybe even start building a raft. A panicky tourist would eat all his food and start swimming toward land. Who's got the best chance for survival?

We need to preserve our available capital for when times get really tough, we need to re-tool our manufacturing industry to make things we need (resource efficiency, medical advancements) and encourage investment from outsiders by maintaining a strong currency and sound banking system. If we use all of our capital now at the whim of political gamesmanship, we might not make it through rainy season to spring, when our chances of being rescued are far greater.

The best thing our government could do is cut as much of it's discretionary spending as possible and lower taxes. Any bailouts, stimulus packages, or spending initiatives will put us in a weaker position to emerge from this crisis strongly.

Again, I'd like to urge readers not to fear this coming depression. It doesn't mean the world is ending. It is just one point on a cycle. It can either be viewed as the end of the last cycle or the beginning of the next. Perspective is everything.

Comments appreciated.

Thursday, December 4, 2008

Update on Gold

Back in early September I wrote an in-depth analysis of the gold market. My working thesis was:
"...I believe the most likely outcome for the precious metals markets is to be for a fairly prolonged period of stagnant prices. This period would likely be accompanied by relative underperformance of other asset classes due to the financial problems that will persist in the global economy. This process has been underway for the last 6 months (dating from the March 08 high) and may persist for as long as another 12 months. After such a period, the technical and psychological components to the precious metals markets will be more amenable to another multi-year period of rapidly rising prices."

So far, three months later, this thesis is playing out as gold has been bouncing between the $650-900 range I had projected.

I don't remember ever getting more hate-mail from something I have written than after this article. And that only further confirmed my opinion that gold was likely in a phase where there was too much bullishness, and that needed to be slowly bled out of the market before higher prices could prevail. Another indicator of too much bullishness is the apparent premium people are willing to pay for small denominations of coins and bars on EBay, when they could simply take delivery on a futures contract at a steep discount. On Monday of this week, we saw a stomach wrenching decline in all assets, gold included.

There are some very interesting technical things to look at with gold, primarily how it has been reacting to it's 200 day EMA. It bounced cleanly off that line a number of days ago and now looks like it wants to test it's low of $681 (which was a clean bounce off the 200 week EMA.) I don't think that level will hold and we could see gold prices in the $600-650 range in fairly short order. This would be in reaction to the growing deflationary pressures in the economy, and another bout of strength in the US Dollar. I am adjusting the lower range of my thesis to allow for a potential 0.618 fibonacci retracement of the entire bull move from $255-1033. That would give a worst case scenario of $552 on the downside. A 50% retracement of the entire move is $644. So my lower target range is between $552-644. I think the declining 200 day EMA should do a decent job of containing any upside thrusts (currently at $831.)

I continue to believe that gold is in a multi-month corrective phase that could last until the summer/autumn of 2009, but is in the middle of a super-cycle that will eventually take it much higher. There will be both large rallies and breathtaking declines during this period, all trying to shake out every last believer in the usefulness of gold. If you are a holder of physical gold or silver, I see no cause for alarm. The fundamental reasons for owning it as a portion of your assets still remain - and always will. However, I would not be making speculative bets on the rapid rise in price over the near term.

I still remain a fundamental gold bull. And other bulls should be reminded that relatively, it has outperformed every other asset class except US Treasuries or Japanese Yen year-to-date. Although that may not be of any consolation to holders of gold mining stocks, holders of bullion are still doing okay this year. If the price were to drift down toward the $552-644 range I mentioned, and the premium charged to buy it was to come down to more reasonable levels, I would consider increasing or initiating positions in the metal - especially if such weakness was part of a broader deleveraging panic in other markets.

Monday, December 1, 2008

Will Quantitative Easing Work?

Much has been made recently about the theme of quantitative easing. What is it? In short, quantitative easing (QE) is a central banking policy tool used when the rate of interest falls so close to zero that further reductions are either impossible or are having no effect on stimulating the economy or preventing deflation. The central bank is to create money (electronic money) out of thin air, and use it to buy government securities, although it could conceivably be used to buy anything. Done by any other person, this is a process known as "counterfeiting," but that is the very nature of our central banks. This is what Fed Chairman Ben Bernanke was referring to in his famous "helicopter" speech back in 2002, Deflation: Making Sure "It" Doesn't Happen Here.

It is a tool first used by Japan earlier this decade to stave off deflation, and has been, to say the least, a miserable failure. Why did it fail? For one, the money that was injected into the Japanese banking system didn't stay in Japan. It went elsewhere, fueling "carry trades." Secondly, the Japanese population was rapidly aging and asset prices were too high. They needed to fall further - and indeed they have. Lastly, deflation is partly a psychological condition. People in Japan knew that the inflated values of Tokyo apartments would fall further, so they were far better off to save their money and rent.

In his 2002 speech, Bernanke laid out his reasons that the Japan experiment with quantitative easing would be different from any American attempt.
The claim that deflation can be ended by sufficiently strong action has no doubt led you to wonder, if that is the case, why has Japan not ended its deflation? The Japanese situation is a complex one that I cannot fully discuss today. I will just make two brief, general points.

First, as you know, Japan's economy faces some significant barriers to growth besides deflation, including massive financial problems in the banking and corporate sectors and a large overhang of government debt. Plausibly, private-sector financial problems have muted the effects of the monetary policies that have been tried in Japan, even as the heavy overhang of government debt has made Japanese policymakers more reluctant to use aggressive fiscal policies (for evidence see, for example, Posen, 1998). Fortunately, the U.S. economy does not share these problems, at least not to anything like the same degree, suggesting that anti-deflationary monetary and fiscal policies would be more potent here than they have been in Japan.

Second, and more important, I believe that, when all is said and done, the failure to end deflation in Japan does not necessarily reflect any technical infeasibility of achieving that goal. Rather, it is a byproduct of a longstanding political debate about how best to address Japan's overall economic problems. As the Japanese certainly realize, both restoring banks and corporations to solvency and implementing significant structural change are necessary for Japan's long-run economic health. But in the short run, comprehensive economic reform will likely impose large costs on many, for example, in the form of unemployment or bankruptcy. As a natural result, politicians, economists, businesspeople, and the general public in Japan have sharply disagreed about competing proposals for reform. In the resulting political deadlock, strong policy actions are discouraged, and cooperation among policymakers is difficult to achieve.

In short, Japan's deflation problem is real and serious; but, in my view, political constraints, rather than a lack of policy instruments, explain why its deflation has persisted for as long as it has. Thus, I do not view the Japanese experience as evidence against the general conclusion that U.S. policymakers have the tools they need to prevent, and, if necessary, to cure a deflationary recession in the United States.

Boldface mine.

As can be easily seen, the problems facing Japan in the 90's that Bernanke referred to as different from the US, are now strikingly similar 6 years after Bernanke's speech. Yet he is persisting in the same policies anyway. I'm reminded once again of Einstein's definition of insanity (as I am almost daily): "The definition of insanity is doing the same thing over and over, yet expecting a different result."

Bernanke is clearly insane.

Similarities with Japan aside, others have pointed out for years that because the US Dollar is the reserve currency of the world, deflation is impossible in America. To that I would simply argue that it's reserve status can easily change. Regardless, it should be readily apparent that the US (and the UK - soon to be followed by the EU) is in deflation now. If you read Bernanke's full speech and the tools he said he would use to conquer deflation, it would also be readily apparent that Bernanke himself knows America is deflation (although he may not want to publicly admit it for self-perpetuating psychological reasons.)

So what now? Does America suffer from 18 years of alternating stagnant growth and deflation like Japan? Do they suffer the brutality of a 1930-33 style 10% a year deflation? Maybe it will be something in between, maybe something different entirely. There's not much on the precedent side of things when it comes to deflation - one of the few astute observations made in Bernanke's speech.

The only thing I know for certain, is that if left alone, the economy would heal itself much quicker than with all of this tinkering.

Canada's Opportunity in Crisis

Below is a copy of a letter I sent to my member of parliament, Andrew Saxton of North Vancouver. To be clear, these are not policies that I would say are acceptable from an Austrian Economics perspective. However, given the political situation in Canada, we are faced with making less than perfect decisions or having a socialist coalition takeover of the country's legislature. Gun to head, I choose the former.

I also want to point out that these policies would most definitely not work for larger economies like the US or EU. But Canada's unique position as a resource based economy enable them to take these bold measures without the disastrous effects of its potential failure.

Canada's Opportunity in Crisis

Albert Einstein once wrote that the definition of "insanity" was doing the same thing over and over again, while expecting different results.

If he were alive today, he would have to look at the collective actions taken by governments around the world to stem the financial crisis, as nothing other than insanity. Most economists seem to agree on one thing: individual people and governments were too heavily indebted for their own good. And the "credit crisis" is the economy's way of saying "please, no more."

Yet nearly every mainstream economist's "solution" to this problem is for government to provide "stimulus." They feel that if banks would lend to each other and then to businesses and individuals, the economy will reignite itself. This is akin to a drug addict in withdrawal claiming one last hit will make him better again. Since August 16th, 2007, the United States Federal Reserve has been lowering interest rates. The Bank of Canada and other foreign central banks were quick to follow suit. Since then, central banks have created an alphabet soup of lending facilities. The US Treasury and foreign governments have conducted trillions worth of bailouts of financial firms. And now, like clockwork, other failing industries are lining up at the doors of government for their own bailouts. All of this is being done in the name of "getting credit to flow again." Yet, dozens of initiatives notwithstanding, credit markets worldwide remain closed to most, prohibitively expensive to the rest.

It is clearly not working.

The Credit Crisis is a Symptom of a Greater Disease

The reasons for this "failure to reignite" are many. To start, people and businesses have become psychologically averse to debt. Catchphrases of the past few decades like "utilizing economies of scale," and "leveraged ideas," have become ancient relics of a bygone era. And it has happened seemingly overnight. The principles of economics taught in the best business schools of the world over the last few decades have ceased to function. Commonly believed investment mottos like, "buy and hold for the long term," or "over time, real estate always goes up," have evaporated. In response, policy makers and economists, are asking the wrong questions. Instead of asking "why?" They are asking, "how can it be made better again?"

What if they were to ask "why?" They would find that the answers are far less complex. Asset prices worldwide are falling in tandem for the first time in nearly 80 years. In other words, they are perplexed by a phenomenon only ever experienced by geriatrics: Deflation. Who in their right mind would borrow money to buy an asset that most believe will be falling in value over the near to intermediate future? What bank in their right mind would lend to a person or business with such an ambition? Deflation is at the heart of why current monetary policy has been a miserable failure.

At the root of deflation is more than just falling asset prices. Falling prices are yet another symptom. The total supply of all money and credit in the world, despite the re-inflation efforts of central banks, is declining. And the velocity of that money being deployed in the economy is decelerating, as holders of capital elect to "hoard" rather than "deploy" their savings.

There is yet another deflationary force at work that is beyond the control of any monetary policy maker. And that is the force of demographics. Collectively, the "Baby Boom" generation (defined by most as being born between 1942 and 1961) are entering retirement all across the western world - accounting for half of world GDP. It is likely not a matter of coincidence that the first of this generation hit retirement age (65 years old) the same year our present crisis began in 2007. This entire generation had planned to liquidate their savings of stock, bonds and real estate over the next 15-20 years. And it should have come as no surprise to us that at the first hint of falling asset prices, this generation greeted us with panic selling.

Unfortunately, our younger generations are not only less numerous but they are in poorer financial condition (burdened by student debts) than their parents and are in no position to pick up the slack in terms of asset accumulation or consumption. Additionally, there are socionomic signals suggesting our younger generations are rejecting the materialistic values that have buoyed our economy for decades. One such blatant example would be the international "Buy Nothing Day" scheduled for November 29, 2008. Whether this kind of event makes any impact is irrelevant. It is the overall trend that is important, and that trend shows that consumption is progressively becoming "less cool" in the minds of our younger generations. Considering most western economies depend upon consumption for anywhere between 60-70% of GDP, this is a trend we would be wise to note seriously.

If the reader is to have any remaining doubts that we are in the grasp of an enormous deflationary spiral, let me communicate it on some other terms. As of May, 2008 the total world market capitalization of stock markets was US$57.5 Trillion. By the middle of November of 2008 that total had fallen to nearly $30 Trillion. Conservative estimates put total "developed economy" residential real estate assets close to US$80 Trillion. This would not include the massive property bubbles seen in the BRIC economies. Conservative estimates of "developed economy" commercial real estate assets are near $30 Trillion, corporate bond issuance near $20 Trillion, etc. It is not unreasonable to conclude that the current crisis has wiped out many dozens of Trillions in assets worldwide. Yet most economists and policy makers persist in believing that just a few more hundred billion in "stimulus" will make everything better. They all amount to mere drops in the proverbial bucket. The only things being "stimulated" are the egos of their proponents.

It is a grand illusion that this deflation can be stopped. And the only other excuse for these wasteful actions are that to believe if confidence is restored, all can be well again. Knowing the above uncontrollable contributors to the situation, we can only conclude that such hopes are misguided at best, foolhardy at worst.

How Did it Come to This?

The origin of all financial cycles stem from the environment in which it's oldest generation was raised. For us, that generation is what is known as the "Silent Generation." Silent because they grew up during the Great Depression and WWII with very little ability to complain. Their fathers often jobless, then sent overseas to war. But what is often referred to as the cause of this crisis, US Subprime Lending, is once again little more than another symptom of a process that was set in motion during our last major crisis - the Great Depression. In the desperation to stem the depression, numerous entities were created by the Hoover and Roosevelt administrations in the US, the Bennett and King governments in Canada. Most notable among these entities was Fannie Mae in the US (1938). Fannie Mae was created to stimulate home ownership and it did just that. Artificially increasing the demand for houses, prices naturally rose. This was done on a fairly small scale for decades as cautious lenders were loathe to make the same mistakes they had in the late 20's.

But once the Silent Generation, the only remaining generation with remembrance of that era, moved out of government and out of the front offices of financial institutions, the same reckless type of financial engineering that led to the Great Depression began anew. Of course, this time it was different - but it was the same. What were the trust holding companies of holding companies like the Shenandoah Trust Co. in the late 20's became derivatives like Credit Default Swaps (CDS) of today, and what was 10:1 leverage on stocks in the late 20's became the Subprime Lending for Real Estate of earlier this decade. Only the names are different. The concept was the same. Insane amounts of leverage backed by an asset with little or no intrinsic value.

What would lead lenders and borrowers to such reckless pursuit of high returns on their capital? Greed? Partially, yes. But that is the easy answer. The real motive for this is far more multifarious. Primarily, the urge to attain such large gains at any risk is due to the effects of inflation. The constant pumping of the money supply by central banks discourages people from saving and encourages them to buy things that they perceive to be perpetually rising in value - real estate, stocks, fine art, etc. Government mandated inflation targets are what cause fits of speculation. For if your money is simply sitting in a bank account, you are losing purchasing power. This process has a long perceived illusion of prosperity attached to it. For if my net worth, diversified among asset classes, is rising by a few percent every year, I will "feel" richer, even if my money is able to buy less and less. But eventually, this cycle reaches a peak. Prices can no longer rise because of any number of reasons - demographics being one of them.

The solution to this problem is pretty self-evident. Eliminate the mandated inflation targets set by central banks, and the magnitude of the boom/bust cycle will be dramatically reduced. But this is only a partial solution, and there are many more which I will spare the reader of right now. Policy makers are very disinclined to be thinking of preventing an economic crisis 30 years from now, while there is a crisis now, begging for attention.

The Entire Concept of "Money" Has Changed

Starting in 1971, in conjunction with President Nixon's closing of the gold window and the Bretton Woods agreement, there was a major shift in government's views toward their own domestic currencies. No longer did a strong currency translate to a strong economy. In fact, the opposite became true. Central banks began competitively devaluing their currencies to gain an advantage in the markets for global exports. This process has accelerated over the last few decades to the extent that many large economies have simply resorted to "pegging" their currencies to the US dollar to prevent a rise in the value of their own currency.

The US has had the luxury of being able to issue their currency and have it accepted as the "reserve" currency all over the world. But this may change. As the US accumulates more and more debt, and their unfunded liabilities on the future remain unfunded, their reserve status may be lost, which would set off a domino effect of unknown consequences.

How foreign policy makers prepare themselves for such a potential currency crisis, along with their methods of dealing with the current credit crisis, will determine what nations will lead the way during the next global economic expansion.

So now that we have discussed the nature of this crisis, how we got here, and the policies which have been unsuccessfully taken by governments and central banks worldwide, what can Canada do to weather this storm and position itself for a strong recovery?

The Black Sheep Strategy

The Chinese symbol for "Crisis" is the same as the symbol for "Opportunity."

Although they are not saying it outright, Canadian and most other foreign policy makers have been engaging in a type of trade protectionism. Their method of doing so is not with tariffs as it was during the Great Depression, but rather with interest rates. We are purposely weakening our currency by lowering interest rates as a way of protecting our export driven economy. I think in the intermediate to long term, this is a very self-destructive strategy. Much of our manufacturing sector has already been wiped out in the last 4 years as the Canadian Dollar rose against the US Dollar. What survived were the strong and unique exporters that were providing a service or product that was not able to be found elsewhere. Producers of raw materials (our major export) actually benefited from this strength in the Loonie, as their costs of acquiring equipment was reduced. The value of their products is determined on the international marketplace, therefore, it did not raise the cost to our major export market.

As has been noted frequently, the Canadian banking system has been less harmed than most others, but there is significant risk that our banks will also start having greater issues when the inevitable real estate declines accelerate in our major markets.

Canada has an opportunity to express to the world that our currency, banking system and economy will be a bastion of stability in a time of world economic turmoil. We have a very unique ability to provide ourselves with sufficient energy, sufficient water resources, sufficient food crops, and a wide variety of other natural resources. At the same time, we have a population far smaller and far more educated than the only other nation able to claim the same advantages (Russia). This fact alone makes Canada a prime destination for world capital to find a safe and secure home. But our current policies are driving those same holders of capital away.

The Bank of Canada needs to be raising interest rates, not lowering them. And our treasury department needs to be increasing it's holdings of gold reserves to further bolster the strength of our currency in the minds of world investors. These two acts combined would dramatically increase the value of our currency and the perceived safety of holding Canadian Dollar denominated assets.

It is my belief that the substantial influx of foreign capital that would ensue would not only provide us with the money needed to address our enormous infrastructure deficit, but it would increase the deposit bases of our major banks, giving them a cushion to falling collateral prices on their debt securities. Currently, the remaining savings of the world are rushing into short-term US Treasury notes for their perceived safety. Investors in these securities are receiving almost zero return on their capital. There is certainly a large amount of capital looking for a home.

A rise in interest rates would prove problematic for already struggling businesses, however, the ensuing unemployment would be easily dealt with by infrastructure hiring, re-education programs for workers in old and dying industries, and by the subsequent rush of foreign firms to set up offices in Canada.

Other arguments against higher interest rates are that it would, as it has historically, stifle economic growth. But this assumes that the credit markets are functioning as "normal." They are not. People and businesses are not willing to borrow money at any rate, and banks are not willing to lend to them anyway. Banks are already requiring higher down payments, and higher credit ratings. So higher interest rates will not necessarily have the same effect on the economic growth rates, as one would automatically assume.

Lastly, it goes against common logic that in a time of heightened risk, that borrowing rates be lower. Banks may be more willing to lend at a higher rate of interest, which offsets some of their risk. Without question, if the market were left to be determining rates of interest - without minding the policies at the Bank of Canada, rates would be higher. We are fighting an uphill battle by lowering rates when the market clearly wants them to be higher. And as has been noted, the side-effects of too low rates far outweigh the benefits. Canada could become a top destination for carry trades if international investors were paid to take the risk. Why not welcome them?


- Offering cheap capital to failing banks and businesses is not working because of the uncontrollable forces of deflation - we are pushing on a string
- Policy makers are continuing to throw good money after bad, while confusing symptoms of the crisis with the disease
- Mandated inflation is the root cause of our boom/bust economy
- Competitively devaluing our currency against the US Dollar is having little positive effect on our export economy
- Raising interest rates and increasing holdings of gold to back our currency will boost confidence of foreign investors
- Foreign capital can be used to invest in infrastructure, re-education programs, and new high-tech industries like resource efficiency, and health-care
- A strong currency and stable banking system would effectively pronounce to the world that "Canada is open for business."

It is my hope that Canadian policy makers will look past the already disgraced "solutions" attempted to stem this crisis, and will instead think outside of the box. The policy adjustments I mention here are non-partisan in nature. They should satisfy legislators on both sides of the aisle, while ensuring we do not leave our younger generations with an economy in tatters for decades to come.

"It was the best of times, it was the worst of times; it was the age of wisdom, it was the age of foolishness; it was the epoch of belief, it was the epoch of incredulity; it was the season of Light, it was the season of Darkness; it was the spring of hope, it was the winter of despair; we had everything before us, we had nothing before us; we were all going directly to Heaven, we were all going the other way." - Charles Dickens, A Tale of Two Cities

I am open to hearing other's opinions on this matter (as always). Please leave your comments - even if you think such a plan would be nuts. I'd like to hear why.

View My Stats