Tuesday, March 31, 2009

Economic Deterioration Trumps Talk of Recovery

I've received a number of e-mails from readers wondering how it could be possible to see a 50% rally in the major indices while there hasn't been any improvement in the fundamentals, and in fact, the fundamentals continue deteriorating.

My answer is typically, "never underestimate the foolishness/maliciousness of the media." They have proven over the last few years a fantastic ability to manipulate news into something positive. But regardless, I'm not expecting a move much higher - it merely wouldn't surprise me. The S&P 500 has already rallied 25% from it's lows of 3 weeks ago. That alone is enough to satisfy the requirements for a major bear market rally.

Any move higher would likely be accompanied by reports of improved fundamentals. Most of that would be small bounces in month over month statistics. Surely you heard of the pick-up in new home sales last week? Many analysts were claiming that it could be a "sign" that home prices would bottom and lead the markets to recovery later this year. Well, lets take a look at that improvement in new home sales:

You'll have to click on the chart to actually see the improvement. Still can't see it? That's okay. The reason that it hardly shows up on the chart is because it is such a tiny change in the monthly statistic. You may have also heard about an increase in durable goods orders. Again, the month over month increase pales in comparison to the damage done over the previous 6 months.

To be sure, I'm cherry-picking. There has been meaningful improvements in credit spreads and some other indicators. But in any areas that one would normally see "end of recession" improvement, there is none - or very little. As I've mentioned many times. The eventual recovery, when it comes, will not be marked by an increase in loan activity. It will occur when entrepreneurial people decide to take their savings and use it to invest in a business that will produce value for their customers. Seeing increases in the rate of savings is imperative for this to transpire. And although the gain thus far is a good start, It is likely only a quarter of the way to where it needs to be. I envision this statistic to read +15% by the time we see recovery.

Ironically, the one positive thing I have to say about the economy is what troubles neoclassical economists most. They see a rise in savings as a threat to increasing consumption, rather than a pretext to increasing production. I discussed this in "There Is No Paradox In Saving" a few months ago.

Let us take a look at a few more charts. Once a quarter Brian Pretti reviews the CFO (Chief Financial Officer) survey. He finds that the CFOs, if anyone, know best when it comes to the health of the economy. They see the numbers first. I highly recommend you read the whole article. It is full of interesting charts. Here is one of them:

Pretti also discusses the labour market outlook of the CFOs. Here is the applicable quote:

Very importantly, on the employment front, we suggest the news could not be worse. In aggregate, CFO’s expect to layoff 6% of their workforce this year. If they are even near correct with this comment, this translates to 7.6 million additional jobs to be lost. If that’s the case, we are not even half way through the current payroll contraction cycle. Although these are our comments, the impact on consumption of layoffs of this magnitude? You don’t want to know. 60% of companies will impose a hiring freeze in the next twelve months. 57% of the CFO’s say they plan to reduce or freeze wages. 39% of CFO’s say they plan to reduce hours worked for retained employees. Now you know why we have been screaming so loudly about the decline in wage growth that is sure to come directly ahead. No question about it. Their comments are not good news for the domestic labor market.

If you wanted a picture of the coming and current wage deflation, there you have it. It appears that the increased savings will come at the expense of drastically lower consumption, rather than increased work hours.

Earlier this week, Calculated Risk was talking about his projections for Q1 GDP. His conclusion? Q1 GDP Will Be Ugly. He does a very good job explaining why:

Earlier today the BEA released the February Personal Income and Outlays report. This report suggests Personal Consumption Expenditures (PCE) will probably be slightly positive in Q1 (caveat: this is before the March releases and revisions).

Since PCE is almost 70% of GDP, does this mean GDP will be OK in Q1?


I expect Q1 2009 GDP to be very negative, and possibly worse than in Q4 2008. Right now I'm looking at something like a 6% to 8% decline (annualized) in real GDP (there is significant uncertainty, especially with inventory and trade).

The problem is the 30% of non-PCE GDP, especially private fixed investment. There will probably be a significant inventory correction too, and some decline in local and state government spending. But it is private fixed investment that will cliff dive. This includes residential investment, non-residential investment in structures, and investment in equipment and software.

A little story ...

Imagine ACME widget company with a steadily growing sales volume (say 5% per year). In the first half of 2008 their sales were running at 100 widgets per year, but in the 2nd half sales fell to a 95 widget per year rate. Not too bad.

ACME's customers are telling the company that they expect to only buy 95 widgets this year, and 95 in 2010. Not good news, but still not too bad for ACME.

But this is a disaster for companies that manufacturer widget making equipment. ACME was steadily buying new widget making equipment over the years, but now they have all the equipment they need for the next two years or longer.

ACME sales fell 5%. But the widget equipment manufacturer's sales could fall to zero, except for replacements and repairs.

And this is what we will see in Q1 2009. Real investment in equipment and software has declined for four straight quarters, including a 28.1% decline (annualized) in Q4. And I expect another huge decline in Q1.

For non-residential investment in structures, the long awaited slump is here. I expect declining investment over a number of quarters (many of these projects are large and take a number of quarters to complete, so the decline in investment could be spread out over a couple of years). And once again, residential investment has declined sharply in Q1 too.

When you add it up, this looks like a significant investment slump in Q1.

Here is a chart from the St. Louis Fed showing us how the Q4 slump in RPFI looks over the long-haul. Annualize that 28.1% decline from the top and we'll be seeing a drop-off toward 1,300 on the chart.

It's been a while since I discussed the goings on in Asia. Perhaps there's signs of recovery over there? Nope. Things keep getting worse. I'm hearing rumblings about Chinese crude oil demand falling off a cliff. Considering most of their growth has come from industrial production and construction, and both are fueled by, well, fuel, I wonder how on earth they can meet the Asian Development Bank targets for 7% growth. Military investment perhaps?

Japanese Industrial Production numbers have continued to report negatively. Although there is some hope that the recent declines in inventories will stoke the fires of production over the coming months. Regardless, inventories are still at levels far exceeding historical norms. Unless exports pick up, any increase in production should prove temporary.

And how do Japanese exports look? They're only down 50% year on year.

Unemployment is rising in Japan as well, as you might expect. The unemployment rate hit 4.4% last month. Keep in mind that Japan's job market is very different from ours. Their population is aging so rapidly, that there should be ample jobs available to fill as workers retire. The increase in unemployment tells us that the overall job market is collapsing.

And Europe's biggest economy? Still cliff diving. The latest figures we have on German industrial production are for January. It is expected that February's numbers will be similar.

The Wall St Journal reports that the not usually over-pessimistic OECD is predicting a 5.3% drop in German GDP for 2009 and an unemployment rate of 12% for 2010. The German rate of unemployment is currently 8.1% - again, abysmal considering the aging nature of the workforce.

I could go on, but the trend is clear. We are in the midst of a depression. Along the way, there will be decelerations in the pace of decline and there will be month on month improvements. But there will not be any long term recoveries. The reason is simple: much of the previous gains in industrial production were the product of easy credit. They didn't really exist. And not only are those gains being eliminated, but the reparation of corporate and household balance sheets ensures a protracted drop in consumption on top of the decrease in consumption that was due to credit expansion. In other words, consumers are not going to simply revert back to a level of consumption that is commensurate with their incomes. They will under-consume for a period of years until they have enough savings to spend again.

Believe the "second half recovery" mantra at your own peril. But also be aware that the media will likely try to sell any uptick as a sign that the bottom is in. And that false perception should also not be underestimated in its potential ferociousness. I don't think anyone can say with certainty that they know which way the next 20% will be in stocks. If someone tells you they can, my best advice is to run away as fast as you can.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Saturday, March 28, 2009

Technical Update 11.09

As I mentioned last week, I was caught by surprise by the magnitude of this rally. Most frustrating is that I had been expecting a major countertrend rally starting this spring. When it started 10 days sooner than I expected, I didn't believe it. Thankfully, I've learned from past lessons and haven't tried to fight it. But it is not easy to see the potential gains melt away before my eyes. For example, the JPM calls I had purchased and "prudently" sold at a profit for a double would have turned into a 5 bagger. The remaining puts I had (only about 30% of what I had from the Jan highs) have lost 60% of their premium. I was also whipped out of my silver shorts for a tiny profit - after congratulating myself for a top well picked.

But to keep this in perspective, it comes after a 6 month period where I couldn't seem to do anything wrong and had more than doubled my trading account. 2 steps forward, 1 step back. Fine with me. One needs to be careful not to get too frustrated with mere mortality. I've seen many turn the one step back into three. So what to do? Try an analogy:

When I'm playing tennis, I often find myself down 0-30 while trying to serve out the set. Should one toss his racquet to the screen in anger and go for the powerbomb ace on the next point? Or should one take an extra few seconds, some deep breaths, and focus on what has been working previously?

When trading, I have two solutions that work best. The first is to look at longer time frames. Put away the daily charts and see what is going on in the bigger picture. So today I'll focus on weekly and monthly charts.

As I mention often, Elliott Waves are one of my many tools to determine market trend. Many think EW is garbage. I think it is just widely misunderstood. What it does is provide context and give you a number of different interpretations as to what has happened in the past. EW has a number of "rules" that are used to determine this. For any given pattern, only a number of these rules will be satisfied. For example, a certain pattern can be numbered with 10 of a possible 12 rules satisfied. There could be other interpretations that have 6, 4 and 3 rules satisfied. Depending on the number of rules satisfied, the different interpretations jockey for position as the most likely candidate. So when the S&P broke the 750 level last week, I knew that my interpretation wasn't correct, and another one had taken top spot. By knowing this, I was spared the frustration of shorting this rally.

As of now, the higher probability interpretation is for a continuation of this rally (perhaps after a small pullback to 770ish). There are other interpretations that indicate nearly immediate lower lows. But I don't like betting on low probability events. Let's take a look at the charts. First, a chart of the '29-'32 bear:

Obviously, history never repeats exactly. But this chart gives perspective to the size and frequency of rallies we can expect in this bear market. I am not ruling out a 50% rally from bottom to top that lasts 4-6 months. This would equate with the 200 month EMA and approximately a 38.2% Fibonacci retrace of the entire move from Oct '07-Mar '09.

On the weekly, we see how the Nasdaq 100 refused to make a new low early this month. What is this telling us? Either the Naz is going to lead us higher, or it has been hinting that all of the price action from November has been one big "expanded flat" pattern that will take us to new lows after surpassing January highs. Pick your poison.

Taking a look at crude oil, we see a "peek-a-boo" above the 20 week EMA. If we see a strong continuation downward from this level, a good argument can be made for new lows, or at least an end to this run-up. But if we can hold above the $50 level on a weekly closing basis, the $70-80 area should be a magnet.

The typical correlation over the last year has been lower stocks=higher dollar. But try to remember back a couple of years when it was common logic that gold and oil could only trade higher as a function of dollar weakness. That obviously wasn't the case. So be careful to automatically conclude that one means the other. Correlations tend to break once they become considered "common logic." The longer term timeframes look absolutely atrocious for the Euro and Loonie. First the monthly:

Notice how it hasn't been able to capture the downtrending 20 month EMA (blue line), but also has held above the 100 month EMA (purple), thus creating a wedge. A monthly close below 126 spells trouble. The weekly chart doesn't look much better. It was rejected on this latest rally at the 100 and 50 week EMAs. A close next week below the 20 suggests it is game on for new lows.

The Canadian Dollar looks just as ugly on the weekly. It hasn't even been able to capture the 20 week EMA. A short could be taken with a stop above 82. I still see the Loonie sporting a 6-handle sometime this year.

Sterling doesn't look much better. My call for par with the greenback stands. The UK is a mess.

The TSX Venture looks like it might want to challenge the 50 week EMA. It's a long way up. But if it pulls back hard along with the price of oil over the next few weeks, look out below. Using the two metrics could prove useful in determining the overall risk appetite for the major indices.

You might remember that I said there were two ways I typically "take a step back." One is to use longer timeframe charts. The other is to take some time off from the markets altogether. As such, I'm scanning the web for vacation opportunities. 10 days in the Greek Isles sounds about right! So if there's no updates for a few days, you'll know what's up. Cheers!

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Thursday, March 26, 2009

Some Common Sense

This is by far the best interview I've heard from Dr. Paul on a major network. They let him go for over 12 minutes and actually ask some decent questions.

The bill he refers to about auditing the Federal Reserve is HR 1207. It has 44 cosponsors thus far...

Source Link

And I must mention my new hero, Daniel Hannan backbencher in the EU Parliament. This takes "telling it like it is" to a whole new level. Bravo Mr. Hannan.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Tuesday, March 24, 2009

Geithner Should Resign

I've spent the last couple days drinking a lot of coffee and trying to figure out what the hell is going on.

It seems like the pace of bailouts, major announcements, stimulus packages, etc are accelerating exponentially. What would have been a magnitude 10 event a year ago and front page news for a whole week thereafter is now relegated to the back pages. When this crisis started back in 2007, a few billion dollars in losses was a big number. Months later we were talking 10's of billions. Months after that 100's of billions. Now, the "T" word is being thrown around. Does anyone even have the faintest idea how much a trillion dollars is? I was still trying to wrap my mind around the idea of a billion dollars. My head is spinning.

A couple months ago, I essentially gave up in trying to follow all of this. My cynical side tells me that was probably the point. By throwing around increasingly larger numbers, outrage would turn to numbness; numbness to quietude; quietude to acceptance. Punch-drunk in other words.

But this weekend, I decided to delve into the details of this recent plan by the Treasury led by Tim Geithner. Perhaps it wasn't so bad after all. Heck, maybe it would work. "Don't knock it 'till you've tried it," right? I didn't want my ideological disbelief in government intervention to get in the way of what might otherwise be a good idea. So I read everything I could find on the subject. The result?

Disgust. Not only is this "plan" so far away from the core issues of the crisis (altogether another topic that I won't get into today), but the language used by the treasury secretary in describing it is purposely designed to mislead the average person into thinking this is something that it is not. Typically, these plans have been laced with uncertainty and vagueness with regards to the intended consequences. The Paulson gang had done so in order to ensure "plausible deniability" in the event that something other than it's mission was the result. So while incompetence was suspected, malevolence could not be proven. This is blatantly malevolent, and the treasury secretary is purposely trying to use the "punch-drunk" state of the masses as a shelter for the barrage of indignation that would otherwise spew forth.

Everywhere you look and everything you hear about this plan, including from Geithner's own pen in the WSJ is that this is a "public/private partnership." It is structured like this in order to ensure that a realistic market price is found for the "toxic" assets on bank balance sheets. Without private participation, the government would not have the faintest clue what the assets should be purchased for (which is true), so this participation will ensure that government gets the best "bang for their buck." And the American taxpayers are assured that the only way they lose is if the private partners also lose, and vice versa. If the private partners end up making money, so will the government.

These are all blatant lies.

The language is used in a way that makes people think that the deal is 50/50. It is not. Not even close. Treasury is matching private investment 1:1, but the FDIC is providing 6:1 leverage on top of that. Where does FDIC get the money? From the Treasury, of course. Here is a sample from the Treasury's own website:

Sample Investment Under the Legacy Loans Program
Step 1: If a bank has a pool of residential mortgages with $100 face value that it is seeking to divest, the bank would approach the FDIC.
Step 2: The FDIC would determine, according to the above process, that they would be willing to leverage the pool at a 6-to-1 debt-to-equity ratio.
Step 3: The pool would then be auctioned by the FDIC, with several private sector bidders submitting bids. The highest bid from the private sector – in this example, $84 – would be the winner and would form a Public-Private Investment Fund to purchase the pool of mortgages.
Step 4: Of this $84 purchase price, the FDIC would provide guarantees for $72 of financing, leaving $12 of equity.
Step 5: The Treasury would then provide 50% of the equity funding required on a side-by-side basis with the investor. In this example, Treasury would invest approximately $6, with the private investor contributing $6.
Step 6: The private investor would then manage the servicing of the asset pool and the timing of its disposition on an ongoing basis – using asset managers approved and subject to oversight by the FDIC.

You can't make this stuff up. Let's do some complex mathematics:

$6/$84= 7%

Translation: The taxpayer is on the hook for 93% of the entire bet. The private investors get to reap the rewards of the leverage on the way up and the taxpayer eats the losses if the leverage blows up in everyone's face. It is free leverage for the investors. Pretty sweet deal, eh?

So sweet that one would probably overpay for the toxic waste being bid on in order to benefit from the potential upside, wouldn't they? And if one is willing to overpay, what exactly is that price? Is it a market price? No. It is fantasy.

This might seem perplexing. If the taxpayer is taking most of the burden themselves, and we aren't achieving a true market based price for these illiquid assets, what's the point? Why not just skip the formality and nationalize the assets? This is where it gets interesting.

There are more inherent benefits for the private investors to purchasing these toxic assets at far above their real value than meets the eye. Think about a common situation, where a hedge fund is already heavily invested in financial corporate bonds. Let's call this hedge fund "OCMIP" for no real reason at all. They might own a hundred billion in Citigroup bonds. Those bonds themselves are trading at a steep discount to their NAV (let's say 60 cents on the dollar) and if marked to market would likely require the liquidation of the entire fund. But now you and many other hedge funds have been given the opportunity to make an "investment" in Citigroup's troubled assets. You can put up 6 Billion Dollars, and the government will follow up with 78 Billion of their own dough. All in all, Citigroup gets 84 Billion dollars that they didn't have before (it was there, but not "liquid"). The value of OCMIP's bonds are now much higher because of the perceived balance sheet improvement of Citi. In fact, Citigroup may even have enough money to pay off the entire value of that tranche of debt, thus making OCMIP whole on much or all of their Citi bonds - making them $40 Billion better off than they were before. They can then write the value of the $6 Billion investment down to zero (what it is probably worth) on their balance sheet and hope to "get lucky" if it ever becomes worth something. They are $34 Billion richer and have had to take zero risk to do so.

This is not a program designed to make the banks healthy again. It is a bailout of hedge funds, pension funds, insurance companies and anyone else who got in way over their heads in leveraged bets on bank debt. Geithner is essentially passing out taxpayer money to the greasiest slime on Wall St. They saw the banks getting free money. And now they think it is their turn.

This is a heist. And it is perhaps the biggest heist in human history. No matter how outraged you are about this travesty, I can assure you that it is not outraged enough. Tim Geithner should resign immediately. This is blatant fraud.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Sunday, March 22, 2009

Technical Update 10.09

As of last weekend, I wasn't expecting the rally to push much higher in order for the major indices to make a final set of new lows. They did, so I must adapt and therefore adopt a more bullish stance. However, I would note that trading from the long side in a major bear market is always risky. Surprises come to the downside.

I would also note that the minimum condition for a major bear market rally has already been reached (20% from bottom to top). So there is still the risk that it is already over. I will be watching fibonacci retracement levels (750, 734, 718) for signs of a potential upside reversal. But remember that these numbers don't really mean anything on their own. They need to be used in conjunction with something else in order to be considered useful - like any technical analysis tool. Unless I saw a number of indicators showing strength at these levels, I doubt I would venture into the long side. I'd rather risk missing the multi-month rally altogether. Then again, any idea can be a good one if your risk is defined.

Looking at a weekly chart, we see that even this rally wasn't enough to tag the 20wk EMA.

But the main reason I remain so hesitant about this rally is the position of my oft-cited indicators. They are both screaming overbought at levels as extreme or more so than levels commensurate with other major bear market rally peaks. Additionally, the VIX remains stubbornly high.

As I've mentioned over the last few weeks, the dichotomy between the various indicators of sentiment has never been more confusing. I've read many notes from other analysts noting the broad participation of this rally specifically (the others were more or less short covering rallies in financials). They've also noted the many exhaustion signals that correspond with the ends of other major bear markets (like being down 8 of 9 weeks straight).

But then I look at P/E multiples from outer space and dividends being cut everywhere and wonder to myself how anyone would possibly consider buying stocks right now. 1 year trailing earnings (reported) are at 51.2. No, I did not type that dyslexically. Fifty-one point two. The S&P 500 returned a total of $15 in 2008. Even the fantasy-land "operating earnings" are collapsing. 1 year trailing clocks in at about 15.6. See for yourself here.

Even if one thought this was the bottom, why wouldn't they just buy the corporate debt, which yields far more than common equity and is trading at a discount to NAV itself? I cannot think of a good enough reason to buy a basket of stocks now with the intention of holding them. Other than blind optimism, that is.

I also see societal acrimony getting even nastier. This article from Rolling Stone (hat tip reader Fish) shows how the outrage is going mainstream. Slipping a little profanity into a profane situation will probably shake a few from their nihilism. This is a fantastic read, by the way. I've just started to hear rumblings that the second batch of TARP money has been handed out and congress will soon be asked yet again to cough up. When does this spineless bunch finally put their foots down? It could be a long, hot summer...

The Euro looks like it has reached a climax and should head back down to make new lows. A stop could be set above Thursday's high.

That's all for now.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Saturday, March 21, 2009

Hyperinflation Is Impossible: Addendum

I received quite a bit of feedback to my last article, "Hyperinflation Is Impossible." Most of it was in agreement, some of it was not and gave good counter-arguments, and a small portion was hateful. One person went as far as accusing me of working for the US Government and issuing propaganda. I got a kick out of that one. That never surprises me though. It is a fairly divisive issue. I've seen the arguments from both sides hashed out for years. Long before the crisis even started, folks who knew it was coming were arguing over which shape it would take. With estimates of over 45% of the world's wealth disappearing in 18 months, it should be obvious which ones were in the right. But strongly held opinions die hard, I suppose.

Today, I'll try to dissect most of the counter-arguments that I didn't in the original article. I'll likely miss some of them, but will try to pick out the most important and less ridiculous.

For the record, I don't really think anything is impossible. But I don't walk around trying to protect myself from being hit by lightning. I don't wear a helmet when driving my car. And I rarely bother tagging my baggage at the airport. There are some things that are worth preparing yourself for. Others are such low probability events that preparing yourself for them can actually be counter-productive. This is how I feel about any talk of an imminent hyperinflation threat. As I mentioned in the article, the US Dollar will likely fall victim to collapse at some point. But there are too many factors conspiring in it's favour during this specific crisis. When the stars align again against the dollar (like they were in the 70's) I'll get bearish. But that could be decades away.

For the most part, I feel that those who were disagreeing with me on this matter are massively underestimating the role of changing behavours toward consumption and debt. Areas where the Fed may succeed in expanding the total supply of money and credit, it will be rejected by frugal consumers. Indeed, had the Fed been doing what it is doing now 10 years ago, we would have seen massive inflation. And it could be argued that we did see massive inflation over the last few decades from the actions of the Fed during the early 90's and early 00's recessions. Most monetary aggregates rose by over 10% yearly. And if you insist on using prices as your definition for inflation, how about these factoids:

Stock prices averaged an 18% return plus dividends over 12 years ('88-'00)
Real Estate prices averaged a 10% return in most regions over 15 years ('91-'06)
Commodity prices averaged a 15% return over 7 years ('01-'08)

As Mike Shedlock and others often point out, if one were to substitute home prices for the absurd "Owners Equivalent Rent" portion of the CPI, we would have seen numbers in excess of 10% for over a decade (and negative now). Hyperinflation is most often described as inflation that is "out of control." I would argue that we were dangerously close to that.

The point of this detour and talking about the last few decades of inflation is that it occurred while the Fed and other CBs were doing far less than they are now to encourage it. Why? Attitudes. People were willing (even if they weren't able) to take on the debt that was being offered to them in order to create demand for all of the above. It was the same story for the banks. They weren't exactly able to lend either. So they created all sorts of accounting tricks to make themselves able. The underlying driver of the inflation was not really the Fed's encouragement (although that did help), but rather banks' desire to lend, and people's desire to borrow.

In reality, the Fed wasn't the main driver of the problem then. And now that those desires have done 180's, the Fed certainly cannot be the the driver of a return to that problem. I'll give a few quick examples of these attitude changes on the part of consumers, before getting to my mailbag.

First, is today's poll from Canada's Globe and Mail. The question asked was: "Do you think you will resume your old spending habits once the economy rebounds? Yes or No" As of now, over 60% of respondents have answered "No."

Second, is the title "Austerity Tide Hits Florida Beaches." Understand the dynamic at work here.

Lastly, read this entire article from somewhere in Missouri: "The New Economy of Frugality." You think once these people learn how to cook for themselves, they'll automatically go back to eating at Red Lobster twice a week? You think they'll plow over their gardens when the economy recovers and replace it with energy-sucking swimming pools? Neither do I.

Ok, and now to some reader responses.

First comes from Steven Saville of the Speculative Investor. I've read Steve for years and respect his work very much. Let's see what he has to say:

...there's not a lot I disagree with in the article you linked. First, I'm not expecting the dollar to tank against other fiat currencies (on a long-term basis I'm actually more bearish on the euro than the US$). Second, I believe that private sector credit will either contract or remain stagnant over the next few years. Third, I have argued against the "hyperinflation is imminent" view (I don't think there's a realistic possibility of hyperinflation occurring within the next few years, although it will ultimately occur). Fourth, I disagree with the de-coupling theory put forward by Peter Schiff et al. Fifth, I don't think the moonshot in the monetary base has near-term inflationary implications.

Regarding gold, I've noted at TSI in the past that it is not a good hedge against monetary inflation or the so-called (but poorly named) "price inflation". It is a hedge against a loss of confidence in the official currency and in the purveyors of the official currency. Sufficient monetary inflation will eventually lead to such a loss of confidence, but it can take a long time.

The best long-term measure of confidence in the US$ is, IMO, the Dow/Gold ratio. Gold was extremely over-valued relative to the Dow in 1980, indicating that confidence was at a low ebb. At that point one of two things had to happen: a total monetary breakdown or a secular trend reversal. Obviously, it was the latter. Another secular trend reversal occurred in 2000 (the confidence peak).

Despite the areas of agreement, my view is that an inflation problem is building because the private sector debt bubble is in the process of being replaced by a public sector debt bubble. Note that even though the private sector has been retrenching, total credit in the US economy is still expanding and M2, which doesn't include bank reserves, is 10% higher than it was a year ago.


Thanks Steve. Some good points were raised here by Saville. Indeed, there's little we disagree about. He brings up the expansion of M2 as a potential warning sign that inflationary pressures could be building. As most of my regular readers have noticed, I don't rely much on government statistics as support for any arguments. They are way down on the list when it comes to importance. But let's have a look at the M2 measurement of the Money Supply. Wikipedia defines M2 as "M1 + most savings accounts, money market accounts, retail money market mutual funds,and small denomination time deposits (certificates of deposit of under $100,000)"

In my opinion, a rising M2 could be explained by a number of things. First off, notice the inclusion of money market mutual funds. What are these? Again from Wiki: "A money market fund is a kind of mutual fund (technically, a regulated investment company). Investors receive shares in this company, which buys securities (for example, commercial paper). There are rules on what kind of securities may be held and rules about diversification. Thus, investors have risk on the assets, but not on the bank." My question is this: how much are all of the money market funds really worth if they were marked to market? And what would M2 look like if this were the case? I would guess quite a bit different than the 10%

And second, because M2 includes M1 and all savings accounts, I question whether an increase in this metric tells us anything about inflation. Because of the current consumer retrenchment, we know that debt is being paid back and people are desperately trying to boost their savings. If they are selling their assets (stocks, real estate, etc) and putting the proceeds in their savings accounts, we are only seeing a shift in asset allocation, not necessarily a growth in the total amount of money and credit.

The next point raised by Saville was that he believed a growth in public debt was going to replace the private debt bubble that is currently imploding. I don't disagree that public debt will grow. But will it grow enough to create net inflation? I highly doubt it. Consider that total US public debt currently "only" accounts for 1/4th-1/5th (depending on whose numbers you trust) of the total US debt burden (and this does not factor in the many trillions in possibly worthless credit derivatives). So in order for an increase in public debt to adequately negate the deflationary effects of a crashing private debt, it would need to increase at a rate many times greater than the decrease in private debt - and do so for years on end.

This is possible. But would likely take many years to transpire.

Reader Mike Monchalin writes,

Yes, I understand how the US debt/credit system is deflationary and different from Weimer/Zimbabwe's paper based system. But isn't it possible that paper could be printed in the U.S? Everything that the fed has done so far has been within the debt/credit realm.

Now, the Federal reserve has said it will buy as much as $1.15 trillion in bonds to lower borrowing costs. Could this be the beginning of monetization?

I understand the scope of debt is incomprehensible. But why can't monetization occur on the same incomprehensible level?

Good question. There is currently about $800 Billion in physical notes issued by the Federal Reserve. If I understand the question correctly, you're asking why the Fed can't just start multiplying this number like crazy a la Zimbabwe and just mail it out indiscriminately to US citizens? Of course they could (I've learned to never underestimate the stupidity of central banks). But again, we run into the problem of what people would use the money for. Would they use it to buy skidoos? Or would they go directly to the bank and use it to pay off their mortgage or credit card? I think they'd do the latter. Considering 50% of Americans are one month's wages away from financial ruin, I don't see how one could think otherwise.

Reader JLak at the Generational Dynamics forums writes,

This subject demands a more quantitative treatment. Unfortunately I don't have one to offer, but I can suggest some rational questions to ask. First, the quadrillion dollars or so in derivatives has a centroid (zero-value point) about a certain economic indicator, probably home prices equal to 2007 levels or so. As we approach that point, the risk will evaporate. What is this point? Secondly, with the takeovers, the Fed/Treasury is the counterparty in much of the paper trade, so there is no risk. How much of the derivative market does this represent? Thirdly, every trade has two sides. The Fed/Treasury now holds most of the downside risk. How much upside risk do the banks hold? Fourth, the risk models may have been updated, but in banking, that just means more insurance and higher interest rates. What is the interest rate at which the banks would start lending out their massive excess reserves?

Macroeconomics is more mathematics than narrative sociology. There is a very definite point at which hyperinflation will occur and a very definite point where deflation will occur. Social trends are good to consider, but the fundamentals do matter in economics just as in bridge building.

I disagree with this wholeheartedly. To be sure, we are taught that economics is a mathematical study in most colleges and universities. But this is false. And it is false for the same reasons that Neoclassical models suggesting home prices would never fall were false: because you cannot model human action. In order to make a quantitative statement that "hyperinflation will occur under these specific conditions," but "inflation will occur under those conditions," we need to make literally dozens of assumptions all along the way. How will people react to the increase of A? How will banks react to a decrease in B? All we can do is see what they have done in the past and assume they will do the same in the future.

Think about it. If there was a way to actually determine this, why hasn't the Fed managed to create inflation and prevent deflation from taking hold already? How many interventions are we at now? It's got to be over 20. I've lost count. But each and every one was brought forth with the promises of some economist that his proposed solution would work. None of them have. Why? Because you can't model human action! People are acting in ways they haven't acted for 80 years. The economists with these models either don't have reliable statistics going back this far, or they do and simply don't like the results it gives them. So they make assumptions, which are usually total garbage. Garbage in, garbage out.

I realize that it is frustrating to never be able to predict anything with 100% accuracy. For most economists to admit this, it would require them to admit that most of their qualifications are useless. Much like the astronomers who were put out of work once Galileo had proven that the earth was not the center of the universe.

Neoclassical economists have been trying for over 150 years to base the study of economics on mathematics. It has failed miserably. All along, Austrian economists (whose roots were predominately philosophical) have told them they were fools because their models were ridiculous. (So have Marxists - but they're wrong for other reasons).

I also received a number of questions regarding Wednesday's announcement by the Fed that they are going to be buying 1.2 trillion in securities, some of which will be US Treasuries. Has the monetization begun?

Let me direct you to Kevin Depew, who answered similar questions like this:

So this desperate move by the Fed, the final bullet so to speak, this is clearly hyperinflationary, right?

Not by a long shot.

Here's the thing: When the Treasury issues debt, it takes liquidity out of the market as cash is swapped for Treasury bonds, bills and notes. When the Federal Reserve buys those Treasuries from the dealers, it is injecting liquidity back into the market. But, because the Fed's announcement will cover less than a third of Treasury issuance this year, all that is taking place is that the Fed is desperately trying to at least reduce the amount of liquidity the Treasury is sucking out of the market.

But wait - there are other, more complicating factors at work.

Household net worth has declined by roughly 20% since peaking in 2007, according to the Fed's own figures. Household "wealth" fell by $5.1 trillion in the fourth quarter alone. Combined with rapidly increasing household savings, the Fed, by moving to artificially suppress interest rates, is inadvertently quashing the very risk appetites it desperately needs to motivate in order to kickstart its own ongoing Ponzi scheme.

I don't think I could have put that better myself. These suppressed interest rates are contributing to the lack of willingness of banks to lend. If you were a bank manager, would you make a home loan to somebody for a measly 4% when home prices are expected to decline at least through 2010? I wouldn't. In fact, it would have to be a pretty good business plan for me to consider lending money to ANYONE at 4% right now.

In conclusion, the Fed can do whatever it wants. But if there is no desire for people to do anything with the new credit (or money), it will not have the initial inflationary implications on people's decision making. In order for people to get paranoid to the point that they will buy goods as fast as they can and get rid of their money (hyperinflation), they need to see prices rising first. Otherwise, they will hoard the cash and wait for lower prices. That is, the velocity of money is too low for inflation to take root. They certainly will not be in any rush to take out loans to buy things that are falling in price.

The Fed has been promising that their interventions would be successful in preventing deflation for 19 months now. They had philosophized about it for years prior. And it has failed because the assumptions behind that philosophy are faulty. The same philosophy has failed for 20 years in Japan. The same philosophy failed 80 years ago in the Depression. It will fail again.

I tried to tackle as many of the arguments that made sense as I could. I realize that deflation is not exactly a sexy process. There's not much money to be made on any investment in such a situation. Therefore, it is much easier to wish for hyperinflation so we can all buy gold and get rich quick. If life were only that easy...

My investment stance remains the same. Cash held in various forms and banks, a little bit of gold, and short positions on stocks if you want to take risk. After a few years, one can start picking up cash producing assets (dividend stocks, arable land, rental buildings, small businesses, etc).

Leaning too heavily toward a continuation of the inflation trend could prove disastrous for one's financial well-being.

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Friday, March 20, 2009

Dear Reader

I've been a little inactive of late. Scouring the web for topics to write about has been increasingly making me angry, and adding to my already premature count of grey hairs. Seeing all of the blatant fraud now come to light has had the effect of disillusioning me with the entire financial industry. It just makes me sick. And even more so to hear that Obama is now trying to pose as a great protector of the US taxpayer, demanding 100-odd million in AIG bonuses to be repaid. Seriously, how stupid does he think we are? He gives away trillions, and then demands 100 million back. He's essentially saying that we're too dumb to know the difference between all the zeroes tacked on at the end.

Anyway, I'm compiling a list of arguments to my last post regarding the impossibility of hyperinflation. I'll try to go through as much of those as I can this weekend. I'll also have a technical update sometime this weekend.


Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Monday, March 16, 2009

Hyperinflation Is Impossible

I get a lot of emails and questions from readers and friends about whether I think the US Dollar could collapse and start a bout of terrible hyperinflation. The questions are usually stemmed from watching an interview on TV with extremely biased energy/gold analysts. People who have every reason to sell you on hyperinflationary doom in order to make themselves a quick buck. I have no respect for these people, so I will not publish their names. They know who they are. I call them the "opportunistic hyperinflationists."

But there is another group of "inflationists" who I do respect greatly. Guys like Peter Schiff, Jim Rogers, Doug Casey and Jim Puplava. These guys have spent years, if not decades, railing against the growing debt bubble and warning that it would end badly. A large faction of the Austrian School of Economics (of which I consider myself a student) had been doing the same. They are the "ideological hyperinflationists."

However, this group of economists/pundits/analysts have been terribly wrong in predicting how this debt bubble would unfold. And I am certain that they will continue to be wrong as it continues and reaches it's ultimate conclusion. Typically, these folks have a fundamental dislike of our current system of currency. The feel it is immoral, illegal by the US constitution and is doomed to failure as all paper currencies have been since the beginning of civilization. I agree with them on all counts. But as a function of their dislike for paper money, they have been enchanted by its most obvious replacement: gold. They carry it around with them and flash it at interviews. They become walking salesmen for the return to a gold standard. And they point to a rising price of gold as proof that they have been right all along.

They haven't and aren't.

Their arguments are usually the same. That in order for the massive amounts of debt to be repaid, the Federal Reserve and other central banks are going to have to resort to monetizing that debt via the "printing press." Their claims are well documented. Even the Chairman of the Federal Reserve has promised to do this, should it prove necessary, earning him the nickname "Helicopter Ben" (after promising to drop money from helicopters to prevent deflation). And it appears he has already started. We can see it in their own figures. By now, I'm sure all of my readers are familiar with the Monetary Base "Hockey Stick" graph below that shows how the Fed has essentially doubled the monetary base in just a few short months. This, claim the inflationists, is visual evidence that hyperinflation is already occurring and will inevitably start showing up in everyday prices:

Another common claim by these folks is that inflation is running at far higher levels than what is reported by the very flawed CPI measurement. For proof of this claim, they'll point to John Williams' "Shadowstats" counting of inflation in charts like the one below. It shows that if we only counted inflation like we did pre-Clinton Administration, inflation would be much higher than we're told.

In this article, I will explain why these arguments are wrong.

Money and Credit

First and foremost is the apparent misunderstanding of the differences between money and credit. At times, they may appear to have the same characteristics. At other times they act completely opposite from one another. As an economy is expanding, an increase in the total amount of credit would appear to have the same effect as an increase in physical dollars because credit is widely accepted as an equal to money. In a sense, they are the same. They are both "fiduciary media" (in english they are both a representation of something else, rather than having intrinsic value themselves). But when the economy is contracting, the prospect of default is thrown into the equation. When this happens, money increases in value relative to credit. Money is more valuable than credit because in the event of default, the physical dollar holders are king. Yes, the US treasury could default on it's obligations. Holders of treasury bonds would get a big, fat zero, while holders of physical currency would still have a claim. In effect, they act similar to a preferred share as opposed to common stock. They are a step above in terms of priority.

It is often said that we live with a "fiat currency" or with "paper money." This is not entirely accurate. A very small portion of our total supply of money and credit is in the form of physical currency. It depends on how you count it, but regardless, it is under 10% of the total. This is what differentiates our monetary system with that of Zimbabwe or Weimar Germany circa 1920's. Their economies were based on nearly 100% physical currency because nobody would accept the promises of government in order to issue credit.

The vast majority of our money supply is in the form of electronic credit. Electronic credit can be destroyed, while physical notes issued by a central bank cannot. This is why deflation is possible in a credit based monetary system, but not in a paper based monetary system.

There are hundreds of trillions of dollars floating around the world in credit. Much of that is an insurance contract on top of another insurance contract, on top of a securitized mortgage, on top of an asset. The total value of all the aggregate claims on the asset vastly outnumber the value of the asset itself. That is what this crisis is about at it's very heart. Picture an inverse pyramid with assets occupying the bottom bit, securitized mortgages in the middle, and credit derivatives at the top. A stable economy would have a right-side-up pyramid with assets occupying the bottom, etc.

Our problem now, is not that the assets are going to go to zero. It's the value of the much larger derivatives and mortgages that back the assets going to zero. Their values were derived from faulty computer models that grossly underestimated risk in the underlying asset, but more importantly in the ability for a counterparty to make good on their promise in the event of a default. The counterparties, like AIG or Citi, issued 30 or 40 times more in insurance than there were in assets to back them up. Their models told them that the possibility of all the different assets declining at the same time was negligible, therefore justifying such enormous leverage. Now that the assets have fallen by at least 20-30%, the holders of the securities that were tied to them want to be paid for their insurance. Only there's nothing to pay them with. So the people that hold these contracts are trying to get rid of them as fast as they can, and for whatever price, because they fear that if the counterparty goes belly-up, they'll get nothing. If they can sell, they take the loss. If not, they keep the asset off their balance sheet in what's known as a SIV (Special Investment Vehicle) until they can be sold. While they are kept off the balance sheet, they are still considered to be worth 100% of their original value.

The total amount of these assets is far greater than the equity banks have and their sum represents future losses that eventually need to be realized. No, the value of these assets is not completely nil - because the value of the underlying assets are not nil. But for all intents and purposes, it might as well be zero because it dwarfs their tangible equity.

That was a very long-winded explanation of what the difference is between "money" and "credit" but it is essential to understand this difference. Not only if you want to be an econo-weenie like myself, but in order to understand the very essence of our economy, banking or investing. Any other information is essentially useless unless you can wrap your mind around this concept.

So the next time you hear that the Federal Reserve is "printing money," please do not automatically assume that they are printing physical notes. They are creating electronic reserves (credit) to support the balance sheets of the big banks. There is absolutely nothing inflationary about this. The banks are simply taking it and using it to cancel out their derivative losses or are hoarding it in order to prepare for future losses. Previously, banks would have used the electronic reserves to go out and make 10x that amount in loans to consumers or businesses (in reality the order was the other way around - loans first, then reserves). That is not the case anymore, and until the bad assets are completely liquidated, it will not be the case again.

Thus far, we have a total of $9.7 Trillion dollars in total government/central bank assistance in the United States. An amount equal to that and more has been provided by their counterparts around the world. More is promised. But the fact remains that the minimal inflationary impact these actions have are negligible in comparison to the amount of "problem assets" being devalued around the world. Much of it is just in guarantees - that is, more insurance. The Federal Reserve will offer to swap good assets for bad. All this does is cancel out debt from somewhere else. It's like moving money from one pocket to another. The act of putting money in your right pocket does not make you any richer.

All in all, the central banks are not nearly as powerful as they'd have you believe. The amount of the total money supply that is controlled by them is minimal. They won't tell you that. They'd prefer you to think that just by them moving their lips they can affect the entire economy's decision making processes. It simply ain't so.

This begs the question: why is gold going up? Who knows. It has a mind of it's own. But if it really only moved due to inflation concerns, it wouldn't have declined 75% over two inflationary decades (80's, 90's) would it? If inflationary concerns were real, we would see TIP yields rising along with the gold price. They're not. We'd also be seeing other typical inflation hedges rising - like property prices. That is obviously not the case. A better explanation is that gold is rising because of increased instability. People want to own a little bit "just in case." As they should. But an even better explanation is that it is going up because it is going up. Pure speculation.

No matter how much credit is issued, it cannot make up for the massive contraction elsewhere. The net result will be deflation - even though it will be less than it would be without any interventions. Japan has discovered this over the last two decades - and they had huge demand for their exports, whereas the current situation is global. America discovered this in the 30's - and they had a far smaller debt burden than now. We will discover the same.

Will the US Dollar Collapse?

Closely tied to the belief in imminent hyperinflation and a skyrocketing gold price is the misplaced belief that the US Dollar is on the brink of collapse. Essentially, they are one and the same. Many of my arguments against hyperinflation are the same against a dollar collapse. But there is even more evidence stacked against such an occurrence.

Ultimately, the Dollar will end up at zero - but that is not going to happen any time soon, and I would argue is likely decades away. Until then, the massive amounts of deleveraging will increase our appetite for dollars to pay back debt. There is too much credit in the system, and as we rid ourselves of it slowly, we need to acquire dollars. A large portion of the credit derivatives I mentioned above are denominated in dollars even though the underlying asset may be priced in another currency. This is a theoretical short position on the dollar. A "carry trade" in other words. It must be unwound, just like the Yen carry trade.

This is what is meant when we call the US Dollar the world's "reserve currency." Most people hear the word "reserve" and automatically conclude that because many other countries hold the dollar as their primary currency in their foreign exchange "reserves," that is what is meant by "reserve currency." It is not. Total foreign exchange reserves of dollars are far smaller than total foreign credit contracts denominated in US Dollars (reserves worldwide are "only" ~4.6 Trillion). It is the reserve currency because it is the default currency for international trade and commerce in general. In order for that to change, 100's of trillions in contracts would need to be re-written. Not practical.

As such, demand for US Dollars will persist.

Additionally, the US Dollar is not alone in its state of affairs with an overindebted government and central bank getting itself in all sorts of trouble. In fact, nearly every other currency has the same issues facing it. And even though the numbers aren't quite as dire elsewhere, they are far more likely to collapse than the US Dollar due to the reserve status. Fair? No. But neither is life.

In summary, there are many multiples more debt than capital in the world economy. Debt is being liquidated and will continue to do so until it reaches a sustainable level relative to capital. The process of this debt liquidation puts a higher value on dollars relative to debt, thus ensuring an oversupply of dollars is impossible.

Attitudes Toward Debt

The previous section was devoted to why banks cannot lend. But lets forget all that for now. Lets pretend that by some sort of accounting trick, they are allowed to forget about all of their trillions of bad assets and after gifts from the government/central banks, they are willing and able to start making loans again.

In a recent article, John Xenakis of Generational Dynamics wrote:

As I wrote last month, something that's constantly freaking me out these days is all the talk of greedy bankers. The reason it's freaking me out is because the rhetoric is identical to what I used to hear when I was growing up in the 1950s.

My parents and my teachers often talked about the Great Depression. They talked about how greedy people were in the 1920s. They said that people were so greedy that even if they were rich, they'd borrow more and more money so that they could make even more money.

My teachers often referred to the greatest evil of them all: margin. A greedy investor could buy stocks and pay only 10% of the purchase price. The 10% was called "margin," and the other 90% was borrowed. My teachers emphasized how evil this was, that some greedy rich person would pay only 10% of the price of a share of stock in order to make more money.

I can almost still hear one of my teachers saying: "Thank God! They've made it illegal to buy stocks on margin like that! Those greedy investors will have to pay for the stocks they buy, so we'll never have a Great Depression again!" My teachers must be turning in their graves to see what's been happening in recent years.

Xenakis describes the social revulsion of risk-taking and the attitudes toward debt that lasted all the way into the 50s after the Great Depression. As he mentions, the social backlash against "greedy bankers" and those who put themselves in incredible amounts of debt is frighteningly familiar. How much compassion does the average American have for a person who got in over their heads and is now in dire straits? How willing will people be to take on even more debt than they already have, while risking their social standing to do so?

This is a perception change that has gone from one extreme and is only still on its way to the other. Through the 90's and 00's, anyone who didn't live above their means were the ones marginalized. Renting was for the poor. Anyone who was remotely successful was a home or condo owner and had a nice, shiny new car to go along with it. I shouldn't need to explain this. We all know it too well. Our measurement of success was determined by our ability to portray it, and that ability was provided more by easy credit than it was by actual underlying success.

My, how times change. As I wrote recently in "Say Goodbye to Conspicuous Consumption," this paradigm has ended. There might be a few stragglers that haven't got the memo yet, but the game is up. And it's not going to return for many decades.

People see the massive government bailouts. Those that were responsible know that they are bailing out the irresponsible. The amount of acrimony this will provide toward the former will be more than sufficient to ensure they are kept in check. The same social pressures that essentially "forced" people into living beyond their means (or lose a wife, be cut out of a social circle, etc) will now be pressuring people to stay out of debt and live below their means.

This is the uphill battle the central banks are facing when trying to "get credit moving again."

But that's not all. There is another massive headwind working against any possible reinflation attempts: massive looming supply from a larger "baby boom" generation. They have only just begun retiring (the first ones hit retirement in 2007 - the same year this crisis started - coincidence?). As they retire, they will be liquidating their assets to a far less numerous generation. Coupled with the already excessive supply in housing, autos and other big ticket assets, the only possible solution to a problem of oversupply/falling demand is lower prices. This construct is amplified in Europe.

And now lets think about that younger generation. They will be bearing the brunt of this crisis. They will grow up with few job opportunities, a punitive tax code and a seemingly endless public debt burden. Who will they blame? How will their consumer behaviour be affected by their experiences as a child? Seeing one or more parent lose their job. Having to screen calls for their parents in order to avoid the collection agencies. Seeing the repo man give notice to your parents of their foreclosure. How will these children behave in reaction to their experiences with their parents' excessive debt loads?

Do you really think that this younger generation is going to make the same mistakes they've witnessed their parents make? Will they just pick up where we left off and continue consuming at the same rate we did?

I think not.

Will Chinese Demand Not Be Inflationary?

One would think that the stories of Asian decoupling would have gone away by now. Their markets have crashed just as massively or more as any western markets. The "China Miracle" is no exception. There's reports of 20+ million unemployed migrant workers, and that doesn't include the regular city dwellers who have been put out of work. Mass factory closings are to blame. Chinese imports from Japan, Taiwan, and Korea have been cut in half. Electricity consumption (typically a good proxy for economic growth) has fallen off a cliff. Cargo loadings at their major ports have fallen drastically. Entire fleets of freighters sit idle in the harbours. There is 14 years worth of office building supply in Shanghai - and that is only if buildings are filled at similar rates to the last few years. It is the equivalent of all the office space in Manhattan.

How the jobless Chinese are all of a sudden going to start spending money at a rate sufficient enough to stoke the fires of inflation is beyond me. But suppose they do turn around and start slowly transforming into a consumerist society. What impact would that have? Consider that taken together, the economies of China, India and Brazil are 1/5th the total size of US and EU economies put together (~7 Trillion compared to ~34 Trillion). Consumption makes up for a far smaller portion of the emerging markets as of now. So for every 1% drop in consumption in the west, emerging markets would need to increase their consumption by approximately 8% (doing rudimentary math from the CIA World Factbook Data). And they would have to increase it by far more than that in order to have an inflationary impact.

This is not going to happen. It is so far beyond reality that discussing it further is a waste of time. The fact is, emerging economies are not nearly relevant enough in the scope of the world economy to create a large enough demand for credit to compensate for the falling demand in the west.

Another common argument I hear is that China could one day press the sell button on its 1.4 trillion in US treasuries, thus pushing interest rates up and increasing inflationary expectations.

China would not do this. The very act of selling US treasuries requires that they buy something else with the proceeds. The gold market is way too small. Any other currency is too risky and not strategic enough to justify the cost of switching. So they would have to buy their own currency. This would massively push up the value of the Yuan, further choking their exports. It would be suicidal. Sure, they'll try to jawbone rates higher by rumbling about distaste for US policies. But they won't act.


A credit based economy requires an ever increasing amount of debt in order to support itself. Since the 70s, all of the recessions we have seen involved a slowdown in credit expansion - never an outright contraction. In order for a hyperinflation to occur, we not only need to get back to a level of credit expansion equal to that of 2006/2007, we would need to to exceed that level and continue even further. Let's review the facts:

- Banks cannot lend because their balance sheets are loaded with tens of trillions in impaired paper assets
- The government and Federal Reserve only control a small portion of the total supply of money and credit
- The interventions we have seen are not inflationary because for every dollar of credit provided or guaranteed, another is wiped out
- Social aversion to conspicuous consumption and "living beyond one's means" is catching fire
- An aging boomer generation needs to sell their assets to a smaller, more risk averse younger generation
- Emerging markets like China are in a position of overcapacity and are too small to offset a worldwide contraction

Taking the above information into account, we can only conclude one thing:

Hyperinflation is impossible.

(edit: please read the addendum to see my response to some common arguments)

Saturday, March 14, 2009

Technical Update 9.09

Well that was fun. 13.5% in just 4 days. I had been waiting for some sort of a rally, but had no idea when it would come. I managed to get in on some JP Morgan calls near the bottom and more than doubled it - before watching it scoot even higher, of course. But a double in less than 3 days is okay in my books. No complaining here. What now?

I'm leaning toward another new low before we see a multi-month rally take hold. But I thought this rally would die out sooner than it has, so I could be wrong. The one thing I do feel strongly about is that 666 was not "the" low. Whether it was a low for this specific downleg is likely something that will be resolved next week. Any further follow-through would probably be a sign that I am wrong, and that multi-month rally is now taking root. I'm not going to chase it. I want two things to occur before I would think about buying anything: 1) enough time to elapse to consider the rally "accepted" and 2) a decent pullback that would give me a low-risk entry. Buying now would be suicidal because there is no legitimate way to control your risk. I'd rather watch the markets skyrocket higher for weeks on end and wait for a short opportunity than try to chase 'em higher. Shorting now is equally as dangerous. I would only do it if I had a multitude of reasons and an extremely tight stop.

On the S&P 500, I was looking at the 20day EMA to hold the rally on a closing basis. But Thursday's and Friday's close surpassed it. Does it have the juice to make it to the 50 (800)?

My two favourite indicators are not quite as ambiguous. The put/call ratio moving average is back to where it was prior to both the January and February highs (which is a sign of excessive optimism). The market breadth moving average is nearing the area that has previously marked intermediate term tops.

The US Dollar looks like it wants to retrace a little bit before making any further gains. My eye is on the 85 level for the Dollar index, 0.80 or 0.82 for the Canadian Dollar and 1.325 for the Euro.

Just a reminder to readers that these technical updates are for people with time horizons of under 3 months. DO NOT use this information as any part of a long-term investment decision making process.

Are there any indicators my readers would like me to include in these updates? What are your eyes on? Feel free to leave a comment below or send me an email with your thoughts.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Friday, March 13, 2009

News Tidbits

I try not to incessantly harp on the negatives. Its not good for the soul. But the consumerist/materialist society we lived through for the last decade was not healthy either. I view the downfall of the financial rackets as a net positive. The organic regeneration that will come from it will leave us far better off than if everything just continued on forever.

That's easy for me to say. I haven't been caught up in the negative side effects. I haven't lost my job. And I haven't lost 50% of my net worth. And even though I was screaming from the rooftops trying to warn people before it all happened, I hardly feel any satisfaction in calling it right. But considering the mainstream media does such a piss-poor job of reporting the actual facts, I guess somebody has to do it.

Do try to remember that even though the world looks like it is going to hell, it has looked that way many times before and we've ended up just fine. With that in mind, I give a reminder to 2 of my 12 Themes for 2009:

- Worldwide social unrest or even war as currency collapses, unemployment and falling asset prices shake people's faith in their governments and scapegoats are made of traditional enemies

- Social "witch hunts" for those responsible for the common plight. Multiple scandals uncovered. Persecution and enormous tax increases on the extremely wealthy

We know from studying history that financial collapses, scandals and military conflict are closely correlated. There is a simple explanation for that. When social mood hits a tipping point and people become skeptical and angry, they are more willing to sell stocks and pull their money out of banks whereas before they would think long term and give the benefit of doubt. They tend to seek out people who have done wrong, whereas before they would completely ignore the warning signs. And they are quick to find scapegoats for their problems and "shoot first, ask questions later," whereas before diplomacy was able to solve any problem, no matter how big.

We are undoubtedly on the downslope of social mood. So when I see multiple news stories in a single day about nations at an inflection point making militaristic gestures toward others, I worry more than I would otherwise.

US Warships Head For South China Sea After Standoff

A potential conflict was brewing last night in the South China Sea after President Obama dispatched heavily armed American destroyers to the scene of a naval standoff between the US and China at the weekend.

Mr Obama’s decision to send an armed escort for US surveillance ships in the area follows the aggressive and co-ordinated manoeuvres of five Chinese boats on Sunday. They harassed and nearly collided with an unarmed American vessel.

Washington accused the Chinese ships of moving directly in front of the US Navy surveillance ship Impeccable, forcing its crew to take emergency action, and to deploy a high-pressure water hose to deter the Chinese ships. Formal protests were lodged with Beijing after the incident.

On a day that Mr Obama and his senior officials met the Chinese Foreign Minister, Yang Jiechi, in Washington, Beijing showed no sign of backing down. Its military chiefs accused the unarmed US Navy ship of being on a spying mission.

The US keeps a close eye on China’s arsenal, including its expanding fleet of submarines in the area. Washington says that the confrontation occurred in international waters, but Beijing claims nearly all the South China Sea as its own, putting it in conflict with five other nations that have claims over different parts of the waters.

Half the world's merchant traffic by tonnage passes through it, two-thirds of it crude oil. Whoever controls sea passage through the South China Sea has power over some of the largest and fastest growing economies in the world. And it is this which makes even a water fight a matter not only of local, but of international concern.

Japan Warns It May Shoot Down North Korean Satellite Launcher

Japan today threatened to shoot down a satellite that North Korea plans to launch early next month if it shows any signs of striking its territory.

Tokyo's warning that it would deploy its multibillion-dollar missile defence system raised tensions in the region after North Korea said that it had identified a potential "danger area" near Japanese territory along the rocket's flight path.

The regime told the International Maritime Organisation that the missile would be launched during daylight between 4 and 8 April, and that its boosters would fall into the Sea of Japan – about 75 miles (120km) from Japan's north-west coast – and the Pacific Ocean.

Officials in Tokyo said they reserved the right to destroy any threatening object in mid-flight, despite North Korean warnings that it would consider such a move an act of war.

These kinds of things have been happening for years. And if I didn't know the implications of the socionomic and generational tendencies at different times, I would be inclined to brush it all off as just more posturing. But the two separate measurements of social actions tell me that we are in a period where we are drawn toward escalation, whereas before we were attracted away from it. Like magnets.

My eyes are more fixated on the Japanese situation. Their economy and social mood is in tatters right now. Leadership is like a revolving door. A new one gets elected and after a few months his approval ratings are in the single digits. All it takes is one lunatic to think that they can solve their problems by greasing the war machine against a "weak" target.

I hate having to put such a negative spin on matters. But consider how paranoid everyone had been about a WWIII breaking out ever since the last one ended. Had I been around and following the same two methods of quantifying societal action, I would have been telling everyone not to worry. Fears of cold war escalation were totally inappropriate according to both theories. Today is a different story. It would have to be a complete historical anomaly if we escape this global economic crisis without large-scale military conflict.

On the bright side, there are signs that people are starting to make selfless decisions to accommodate the well-being of their fellow citizens. Consider this story: Beth Israel Workers Agree To Go Without To Save Jobs

Okay, perhaps an article about workers agreeing on a pay-cut doesn't appear to be good news on the surface. But consider that lower wages are a necessary precursor to a recovery in employment. The fact that it is being done voluntarily is a good sign.

And if that wasn't enough to cheer you up...

(photo courtesy of Reuters/Jayanta Shaw)

Just because we're doomed, doesn't mean we can't smile and cover ourselves in paint!

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

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