Saturday, October 31, 2009

Podcast #2 With The Optimistic Bear

I had another interesting discussion with Michael Surkan of The Optimistic Bear on Friday. Among issues touched upon were the last week's stock market performance in the face of primarily positive economic numbers; foreign currency issues and their effects on globalization; emerging markets and whether their outperformance is genuine; the positive nature of various malinvestment liquidations; nanotechnology; the effectiveness of fiscal and monetary stimulus and quite a bit more. Interested readers may wish to have a listen:


Thanks again to Michael for having me on the show.

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.

Wednesday, October 28, 2009

Deflationary Forces Still Hard At Work

Today will be a quick post on some of the more deflationary forces that have been going on under the surface over the past few months. It has been fashionable of late to speak of how central bank monetary stimulus and government fiscal stimulus has "brought us out of recession." Tomorrow morning we will get US Q3 GDP numbers, and they will surely be positive. The media will sing the "recession is over" tune until they are hoarse. But they will be wrong. As per usual.

To be sure, many companies and individuals have used the relatively favourable conditions in the bond markets to build capital, refinance their debts and a select few are even acquiring new assets and R&D funding. But this is the exception, not the rule.

What is easily seen by casual observers is that governments and central banks went on a shock & awe campaign in a "war against recession." News happened to stop getting progressively worse around the same time, and the layman assumes one caused the other. They conveniently forget that both fiscal and monetary easing started more than a year and a half prior to the March lows in the stock market. So did these policies all of a sudden go from failure to success overnight? Or had the stock market simply gone "too far, too fast" and needed time to sort out the good from bad?

It is my contention, that it has been a mere correction in the mood of investors and not in the actual health of the capital markets. I have discussed my opposition at length to the money multiplier model of monetary expansion used by central bankers. I believe that their models are incorrect. They state that if they (the central bank) is to deposit $1 of newly created 'money' at a member bank (Bank of America, for example), then BofA will then go and lend $10 to others. As has been discovered by numerous economists over the course of the past few decades, this is precisely backward. Banks lend out money first, based on their belief in the ability to make a profit on their loan. Thereafter, they acquire deposits to meet capital requirements. This explodes the myth that any of the Fed's asset swaps or QE has somehow inflated the money supply. They have merely shifted the existing supply around, hoping that in its new home it will multiply. It hasn't. And it won't. Because it can't.

Below is a chart of the past 60 years of commercial and industrial lending measured as a percentage change from the prior year and as a percentage of total GDP. Despite the hockey stick graph that so many like to point to as evidence of impending hyperinflation, the banks that have been given this so-called "printed money" are not lending it. Lending is falling off a cliff to businesses and shows no signs of turning around. (Chart courtesy Econompic Data)



Why aren't they lending? Are they just being greedy and keeping the money for themselves as the many populist cries imply? Or is something preventing them from lending? Glad you asked. For those with a short memory, the panic of 2008 was caused by people defaulting on mortgages. With a 50% rise in the stock market, one would assume that problem has at least dissipated slightly, right? Wrong. Mortgage delinquencies continue rising. See Exhibit A (from Calculated Risk):



That doesn't look like much in the way of improvement to me. Fannie is in the same bind. And the FHA, which has been recruited by the government to pick up the slack in doling out garbage mortgages, is even worse. Below we can see that although home prices may have ticked up in response to HAMP (cash for cabins), foreclosures (blue bars) have not yet caught up to delinquencies (red bars).



What does that mean? It means that banks cannot foreclose on properties fast enough. Alternatively, they may feel that they can modify these loans or that those that are delinquent will get their jobs back in due time. That is wishful thinking. Not even the flaming optimists see employment turning around anytime soon, and banks have already found that more than 60% of loan modifications re-default within mere months. Either way, there is massive supply of homes that are soon to be bank owned and liquidated.

So I suppose that would explain why banks can't do anything with their "excess reserves." Also keep in mind that much of these reserves are on temporary loan from the Fed in exchange for other garbage securities.

But it is not just the banks that aren't lending. Trade Credit is falling sharply also. As defined by Wikipedia:

Trade credit exists when one firm provides goods or services to a customer with an agreement to bill them later, or receive a shipment or service from a supplier under an agreement to pay them later. It can be viewed as an essential element of capitalization in an operating business because it can reduce the required capital investment to operate the business if it is managed properly. Trade credit is the largest use of capital for a majority of business to business (B2B) sellers in the United States and is a critical source of capital for a majority of all businesses


Chris Whalen of the IRA Analyst interviewed two of the leading corporate credit ratings firms, Jerry Flum and Bill Danner. Below are some excerpts, but the whole interview is worthy of a read.

The IRA: So what are you seeing at CRMZ in terms of corporate credit, accounts receivable and the data you gather?

Danner: The dollar value of accounts receivable we collect are down sharply. In general vendor credit is down much more than the drop in bank lending.

Flum: Not only that, but you've got to remember that the rate of gain and the expansion of bank lending is down. If trade payables are also down, then there is no grease for the real economy.

Danner: Yes, to put a finer point on it, trade credit is down bigger than bank lending. Remember that commercial receivables are huge, something like 3x commercial bank loans. This is the real economy's lifeblood, but trade credit is down more than the decline in sales and down more than the decline in bank lending, including metrics you guys track on banks like exposure at default ("EAD").
...
Flum: I have been doing this for 40 years. Started in the financial business after working at a law firm. I got my head handed to me in 1973-74 in my hedge fund and had to learn how markets behave. When I boil what I've learned all down to one factor that drives the markets and an economy, it is debt. Debt vs. GDP, for example. Every dollar of debt moves a future purchase into the present.

The IRA: In a fiat money system, there is no money, only credit.

Flum: Correct, and as credit grows we spend more of it now. So, if you look at debt vs. GDP, we are already at record levels. We can also look at incremental debt vs. incremental GDP. In the 1950s, it took $1.50 in debt to produce an incremental $1 of GDP. Today it takes more than $6 in debt to produce a $1 of GDP, so we are approaching the end of the game. This economic inefficiency is a sign of being closer to the top than the bottom and a new beginning.
...
The IRA: So the efforts to restore the commercial paper markets and add liquidity to the markets has not trickled-down? The Fed would tell you that they have restored normalcy

Danner: The numbers we are seeing on A/R and trade credit volumes are continuing to get worse, not better. A big part of that is financing.


So much for monetary stimulus. Behind the smoke and mirrors from the central banks and the flashy lights in our financial media, absolutely nothing has been achieved by these measures. That is, if one chooses to ignore the unintended consequences.

But what about the government stimulus measures. Surely the various programs and stimulus cash is having its effect on the economy? Not likely. Again, the models that suggest that this works suffer from a similar affliction: they ignore debt. And in a credit inspired recession, adding more debt does nothing good. Sure, it can be good for some people who are direct recipients of the loot. But for the rest of the taxpayers and businesses, the implied future rate of taxation rises in lockstep. This is something that I have mentioned before, but I had not heard anyone else take up the cause. Until yesterday when I happened upon a fairly wonkish post from Rob Parenteau. In it he makes the same observation:

DoctoRx next considers a contradiction in using policy responses to debt deflation dynamics that require higher government debt. He suggests we best think of the government balance sheet as consolidated with the domestic private sector balance sheet, since Treasury debt is an obligation that ultimately must be paid by taxpayers. This of course is a variant of the Ricardian equivalence argument, whereby fiscal stimulus is deemed to be ineffective at inducing economic growth since the households receiving higher income from deficit spending simply save the entire proceeds in expectation of future tax liabilities of equal magnitude. DoctoRx is probing along similar lines when he observes, “after all, the private sector has to debit its bank account to send the funds to the government in order to buy the debt. All that is really happening is that the private sector had cash, and now the government has the cash with some repayment terms.” Fiscal deficits are, in other words, just an asset swap.
...
Money and finance are not neutral with respect to real economic outcomes, nor is money simply a veil for real exchange, as is taught in mainstream economics and as is held as holy truth by contemporary central bankers. Read a little Fisher or a little Minsky, and then reflect on recent events. Did we destroy some productive resources, lose some technical knowledge, or otherwise experience an exogenous productivity shock to drop into the deepest recession of the post WWII period, or was the drop in real economic activity in no small part a result of a highly leveraged private financial and nonfinancial sector encountering some very drastic financial conditions as fraudulent loans and fraudulent debt ratings were exposed? Does the government need the private sector’s money to “fund” its expenditures when a) the nonbank private sector cannot create money, and b) the government creates the money the private sector accumulates to pay taxes and buy bonds? Under what conditions can the business sector as a whole accumulate tangible capital without issuing financial liabilities, and are those conditions we observe in the real world around us?


Again, read the entire piece. Have a drink beforehand as it runs deep to the present situation. Parenteau, the Austrians, and followers of Minsky's Financial Instability Hypothesis understand that debt is the problem. They understand that either shuffling it around (as are central banks) or creating more of it (as are governments) is not a viable way to combat credit deflation, while it may 'work' during a run-of-the-mill overcapacity recession.

The equity and commodity markets are acting as if there is no difference between the characteristics of the two separate types of economic contractions, responding as they would to the expected recovery from undercapacity. As we can see from the charts above, the deflationary forces that began the crisis two years ago continue to accelerate.

Bernanke and Geithner are trying to fit a square peg in a round hole. Vegas odds are 1:1 on them succeeding.

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, October 25, 2009

Technical Update 41.09

Another interim top has materialized. Like all of the other tops along the way, it will require a significant change in market character prior to allowing for confirmation of the primary top I am expecting. For the past few weeks I have outlined a number of factors that would help make this distinction.

1. Consecutive daily declines of 2.5% or more. This hasn't happened since the rally began (if so, only marginally).
2. Weaker internals than previously displayed during the rally via 10 day moving averages of a) put/call ratio b) advance/decline issues c) advance/decline volume.
3. A considerable increase in the US Dollar Index. A crossover of the 20 day EMA over the 50 day EMA is something that has not yet occurred since early April.
4. Divergence between major indices. Dow, S&P, Nasdaq, Transports, Banks. We should see significant divergence between some of these indices at a major top. There have been divergences present at various points, but they have quickly resolved themselves. Specifically, I am looking for underperformance in the transports, banks and/or the nasdaq.
5. A complete Elliott Wave '5' down on more than an intraday basis.

We are seeing early signs of divergence in certain indices, but not others. And market internals seem to be getting progressively weaker on any push higher. On an anecdotal level, I can sense mood shifting toward pessimism again. Earnings reports, while still very weak, have largely blown away analyst 'expectations.' Yet for the most part, this has not resulted in favourable reactions in the overall market. The US Dollar remains subdued, falling marginally with the market this week.

On March 3rd, I wrote about certain stocks and sectors that had been displaying relative strength in opposition with their November lows. Indeed, most of the stocks mentioned have enjoyed more than 100% gains from their lows. Of course, one would have done better buying some of the worst performing sectors, but picking the winners that experienced 1400% gains over those that only got 14% was impossible to determine at the time. Back in March, there was little that would suggest Fifth Third (FITB) would drastically outperform Keycorp (KEY), but momentum chasing of the former allowed this to happen.

I am currently tracking a list of stocks and sectors that are showing relative weakness to the overall market. Similarly, there may be greater downside potential found in those that have made the greatest gains over the past 7 months, but with those comes also greater risk. Trading in high beta sectors is a double edged sword. Below are some sectors that have failed to confirm the market's new October high. If I were looking for short opportunities, these sectors are where I believe the lowest risk will be found.

Transports and particularly the railroads have shown some of the most notable underperformance. For the week, both finished down more than 5%.



The solar energy sector topped in June and has been meandering sideways since then.



The biotechnology sector happens to be one of my favourites from a long term fundamental standpoint. But it is now also an underperformer over the past month, giving back more than 6% last week alone.



It is no secret that the problems with the banks are yet to be resolved. For much of the rally, bank share prices have been the leader in hopes that eventually "everything will work itself out." But they are not leaders any longer, showing weakness over the past two months and only able to marginally achieve new highs despite better than expected earnings numbers.



But weakness can be seen even more in Canadian financial institutions.



Another area that has received heightened attention by central planners is the housing market. It is believed by most contemporary economists that if home prices would just start rising again, then all the problems will go away. This comes from a fallacious interpretation of what went wrong last year, but it hasn't stopped them from trying all sorts of policies to fix home prices. Regardless, the homebuilding industry is now also displaying weakness. "You can't fool all the people all the time..."



Have a great week!

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.

Wednesday, October 21, 2009

Podcast With The Optimistic Bear

Last night I participated in a podcast with Michael Surkan of The Optimistic Bear.

We discussed a number of issues ranging from international banking, the inflation/deflation debate and health care to generational cycles and the secular changes I see developing in attitudes toward risk. You may listen to the full interview in the player below.



There were some other issues that I was hoping to touch on. For instance, I did come across as quite the pessimist in the interview. In fact, I see myself as more of an optimist. I view the contraction of credit and falling asset prices as positive, not negative. In order for organic productivity-inspired growth to occur, the dead waste needs to be cleared first. So I don't view the onset of depression as "armageddon," rather as the first stage to future prosperity.

If time were never an issue, I could have also elucidated some areas I believe will be kind to investors in the intermediate term. I am very positive on the prospects of South America. Much of the continent has far more favourable demographics than other emerging markets. And from a generational perspective, many nations have put their dark histories with dictatorial governments behind them (eg. Pinochet). Chile, Colombia, Uruguay, Brazil, Peru and eventually Argentina (when they get their house in order) should all be ideal investment areas over the coming decades. I am also very positive on the eventual application of nanotechnologies, and I believe this will be a spectacular area of growth once the required investment resources are freed from their current wastefulness.

I'd like to thank Mike for being a great host and having me on his show. Hopefully my readers find it to be worthy of their time. It was the first time I have attempted something like this, so any feedback on the subject matter or even my communication abilities would be much appreciated!


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, October 18, 2009

Technical Update 40.09

The major indices finished the week higher, a feat achieved 24 of the last 34 weeks (70.5%). Rising stock prices seem to be ingraining themselves into the collective conscience of market participants even as confidence measures remain somewhat benign. It tells me that while many do not believe the economic recovery story, they have become exhausted with trying to short it. Many have taken a similar posture as myself, waiting for confirmation of a move before committing capital to shorts or liquidating longs. Being a person constantly looking for contrary indicators, my own emotions and those of others typically provide clues to changes ahead. Perhaps this is one of those times...

It is a market driven by momentum. In talking with various colleagues, I try to get a handle of how much conviction buyers seem to have. I don't get the feeling that many of those holding substantial long positions would tolerate much of a decline before checking out. Where are the stops? A 10% market decline? If many are indeed acting under this sort of a mentality, a selling panic could easily ensue once this line is crossed.

But that is subject for another day. Today, we have a climbing market to chart. Other than a nasty underperformance this week in banks, transports and the nasdaq, we have not yet come close to satisfying the qualifications I am waiting for.

1. Consecutive daily declines of 2.5% or more. This hasn't happened since the rally began (if so, only marginally).
2. Weaker internals than previously displayed during the rally via 10 day moving averages of a) put/call ratio b) advance/decline issues c) advance/decline volume.
3. A considerable increase in the US Dollar Index. A crossover of the 20 day EMA over the 50 day EMA is something that has not yet occurred since early April.
4. Divergence between major indices. Dow, S&P, Nasdaq, Transports, Banks. We should see significant divergence between some of these indices at a major top. There have been divergences present at various points, but they have quickly resolved themselves. Specifically, I am looking for underperformance in the transports, banks and/or the nasdaq.
5. A complete Elliott Wave '5' down on more than an intraday basis.


The recent push from the early October low of 1019 has certainly been achieved with declining participation. See the divergence below:



The ratio of the Dow to the S&P seems to move contra-cyclically. The Dow underperformed on the way down and now outperforms. A divergence in ratios like this, as well as with the Nasdaq may provide a window to the market's internal happenings.



I'm also watching the ratio between the VIX and VXV. This monitors the premium/discount of 3 month volatility to that of the present. As future volatility gets sucked out of future option prices, the ratio falls. For months, option traders were willing to pay a premium for September or October options. Due to seasonality it seems that many had been forecasting a market turn by either of these months. With October expiry out of the way, any distortions this may have created may be free to resolve themselves.



I do find it interesting that such an enormous consensus exists in utter hatred for the USD. Nearly everyone has been sold the story that the Dollar is destined to soon become worthless. But what is really interesting is that this has occurred while the dollar index remains well above its prior lows. I am anticipating a sharp move higher one of these weeks that will trigger quite a bout of short covering.



Have a great week!

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, October 15, 2009

Market Breakout, Bonds, Oil and Earnings

Third quarter earnings have been seeping out this week, mostly to critical acclaim. Thus far, profits from the big financials appear to be mostly concentrated in proprietary trading (again). And once again, there's very little transparency to the banks' actual balance sheet due to the suspension of mark to market accounting. The plan is that these rules will be reinstated by yearend, and the consequences to earnings are quite obviously ground-moving. Cynically, it should be assumed that these banks will throw untold millions at lawmakers to have the rules postponed again. But the real question is not necessarily the rules themselves, rather the willingness of speculators to take the risk.

Risk appetite trumps fundamentals.

I wish I could be bullish on the economy. But I do not see the proper characteristics for sustainable economic growth. Money is being piled into the old bubble sectors (FIRE - Financials, Insurance, Real Estate), which themselves produce no wealth. Meanwhile, small businesses, startups and individual consumers are starved for both capital and access to credit. I struggle with how this could go on for so long, but I then think back to '07 when everything was similarly levitating in the face of the blatantly obvious. The necessary deleveraging was also avoided in '01-02 and continued for years. So while I prepare for the possibility that this lasts much longer than anyone expects, I don't foresee it doing so.

One thing I do expect is confusion. Lots of it. I expect to see some major separation from previous positive correlations. For instance, long term interest rates have risen substantially over the last two weeks (30 yr treasury yield up 43 basis points), and I have a feeling that this may be a more permanent sort of move. I would not be surprised if the long bond starts trading as a risk asset on any subsequent market decline. Rising rates are also something that has the potential to kill what many are calling a bottom in the housing market (I think not).

Oil may also be something that finds some separation from its recent 'beta' with the stock market. It seems like forever, but there was a time when rising oil prices were seen as a bad thing, and every tick higher in crude was matched by a tick lower in stocks. Oil broke out above new highs this morning above my long standing cited resistance around $75, many technicians see it with little resistance up toward $100. Whether the market reacts to this negatively or not, it is going to start putting big pressure on consumers. And if there is one thing that angers populations more than anything, it is rising gas prices. It would be sweet irony if rising oil prices, at first thought to be a harbinger of economic growth, eventually killed the rebound in social mood and sapped the willingness of consumers to consume - just as we edge into Christmas shopping season.

Traders and investors become married to correlations. When they break, they cause chaos for weeks at a time while managers reposition their portfolios for what seems like the "new normal." The present correlations have held for quite a while, likely lulling many into complacency. Watch them carefully.




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, October 10, 2009

Technical Update 39.09

The material change in market character we were looking for did not materialize. As suggested, the first whiff of this led to bulls piling back on and quickly retesting the previous highs. Without significant followthrough from last week's decline it was readily apparent by Monday that dip buyers had not exhausted themselves and the risk seeking behaviour we have witnessed over the last seven months would reassert itself.

The Elliott Wave structure was confirmation of this after failing to register 5 full waves to the downside. The most probable counts now show the S&P rising in either a 5th wave to ~1120 peak or a 1st wave of something far more bullish (projecting to over 1200). The rally obviously intends to destroy as many bears as possible prior to reversing. Maximum ruin indeed.

Two weeks ago I outlined 3 indicators I was watching for confirmation of a rally peak. I will expand on that this week with a few more and will continually track them as the weeks pass. Readers can feel free to add their own.

1. Consecutive daily declines of 2.5% or more. This hasn't happened since the rally began (if so, only marginally).
2. Weaker internals than previously displayed during the rally via 10 day moving averages of a) put/call ratio b) advance/decline issues c) advance/decline volume.
3. A considerable increase in the US Dollar Index. A crossover of the 20 day EMA over the 50 day EMA is something that has not yet occurred since early April.
4. Divergence between major indices. Dow, S&P, Nasdaq, Transports, Banks. We should see significant divergence between some of these indices at a major top. There have been divergences present at various points, but they have quickly resolved themselves. Specifically, I am looking for underperformance in the transports, banks and/or the nasdaq.
5. A complete Elliott Wave '5' down on more than an intraday basis.

All or most of these factors should be present in the first 10% decline from the highs. Until then, it should be considered that the bull trend remains intact. It seems that too many are focused on calling the exact top (I'm guilty of this sometimes) rather than waiting for confirmation. Keeping it simple is typically the most prudent course when using technical analysis for timing entries and exits. And most of the best known traders adhere to this principle. Giving the market 10% on either side of a large move still allows one to participate for 80% of the move.

The German DAX has a very logical target denoted by the blue line on the following chart. The 6100-6200 area has proven to be a point of inflection numerous times over the past few years. And it is also where the Mar-Jun wave A would be of equal size to a wave C peak.



Finally, it needs to be pointed out that the US long bond experienced two consecutive days of intense selling to close out the week. What is it trying to say? Is it sensing a potential rise in the Fed Funds rate? Is the long bond now trading as a risk asset class? Is the cessation of Fed POMO activity being reflected by interest rates rising to a more natural level? Nobody knows for sure, but the activity is certainly deserving of attention.



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, October 6, 2009

Weighing In On Fractional Reserve Lending

Mish and Karl Denninger have been having an interesting back and forth on the topic of fractional reserve lending. There is vast disagreement on this subject even within various schools of economic thought. It does not seem to be an ideological debate, but rather a juridical one, which makes it less emotional and perhaps worthy of debate.

Both Mish and Karl bring up good points about what is fraudulent about our financial system. Mish feels it is more systemic and Karl thinks it is a lack of regulatory will (due to capture, corruption, etc). I have stated previously that with a proper legal foundation, no regulation is necessary. So I would have to agree more with Mish. I sent him an e-mail this morning, which I will republish here:

Mish,

The best arguments against FRL I have read can be found in Jesus Huerta de Soto's Money, Bank Credit and Economic Cycles.

You touched upon this, but de Soto has a better way of explaining it through a historical (dating back thousands of years) understanding on the nature of contract law. When a depositor gives their money to a bank, they are doing so under the impression that the bank keeps their money safe. If this were not the case, people would buy bonds or some other investment. Historically, the act of keeping money safe was a service that depositors would pay for. By lending money out that has been promised to someone else, the bank is abrogating their contract with the depositor. In order to do so, the bank must consider the deposit as an asset, something the depositor simultaneously believes he has. Very simple contract law states that two separate entities can not claim ownership to the same asset. Thus, the bank is guilty of misappropriation by promising safekeeping of something they do not possess.

The confusion seems to surround the difference between two distinct types of contracts: the Monetary Irregular Deposit and the Monetary Loan. Below is a table copied from pp. 19 of Money, Bank Credit and Economic Cycles, contrasting the two types of contracts:

Economic Differences:

Monetary Irregular Deposit: 1. Present Goods are not exchanged for future goods. 2. There is complete, continuous availability in favour of the depositor. 3. There is no interest, since present goods are not exchanged for future goods.

Monetary Loan: 1. Present goods are exchanged for future goods. 2. Full availability is transferred from lender to borrower. 3. There is interest, since present foods are exchanged for future goods.

Legal Differences:

Monetary Irregular Deposit: 1. The essential element (and the depositor's main motivation) is the custody or safekeeping of the tantundum [deposit]. 2. There is no term for returning the money, but rather the contract is "on demand." 3. The depositary's obligation is to keep the tantundum available to the depositor at all times (100 percent cash reserve).

Monetary Loan: 1. The essential element is the transfer of availability of the present goods to the borrower. 2. The contract requires the establishment of a term for the return of the loan and calculation and payment of interest. 3. The borrower's obligation is to return the tantundem at the end of the term and to pay the agreed-upon interest.


Similar to a monetary irregular deposit would be the storage of crude oil in large tanks. The depositor of the oil pays the storage company a fee. The storage company cannot now go out and sell the oil - that would breach their contract.

Time and time again, throughout history, bankers have attempted to turn monetary irregular deposits into monetary loans in order to speculate with their customer's deposits. Throughout history, from Ancient Greece to the early 20th century it has been determined in courts of law that this practice is illegal. We have institutionalized it. We have created all sorts of fancy schemes in order to cover up this misappropriation (think FDIC). And we have central banks who attempt to mandate positive inflation which encourages depositors to seek return rather than safety with their life savings.

We need a banking system that clearly separates the two kinds of contracts: Depositary Institutions and Loan Intermediaries. With such a system, the central bank's ability to perpetually inflate will be castrated and a truly free-market would be able to prosper (something we have never had). Note that this does not require a gold standard for discipline. A currency could be denominated in anything so long as the legal principles of the monetary irregular deposit were upheld.

Addendum:

To elaborate on the last point. I am not in favour of a legislated gold standard. Although I do believe gold would have a role to play as a medium of exchange if it were permitted (ie. if legal tender laws were repealed). Many of gold's detractors fail to discriminate between Gold Exchange Standards, Bimetalism and 100% reserve gold standards. The latter has very few historical examples of any length. But this is conjecture. I am in favour of multiple competitive currencies which may be freely exchanged electronically, provided 100% reserves are kept and available at any time. There is no reason, with our current technology, for this to be prohibitively complicated. I walk into a bakery to buy a loaf of bread. I elect to pay at the cashier from my account with wheat. If the baker doesn't want wheat, he can program his account to immediately convert wheat to gold or land or whatever she chooses. The intermediary charges a small fee each time this occurs.

Separately, other intermediaries may provide participants the ability to borrow from others who are in the market to lend. Rates would vary according to the risk taken and a term would be agreed upon prior to the transaction completed.

Some Austrians argue that this would effectively end the business cycle. I disagree. There would still be a very noticeable boom/bust cycle because entrepreneurs will always display a herding behaviour and fail regularly. However, the busts would not be systemically jeopardizing due to the lack of leverage. Banks would be mere service providers, not permitted to speculate themselves. Thus, their ability to create loans prior to finding lenders, essentially playing arbitrage on current asset prices vs. inflation adjusted asset prices, will be nixed.

The giant vampire squid's blood funnel would be cut off.



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, October 4, 2009

Technical Update 38.09

Another week of losses for the major averages gives heightened probability that a major top has been reached. There remains, however, numerous market anomalies that one would not expect if "a change in market character" is what one is looking for. This could, in fact, be nothing more than an overbought correction much like we saw in July.

In the "failing to confirm" category lies crude oil, which remains sticky after posting a 6% weekly gain. The US Dollar, which only managed a third of a percent gain for the week, may also be hinting at something amiss with the validity of the selloff.

I remain cautiously bearish until those two above factors resolve themselves. But I would warn against complacency for those holding large long positions. When this major downward movement materializes, it will not be merely a "correction" of the March-September bull market. We will be proceeding to substantial new lows as the economy deflates, deleverages and completely retools for future expansion. In all likelihood, the highs we achieve in the next weeks (or have achieved already at 1080) will remain in place for a decade or longer.

Moving back to the shorter term for a moment, I would point to some of the recent failures in the S&P 500. Strong markets display strong price movement into the ends of days and weeks. For two weeks running now, we have seen midweek tops on Wednesday afternoon and continued selling pressure for the remainder of the week. This shows that traders are more reluctant to hold positions over the weekend.



Also note that there were two very noticeable bullish patterns carved out this week, both of which failed. Failed patterns often lead to sharp moves in the opposite direction.



Market internals continue to weaken. Advancing/Declining issues and volume are both on the brink of displaying their weakest readings since March.





Market volatility is also ticking upward and recently displayed a positive divergence with the overall markets, refusing to move significantly lower as the major indices climbed higher in September. Additionally, the VIX has broken a trendline dating back to the October/November '08 peaks. Does this breakout look too obvious?



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.

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