Technical Update 3.09

I have recently come to the conclusion that blogging and modesty are incompatible. A prerequisite of writing your thoughts for others to see is the belief that others actually give a damn. However true that may be, I will continue in my attempt to avoid coming across as some arrogant jerk, screaming for attention.

Sometimes I'm right, sometimes I'm wrong. I've made a decent living the last few years being more of the former. But from what I understand, that is no feat in itself. Many, if not most, can claim a similar record. Others will simply convince themselves of righteousness. In fact, I'd be willing to bet that nobody believes they are wrong more often than they are right. Just like 90% of people grade themselves as above average drivers.

So what does this preamble have to do with technical analysis? Everything. Wall Street, Bay Street, High Street and many others to be sure, are littered with the corpses of those who thought they were god. If nothing else, this current crisis is testament to that. Only this time they weren't playing with their own accounts and livelihoods. They were playing with everyone's.

One of the toughest paradoxes I've had to confront in doing what I do, is to reconcile differences with time horizons. Most of my analysis is done on a very broad, macro scale. Yet most of my profits come from short term speculations. And depending on your definition of "short term," that is what everyone else is doing also. If anyone tells you they are a long-term investor right now, they are probably lying to themselves. We're all "renting" stocks to a certain extent. The days of investing for the prospect of dividends is essentially gone. Even today, when confronted with an opportunity to buy a company with a robust dividend, we are more or less speculating on that company's ability to survive. Very few robust businesses are paying robust dividends.

So please try to view these technical updates through the appropriate lens. My sentiments here may contradict sentiments expressed elsewhere due to the time horizon I am dealing with.

The S&P 500 is my primary benchmark for market direction. But I like to see confirmation in other indices like the Dow and Nasdaq before I draw my conclusions. The Dow has been a laggard over the last week as earnings disappointments hammered some of its components. The S&P had to drag the Dow along with it when it broke above resistance at the 840-850 level. As of Thursday's close, the major indices are at a very vital juncture. Any sort of follow through of Thursdays action would portend very poorly on weekly and monthly charts. I will be watching Friday carefully.



As can be seen from the chart above, the S&P is looking vulnerable after a potential "price too high" rejection of the breakout. Fast moves follow failed patterns.



Here is a weekly of the Dow. The considerable underperformance could even see the average post a weekly drop for the fourth consecutive week in January.



Above is a chart of the 10 day moving average of the NYSE market breadth. That large spike above the red line early in the year was one of the signals I used to start getting short. We have now rebounded back to the historical area of "overbought" and are falling again. An oscillation down to the -1000 mark would undoubtably see the major averages surpass their November lows. I expect this to happen.

Another one of my trusty indicators for market sentiment is the put/call ratio. It also gave an extreme reading early this month and has nearly revisited those readings on this shallow rally. This should be a very concerning divergence for bulls. See below:



Suffice to say, I expect lower prices in the immediate future.

As regular readers know, I have been wrong on the recent rally in gold. And I mentioned last week, that if any rally could hold above the $900 level, I would have to re-evaluate my stance. On Monday morning, gold opened higher and continued to rally. I'd like to share the following psychological process I went though, because it is one that often leads to losses. As gold opened higher, one of my requirements for higher prices had been met. For fear of it running away, I thought about buying it. Regardless of the fact that there was no reasonable levels of support to make such an entry with defined risk. I didn't want to miss "it." "It" being the run-away prices of $2000 or higher that many gold bugs have talked about, and that I have warned against. "What if it happens and I miss it!"

Luckily I caught myself. Fear of missing profits was not on my list of legitimate reasons to enter a trade. I had the feeling that others were going through a similar process, so instead of buying gold, I shorted it. I covered near the open on Thursday for a decent profit. Today, I see gold up sharply in European trading, near it's highs from Monday. However, it has been trading down every day this week, only to open flat or higher in New York. (side note: don't expect gold bugs to decry price manipulation if gold is being bought every day before the open - they only see it when it happens the other way).

I don't know what gold is going to do here. If it is indeed in a "long-term" bull market, it "should" correct further and for longer prior to any further upside. I'll take a wait and see approach before drawing any further conclusions.



I don't consider myself as one of those screaming about a bubble in treasuries. I think if inflation was calculated properly (as an aggregate of total money and credit) we would see that real interest rates were high at anything above 0. Clearly, prices got ahead of themselves in December. But I wouldn't be surprised to see even higher prices if the stock market goes in the tank again and people flee for something "safe." I like the 122 area with defined risk on the 10 year.



That's all for now.

Carney Declares War on Loonie

In a speech today at the Halifax Chamber of Commerce, Canadian Central Bank Governor Mark Carney made some simply outrageous assertions that cannot go unchallenged. The entire speech can be viewed here, but I will cherry pick a few excerpts for the amusement of my readers.

Carney, 43, started the speech as all central bankers do: With some light humour poking fun of his age. Familiar readers of mine might find it quite ironic that I, being a full generation younger than Carney, am poking fun of Carney poking fun of his age. And they might be correct. However, it is important from a generational perspective to know that Carney has never lived through an economic crisis in his adult life. Additionally, it has been precisely his generation (Gen-Xers) that have perpetuated the worst crimes of this crisis. Complex quantitative models devised by Harvard grads like himself, assuming based on 10 years of data that asset prices never fall, are precisely what have failed. And we can see the same traces of this complete ignorance of history in today's speech. To the speech:

These are challenging times, indeed. We are facing a financial crisis without comparison for generations. Most financial markets have experienced historic declines in prices and unprecedented spikes in volatility. Storied financial institutions have fallen. The global capital market is under great strain. Issues of financial stability that were once the obsession of a pessimistic few are now the daily concern of many.

Were we obsessive pessimists or constructive realists? At least he's not trying to say nobody saw it coming, as many have claimed.

In challenging times such as these, people, rightly, look to a few constants: to institutions they can rely upon and to certain expectations that will be met. My message today is that Canadians can rely on the Bank of Canada to fulfill its mandate; they can expect inflation to be low, stable and predictable. The relentless focus of monetary policy on inflation control is essential in this time of financial crisis and global recession and remains the best contribution that monetary policy can make to the economic and financial welfare of Canada.

Translation: Don't worry. We'll find a way to steal your purchasing power. One way or another.

Inflation is, of course, defined as a persistent increase in the average price of goods and services; in other words, a rising trend in the cost of living. In the broadest terms, this is measured by the total, or headline, consumer price index (CPI), which tracks the retail prices of a representative "shopping basket" of goods and services over time. It is also the rate that the Bank of Canada targets for its monetary policy.
Disinflation occurs when there is a decline in the rate of increase in prices, while deflation refers to a sustained fall in prices; where the annual change in the CPI actually turns negative year after year.

This is a faulty definition of inflation. Inflation, by the Austrian definition, is an increase in the supply of money and credit. Rising prices are a symptom of that phenomenon. The reason is simple. A static or slowly expanding quantity of goods and services will prove a better store of value than money, which is growing even faster in supply. So people have an incentive to borrow money and buy assets, thereby driving up their price. Cause & effect.

Therefore, by measuring a "shopping basket" as inflation, the BoC is always misinterpreting the rate of inflation one way or another. By extension, their decisions on interest rates are always compromised by faulty data. It is akin to a doctor measuring the loss of hair on a leukemia patient as a benchmark for the growth of white blood cells. It is completely backward. Back to the speech:

While such transitory movements in prices are generally harmless over the long term, greater risks arise from a sustained fall in prices. Such deflation, if left unchecked, can weigh on economic activity in two main ways. First, it increases the real burden of debt, making it more difficult for indebted households to consume and leveraged firms to invest. Second, if deflationary expectations take hold, purchases and investments may be postponed in the expectation that they can be executed at a lower price at a later date. After all, if prices are falling, why buy that new car or refrigerator – or invest in technology or equipment – when they could be cheaper in six or nine month's time?

Carney is talking about the "psychology of deflation," which I have been writing about for months. Anyone with a clue has noticed that the prices of big ticket items are falling dramatically. How many young Canadians still believe that they have to buy a home now, or they'll be homeless for life? How many Canadians think that auto dealerships are not going to have to cut prices further to clear their inventories? Its as if Carney is drawing up plans to prevent a hypothetical Japanese attack on Pearl Harbour, yet it is already midway through 1943 and nobody has told him it already occurred.

With this backdrop, the question is being asked whether sustained deflation could happen here in Canada. The possibility is actually remote for three reasons.

First is the resilience of our economy. The Canadian economy has a number of advantages: labour, product, and capital markets that are flexible and open; one of the soundest banking systems in the world; and households, corporations, and a public sector that have considerable financial flexibility. So while our economy will be tested by the current global crisis, it is well positioned to respond.

I believe quite strongly that the common proud assertion of Canadian banks being "the soundest in the world" is something that will come under fire in 2009. The reason they have been relatively insulated from the credit crisis thus far, is because our real estate markets have been some of the last to collapse. The falling collateral values on balance sheets of Canadian banks and households alike will prove that there is nothing magical about our banking system. We engaged in the same reckless fractional reserve lending tactics as the rest of the world. Was it just as reckless as Countrywide or IndyMac? No. But that's irrelevant.

Think of it this way: If a Russian mobster caught me looking at him the wrong way, and came up to me and said, "100 meeelion dollars, one week, or I cut you!" I'd likely think, "oh man, I'm screwed." I'd skip town and change my name. Consider the same scenario but it was only 10 "meeelion." The result is the same. That's essentially the argument made for Canadian banks being "sound."

Second, a floating currency means that we have an independent monetary policy. Quite simply, we are in control of our own monetary destiny.

Third, we have used that monetary independence to great advantage. As one of the pioneers of inflation targeting, Canada has deep experience with the clearest, most powerful monetary policy framework. The advantages of that framework have been demonstrated, with inflation brought down and kept low and stable since the early 1990s, and they are equally relevant in times of disinflationary pressures. To underscore this point, and before turning to the outlook for growth and inflation, let me review the Bank's monetary policy framework.

Aha! Now we're getting somewhere. One of the major problems for European Monetary Union (EMU) member states is that they cannot set their own interest rates. Even preliminary member states like the Baltics have given up control of their own monetary policy. So when the economies in Spain, Ireland and Estonia started tanking, there's nothing they could do to stimulate them, other than cut wages. Now that may be what needs to happen, nobody knows, but if they were allowed to set rates on their own, or better, if the individual market could set them, the original bubble wouldn't have occurred in the first place - or it wouldn't have been so big.

In Canada, Carney is quite proud of his ability to destroy the Canadian Dollar and thus attract productive capacity otherwise destined for the US. And indeed, he has been trying to do his part by buying up worthless mortgage securities in exchange for the government securities that normally occupy their balance sheet - the same balance sheet that our dollar derives its value from.

How far will he go in trying this? What happens if those mortgage securities can't be resold because home prices are falling rapidly? What happens if that extra production doesn't set up shop in Canada because many other central banks are trying the same thing? Or worse, what happens if the global slowdown simply dwarfs any competitive "advantage" a weaker Loonie would normally bring? Carney's Harvard model says that won't happen. Thank goodness!

Carney went on to profess the genius of the BoC's inflation targeting policy. He used the word "inflation" 21 times in 7 paragraphs. Somebody call Guinness. Unfortunately, every single use of the word was incorrect, as mentioned above. So the entire section was nonsensical. Carney alleged the BoC had been keeping the "core inflation" rate within their target range. What that means for the average person is precisely nothing. Not when home prices were rising at rates of 15%/year. Not when food and energy prices were skyrocketing for years on end. Not when the cost of getting your car fixed or furnace replaced was, well, whatever they wanted to charge. No, I've yet to meet one Canadian who actually believed those figures. Sure, Statscan (the ones who collect inflation info) can pick and tinker with the data to make sure it stays relatively stable. But that stability means nothing to people watching their savings dwindle in relative value.

Equally, the numbers mean nothing now when home prices are falling at 20% annualized in some areas, fuel prices have fallen dramatically, the value of Canadians' investment portfolios are off by more than 40%, etc. Savers are becoming richer by the day - compared to those stuck holding depreciating assets. Try and tell an average Canadian that there is more money in the economy than there was last year. You're liable for any hockey sticks that come flying your way. Carney can get away with this because he makes his speeches at places like the Halifax Chamber of Commerce. I wonder what would happen if he were to make the same speech to a strata council in False Creek.

Stabilization of the global financial system is a precondition for economic recovery. To that end, governments and central banks are taking bold and concerted actions. There are signs that these extraordinary measures are starting to gain traction, although more will be required and it will take some time for financial conditions to return to normal. In addition, considerable monetary and fiscal policy stimulus is being provided worldwide.

Carney is still operating in the old paradigm, otherwise known as "La-La Land." This was when people would scramble to take risk so they could impress their friends. It was also when the Boomer generation was still working and accumulating assets. This is all Carney has ever known in his adult life. Therefore, he considers it "normal." What he doesn't understand is that the entire paradigm of debt accumulation (starting in the early 80's) was itself anomalous. Lower burdens of debt and living within our means is "normal." That is what people are trying to achieve now. Any world economic recovery is going to be based on something else completely, which I explained in "Solutions for a Paradigm Shift." Carney still thinks the old paradigm will come back. Does he know that the younger, less-numerous generation wants nothing to do with debt accumulation? I doubt it.

I want to emphasize that this projected brief period of falling prices does not signal the onset of deflation for four reasons. First, most prices will not, in fact, be falling. At present, the prices of more than half the goods in the CPI basket are actually rising at more than the 2 per cent target.

Second, while core CPI inflation in Canada should ease through 2009, its anticipated low should be 1.1 per cent in the fourth quarter of this year – still within the target range for total CPI.

Third, consistent with the past experience that I referred to earlier, and reflecting the accommodative stance of monetary policy, we expect total CPI inflation to begin to converge towards core, starting at the end of this year, reaching 2 per cent by mid 2011.

Fourth, we should again see the benefit of well-anchored inflation expectations in helping to return actual inflation to the target...

The amount of arrogance in this last bit is extraordinary. Carney believes that simply because the BoC says inflation will stay within the targeted range, people will automatically believe it and therefore make it so. This is a load of crap. As I mentioned earlier, nobody believes Statscan's numbers, and nobody uses them to make economic decisions (except for the government). People use inputs from the real world. When they see condo prices in Vancouver being offered for 40% off, they take that as a signal that prices are falling. They don't ignore it and say, "well, Statscan said prices are still rising..."

The Bank's projection of an economic recovery reflects, in part, the monetary easing that we have already put in place – cutting the policy rate by 350 basis points since December 2007. Guided by its forward-looking framework, the Bank began cutting interest rates sooner – and has cut deeper – than most other central banks. With the usual lag, these moves will have a powerful impact on economic activity and inflation.

Again, this is old paradigm thinking. Carney assumes that because lowering interest rates "worked" in the mid 80's, early 90's and early 00's, it will work now. But he is not taking into account any of the socionomic or demographic changes that make today's environment different.

Finally, the role of the exchange rate in monetary policy should not be overlooked. The substantial past depreciation of the Canadian dollar provides an important offset to weaker global demand and lower commodity prices.

It is this ideology that I find the most dangerous for the Canadian economy. Carney thinks Canada can competitively devalue the Loonie to prosperity. He makes no mention of any negative consequences this could bring. How low is too low? 60 cents? 50 cents? Heck, if its so beneficial to have a weak currency, why not devalue it all the way to 10 cents per US Dollar? The reason is that because at a certain point, with the currency so weak, foreign capital flees for fear of a complete collapse. There's very little to stop Canadians from panicking and converting all their cash to US Dollars. Carney appears to think it's worth the risk so we can boost the manufacturing sector - for which there is no global demand anyway. He has apparently not received the memo that global trade has come to a standstill. There is no guarantee that a weaker dollar will attract capacity. Foreigners are retrenching.

To conclude, let me say that the inflation target that has served Canada so well when inflation was above the 1 to 3 per cent control range, will also serve it well when inflation falls temporarily below that range. So let me leave no doubt, no uncertainty about the Bank's commitment. Our focus is clear, our actions consistent, and our objective explicit: 2 per cent CPI inflation

In conclusion, Carney has now officially joined the ranks of Ben Bernanke and Paul Krugman in proving without a doubt that he is intellectually bankrupt. Due to his ignorance of what inflation really is, he is walking a tightrope between the most catastrophic potential outcome: A rapidly depreciating Loonie and a flight of foreign capital exacerbating falling asset prices. It is a cocktail meant for one purpose only - the rapid decline in standards of living for ordinary Canadians.

Solutions For A Paradigm Shift

I often take flak from readers in the comments section of my blog or in personal e-mails about being unfair in my criticism of modern day monetary policy and of policy makers in general. Often, the critics suggest that if I feel what is being done is so idiotic, perhaps I should put forth my own solutions. Kind of like a heckled baseball player suggesting the fans try and hit that pitcher's four-seam.

Well, no. Not really. That's a bad analogy. Bad, because the game I'm playing is different from those currently making decisions. I don't believe government can conceivably "fix" the economy because I don't believe in centrally planned economies. I don't believe a government can actually "create" anything - it can only displace "creation" from somewhere else or borrow it from the future.

Therein lies the problem. The entire structure of our economy was unsustainable. It was based on a belief that we could borrow infinitely from the future, yet not expect to one day bear the consequences. Yet thus far, all proposed solutions offer nothing that rejects this most unrealistic paradigm, and attempts to replace it with something else. All proposed solutions offer only the "hope" that we can return to this unrealistic paradigm. Separate from my belief that a return to this paradigm is undesirable, is my belief that it is unobtainable. Unobtainable because of the irreparable damage done to the collective psychologies of those involved in carrying it out. Also unobtainable because of a demographic situation in offending economies that will be seeing a smaller generation (Millenials) needing to take over from the productivity of a much larger generation (Boomers).

If a resuscitation of this old paradigm were to occur, two things would need to happen: a) younger generations would need to be re-convinced of the merits of going into debt (ie. a materialist "gotta have it now" mentality); and b) they would need to take on an even higher proportion of debt than their parents as a function of their smaller size.

Neither of those things are even remotely possible.

A legitimate solution needs to address the inconvenient truth that the old paradigm is not coming back. For the 97% (or thereabouts) of people who have been left with the short end of the stick throughout this giant experiment, this should bring no anguish. However, most people's major source of information (mass media, corporate advertising, politicians) happen to be among the 3% that benefited greatly from the common person's plight. Hence, any notions that the old paradigm be replaced are met with the fiercest of fear-mongering propaganda one could imagine. I suppose if I had a way of legally stealing from others, I would defend it also. But alas, I don't.

For starters, these proposals are to be considered global in nature. However, as the US still enjoys the benefit of issuing the world's reserve currency, I am sure that if they were to be pro-active, others would soon follow.

1. Address the way banks do business. The current system of lending money into existence is a broken one. If depositors cannot trust their bank to look after their deposit, the banking system will always be dysfunctional, and the economy will be prone to periodic panics of confidence. Instead, banks should be required by law to keep 100% reserve ratios at all times on any demand deposit and it's equivalents. Doing this would eliminate the need for government deposit insurance and it's resultant moral hazard implications. Banks would go back to making money the way they used to: lending money at a slightly higher rate than they pay in interest on deposits and through service charges. The need for tight regulatory control would be non-existent. Of course, banks would protest this vehemently because it would take away their oligopolistic control. Nearly anyone with a fair amount of savings would be able to set up a neighborhood bank and operate it at a legitimate profit.

2. Repeal all laws granting government a monopoly over determining and issuing currency. The logical offshoot of this is that the market would naturally return to a gold standard as it has countless times throughout history. But that should not exclude other assets from being exchangeable as well. In fact, with today's technological advancements, there should be nothing stopping a multiple currency system of banking. Land banks, grain banks, metal banks, and others would inevitably pop up. People could just as easily pay for a new suit with bushels of wheat as they do with paper money, because everything is done electronically. Employers and employees could agree on payment by any number of "currencies." The reason a barter economy was always considered inefficient was because it was impractical for the farmer to bring 20 bushels of wheat to the tailor as payment for his suit. We now have the technology to make that practical. If the tailor doesn't want wheat, but instead wants gold, he can immediately make that conversion on the open market. Either that or the buyer can do so prior to the transaction. As long as it is ensured by law that banks keep 100% reserves of whatever currency they say they have, such a system would be more resilient to panics than the world has ever experienced. It also need not hinder the advantages of an efficient division of labour.

3. The implementation of the prior two ideas would render the need for a "lender of last resort" as redundant. The current justification of a Central Bank is twofold: to prevent banking panics by providing weak banks with access to capital if depositors were to stage a "run" on the bank in question, and to also "smooth" the business cycle by manipulating the rate of interest. I don't agree with either. As we can see, increased banking stability nor a smoothing of the business cycle has been achieved. In fact, I argue that the moral hazard implications of banks knowing they will be backstopped actually create what they try to prevent. And I argue that manipulating the rate of interest creates malinvestment, which serves to accentuate the business cycle rather than suppress it. With the central banks out of the way, the market would be left to determine the appropriate rate of interest based on it's perception of risk in lending to businesses or individuals. Because banking will have returned to it's rightful role as a small, local operation, the rate of interest can adjust to the fluctuations of the local economy. Gone will be the problem of trying to find a flat rate of interest for an economy as large and as diverse as the US or Canada. Individual lenders and individual borrowers will set a rate of interest on their own. The way it was always meant to be.

A common theme to the above suggestions is a discriminatory reduction in the role of government in the economy. Government's role as the "stabilizer" of an unruly free-market has been proven as fallacious. No amount of regulatory control or monopolistic decree has has had any such stabilizing effect. In fact, the current crisis shows us that it has done the exact opposite.



Above is a graph of US government expenditures as a percentage of GDP over the last two centuries. Can anyone tell me what this massive increase has achieved? Other than a debt that can never be paid, a mountain of still unfunded promises in the form of social security/health care, and a legion of aggravated foreigners? The same can be said about most other major economies. The overall size of government has been shrinking in Canada, yet the starting point was much higher.

Did the lack of big government in 19th century US hinder an increase in the standard of living? Quite the opposite. Going back to that traditional role will not have the disastrous consequences trumpeted by the few who benefit from this current paradigm.

In addition to the above suggestions and the subsequent reduction in the size of government, a number of other positive consequences would naturally result:

4. The elimination of the federal income tax. The role of this tax varies greatly depending on each individual country. But to be sure, it's implementation in the United States (1916) and Canada (1917) were originally considered temporary as a means to pay for the Great War. They were never repealed, and as can be seen from the chart above, they fueled an enormous expansion of government. This is not to say all taxes can be eliminated. But a large chunk of the most punitive ones can be either drastically reduced or repealed entirely. Government would still be able to fund it's defense obligations (assuming a non-interventionist foreign policy), basic emergency services, and implementation of justice via it's other various income streams. The benefits of a lower income tax are obvious. Increased incentives to work, thereby boosting productivity. Combining this with an open competitive currency system, people would have the incentive to work longer hours or multiple jobs, but as a result of their increased productivity they would likely be able to obtain a higher quality of life by working less.

5. A new social morality. A new precedent would be set by the implementation of the above. Confiscation of one person's property would be seen as immoral no matter who does it. If government cannot get away with counterfeiting currency (currently done under the guise of "monetary policy"), even less justification can be found for private citizens to attempt the same. "Trust" will be restored to society. Instead of the suspicion that is bred by having someone's hand constantly in your pocket, we will be more inclined to "love thy neighbor." This new social conscience is a far cry from the paradigm we have lived through recently. Government's rampant inflationary policies have been the lifeblood of society's greed and materialism. The knowledge that your purchasing power will become greatly reduced naturally disincentivizes people from responsible social behavior and encourages debt accumulation and a gambling mentality. Disagree? I've got evidence: Exhibit A. Exhibit B. I rest my case.

Admittedly, on the surface, much of the above seems quite far-fetched. Paying for your clothes with electronic grains? No income taxes? No Central Bank? No more obnoxious music videos? But think about it. If you tried to explain our current system to people 120 years ago, they would laugh with incredulity.

The remaining task is to determine a logistical way to fairly implement this shift. In my opinion, it is not a matter of if we experience a paradigm shift. The question is how it will happen. Through chaos or through order. The old paradigm is not revivable, as discussed earlier. By not addressing the inconvenient truth that we are bankrupt as a western civilization, we risk the possibility of an eventual sudden breakdown. Iceland experienced this last year. California is experiencing this as of this writing. And other large states or nations are lining themselves up for a similar fate. Ireland, Spain, Mexico, Pakistan and the Baltic states. Russia and the UK are not far behind.

Doubtless, anytime there is a paradigm shift of this magnitude (think collapse of Soviet Russia, fall of Habsburg dynasty, French Revolution, etc) there are winners and there are losers. Questions we need to ask ourselves include: shall the average person pay the price for mistakes made by others? To what extent will we extort money from the innocent to pay for the guilty? If they can no longer pay, lest they starve, do they become the criminals?

Those are all rhetorical questions. We know the answers, even if they mean tough decisions. But like the bank robber finally caught 20 years after the crime - who has turned his life around and has a family. He still needs to be punished (and give the money back, of course). So too must the holders of fiduciary media (a paper claim of future payment, ie. government debt) be the casualties of this shift. Many of these holders are undeserving of this treatment, but at least they made a conscious decision to take the investment risk. The alternative is to make the average person pay for other's misperception of risk. And that payment will be endless. The amount of inflated paper claims that no longer have any value (derivatives, mortgage securities, government debt) dwarf the actual economy. Most of it is hiding in off balance sheet vehicles. This is precisely where the TARP money has been going, and why nobody can see where it went. Banks have been using it to write down the asset values of their Level 2 & 3 assets. Citigroup's Level 3 assets total over 800 Billion alone. That gives credence to the enormity of the problem. Obama's stimulus package would be enough to bail out one bank.

Bad debt needs to be liquidated. This means many banks will go bankrupt. Many companies will go bankrupt. Prices of everything will fall. Unemployment will rise. The danger is that this occurs over a long period of time. If it is permitted to occur fairly rapidly, savers will soon return to buy up assets and the middle stages of production (those requiring labour) can occur sooner. This is the only course of action that gives justice to the average person. Congressman Paul recently argued for a similar solution in a statement before the house.

To that end, I offer the following immediate actions that should be taken:

1) Move to back all demand deposits and their equivalents with 100% physical reserves, thus keeping depositor's money safe
2) Legislate mark-to-market accounting for every institution
3) Allow the "fire-sale" of securities to which there is a claim for a tangible asset
4) Repeal laws outlawing the use of non-government issued currency
5) Eliminate securities that are of no claim to anything tangible, including government debt

There would be pain involved, but the economy that emerges from the rubble would be one based on legitimate production and accumulated wealth. Much of the rest would take care of itself. People will find a way to get through the tough time in between. They'll grow gardens in their backyard. They'll knit their own clothes. The lower prices of everything will assist people in getting by. History is rife with examples of societies displaying incredible ingenuity in times of stress. I hardly doubt this time would be any different.

You wanted my solution? Now you have it.

US Economic Round-Up

As the markets whipsaw back and forth in a nonsensical manner, the greater scheme of things is still unfolding. Analysts who months ago were saying, "We must be at a bottom because it can't get any worse than this," are now eating their words. It has gotten worse. Home sales numbers are worse. Retail sales numbers are worse. Unemployment numbers are worse. Nearly everything except credit spreads have continued deteriorating since autumn.

These analysts were using charts of 30-40 years of economic data (or less) - not coincidently the same length as their careers to date - and noticing that many of the indicators were matching the worst readings of prior recessions of '74, '82 or '90. Therefore, according to their logic, the bottom must have been at hand.

But wait a second. What if the recession was worse than anything they have experienced in their lifetimes? What if we don't have statistics going back further than 40 years on many of these measurements? Then what? These are the questions those same analysts are beginning to ask themselves as numbers fall below levels that were on their charts. They are starting to ponder the meaning of "unchartered territory." This second-guessing and subsequent use of no better word for what they are seeing than "depression," will likely be what leads to the next devastating leg down in the stock market.

Here are a few examples:

The following are a few charts from Calculated Risk:



Above is a chart of total miles driven in the US since the early 70's. It is a 12 month moving average. As you can see, miles driven has fallen below that of even the 70's oil shortages. There has been no shortage of gasoline this time. The fact that gasoline prices have recently fallen in half makes this move even more meaningful.



This is a chart of total US vehicle sales. The gradually sloping upward trend can likely be attributed to growing population over the decades. So adjusting for total population, this chart would be showing an even more drastic decline. Until the auto industry realizes that buyers are waiting for much lower prices, total sales will continue to deteriorate. Judging by the ineptitude thus far in Detroit, I would guess they finally figure that out sometime between "too late" and bankruptcy liquidation.



And finally, we have total housing starts. I wonder what happened to housing starts in the Great Depression. Surely, the number cannot go to zero, but with so much supply looming, what possible reason could there be for this to turn around?

And what about earnings? Well, they've been terrible thus far. Analyst estimates keep getting taken down. Last week they were taken down to -20.2% from -15% the week prior. Remember that these estimates started at +59.3% on July 1st. I would imagine that with this week's terrible reports from Microsoft, Generally Eclectic, and others, we will see another reduction. How low it goes before all the earnings roll in is anybody's guess. But what we know for certain is that there was no legitimate reason for estimates to be that high in the first place. I wrote about this back in early December in "On the Cusp of a Deflationary Depression."

Will the analysts get their way and play the same game for Q1? Or will investors and fund managers wake up to the ruse and front-run their idiocy? You would think that after 5 quarters of missing estimates by 40% or more, these clowns would maybe take a step back and try to figure out what they're doing wrong. Maybe that's giving them too much credit.

Elsewhere, we see other signs of the economy affecting state budgets. Lower tax revenues have caught state governments with their pants around their ankles. Now, after months of finger-pointing and name-calling, services are being cut to prevent total bankruptcy. For example, California Delays Tax Refunds, Suspends Welfare Cheques.

I wonder how the poor are going to react when they go to pickup their monthly handout from the government, and are told, "sorry, not this month." California is not alone. Mike Shedlock writes, 44 States Facing Huge Budgetary Shortfalls. Hungry people are not happy people. Unhappy people leads to social retrenchment and abstinence from outward expressions of wealth - which further reduces consumption. It is a positive feedback loop of social acrimony that is the issue here. I suppose if the states are willing to part with a little bit of their legislative autonomy, the federal government will be gracious enough to lend them a hand.

So with all that going wrong, what else could we think of that could make matters even worse? How about, Obama Administration Firing Economic "Shots Across the Bow" Toward China? Yes, the Obama Administration has taken steps to officially consider China a "currency manipulator." Although the term has been thrown around loosely for years, steps were never taken to make it "official." Now that it appears to be official, the door has swung wide open for trade sanctions.

Perhaps that is the reason behind gold's $40 spike higher today. Perhaps it's something else. It is now sitting at 13 week highs. As I've been mentioning previously, if it holds this level and avoids a massive selloff on Monday, I would have to reconsider my intermediate bearish posture on the yellow metal.

Let me wish my readers a great weekend!

Technical Update 2.09

I've been following the recent downtrend of the major averages since the early days of the New Year when I suggested the corrective rally may be nearing it's end. Last week, with the S&P at 870, I pointed out some support around the 820 level:

As for the major averages, I am leaning towards a fairly significant bounce from around the 820 area - perhaps all the way back up to 920. However, being in a bear market, the potential is great that we just plough through 800 on our way to new lows.

The 820 level did provide some short term support, creating a 5% short covering rally into the long weekend. However, early Tuesday morning, the tires burst and markets gave up all of that 2 day gain and closed at it's lows of the day for a total loss of over 5%. This all occurred as inauguration festivities were supposedly injecting new optimism in Americans.

Tuesday was a perfect example of how markets do not react to the news, rather the markets determine the news. If markets had rallied, it would have been because of Obama's inauguration. Instead, markets fell because of poor earnings by State Street, a 8 cent drop in the British Pound or the potential nationalization of British Isle banks. I always find it hilarious when major media outlets scramble to find the reason for why markets moved on a slow news day. It's the same on days like yesterday when there are contradictory bits of news. How many papers would they sell if they simply told the truth and reported, "Traders and investors reacted to subliminal, endogenous signals that stock prices were too high, and felt they could benefit from purchasing shares at a lower price sometime in the future. Traders and investors with the opposite sentiment were overpowered by the former."

But I digress. The news is more interesting. Even if there is no way to measure how it effects our decision making.



A number of technicals experts I subscribe to or follow closely have been eyeing the 787-791 area as potential support for a multi-day rally. So I'll be watching that level closely. If it provides a bounce back through 800, I would consider covering some of the short exposure I took at the highs. If it does not provide support, or if a bounce is on low volume, or if financials do not participate (!), I will continue to eye new lows. I do not give the possibility of a double bottom a very high probability. Meaningful double bottoms typically take place over far longer timeframes than 8 weeks. My first target remains 600, which will be refined as time and price develop.

In my Currency Outlook for 2009, I wrote:

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

Over the weekend we learned that the big UK banks were going to require yet another government bailout to stay 'affloat.' The government increased it's stake in the Royal Bank of Scotland, and fears are that Barclay's and Lloyd's will be next. Of course, the pound got clobbered - again. Apparently, throwing a life preserver to a rotting corpse is not seen as proactive. I stick to my 2009 target of 'par' with the Greenback and will likely go under compared to the Euro. See the carnage:



Gold did not react negatively yesterday to the large uptick in the dollar. That is the type of divergence one would expect to see if the yellow metal were to continue higher. I remain intermediate-term bearish on gold, but understand that as it is still in a long-term bull market, surprises will come to the upside. A close above $900 would likely have me buying.

That's all for now. I'll try to make this a weekly post.

No Hope For Obama

To be blunt, I see absolutely no reason for the amount of optimism surrounding Obama's inauguration today.

The amount of "change" and "hope" rhetoric is, if anything, baseless. Yes, Bush was terrible. Maybe the worst ever. But to transfer that into some sort of blind optimism that any successor will be better is, in my opinion, incredibly naive.

I suppose being young and from a very multiculturally tolerant city (Vancouver) dulls the allure of his achievement as the first black president. I didn't live through the race riots. I never experienced segregation. So as great as it seems that the 'barrier' is officially out of the way, it has little to do with how I evaluate what this day means for the world.

What I am looking at is the people he has surrounded himself with and the policies he will implement. I see very little change. And where I do see it, it is for the worse, not the better.

In a way, I am more fearful of an Obama administration than I was of Bush's band of jackasses. Here's why: Bush had such abysmal approval ratings that he was able to get away with very little in his last 4 or 5 years. Most of the damage he did (Iraq War, Patriot Act) made him so unbelievably unpopular that any radical decisions thereafter were looked at with such disdain, even from his own party, that he couldn't even try to sneak it through. Obama doesn't have that problem. A poll at realclearpolitics.com shows a shocking 73% approval rating. Only 14.8% have an unfavourable opinion. Other polls are similar. There is near unanimous consent from the American people, that they will allow him any amount of leeway to achieve "change."

When I combine that with the people he has selected as his advisors, I get chills. Rahm Emmanuel, Zbigniew Brzezinski, Robert Gates, Hillary Clinton, Larry Summers, Robert Rubin, Tim Geithner. The list goes on. These are not good people.

Brzezinski is a complete sociopath who has been questing for US world domination for decades. Emmanuel is a duel Israeli-American citizen that has advocated bombing Iran and a military draft. The latter three have all been instrumental in destroying the US financial system over the last 15 years. I am sorry, but I don't see any change here. Not in foreign policy. Not in economic policy. I see the status-quo. Which is perhaps why so many Republicans seem to be onside with the new administration.

All over, Obama is looking to the same people that created or didn't see the financial crisis coming, and expecting them to find a way out. Of Paul Krugman, Obama said recently, "If Paul Krugman has a good idea...then we're going to do it." Now typically, I would assume that since Krugman has never had a good idea in his life (short of perhaps choosing a black tie over an orange one), that this would be nothing to worry about. But these are people that think he is a genius. So they are liable to do anything he says. This scares me.

But if there is anything that frightens me more than the people in Obama's inner circle, it is the people that have taken him as some sort of cult leader. Take for example this video of an Obama Youth Brigade of some sort. Do these people come across as folks who would stand up to a government overstepping it's authority?

I don't believe that that is representative of the average Obama supporter. But judging from the massive crowds at his inauguration ceremonies, I sense a unwavering support for the man. Combine that with the rising unemployment and bankruptcy of millions of Americans, and you have the same recipe that has preceded countless totalitarian regimes over history.

Keep in mind that even though he seems to be a political moderate, his constant rhetoric of "desperate times call for desperate measures" should not go unnoticed. He still retains every bit of increased presidential power that Bush gave himself. Unemployment riots can still be met with martial law. War can be waged without a declaration. The constitution can be trampled underfoot. What if he were to advance North American Union talks? With Canadians gaga over the man and Mexico in chaos, who would stand up to this?

Absolute power corrupts absolutely. No time in history has this been proven otherwise.

The Crisis of the Euro

Ambrose Evans-Pritchard writes in the Daily Telegraph, "Monetary Union Has Left Half of Europe Trapped In Depression"

Events are moving fast in Europe. The worst riots since the fall of Communism have swept the Baltics and the south Balkans. An incipient crisis is taking shape in the Club Med bond markets. S&P has cut Greek debt to near junk. Spanish, Portuguese, and Irish bonds are on negative watch.

Dublin has nationalised Anglo Irish Bank with its half-built folly on North Wall Quay and €73bn (£65bn) of liabilities, moving a step nearer the line where markets probe the solvency of the Irish state.

A great ring of EU states stretching from Eastern Europe down across Mare Nostrum to the Celtic fringe are either in a 1930s depression already or soon will be. Greece's social fabric is unravelling before the pain begins, which bodes ill.

Evans-Pritchard is one of the few mainstream writers who manages to get things right on occasion. With this article he is bang on. The euro is in disastrous shape. Back to the article:

This week, Riga's cobbled streets became a war zone. Protesters armed with blocks of ice smashed up Latvia's finance ministry. Hundreds tried to force their way into the legislature, enraged by austerity cuts.
"Trust in the state's authority and officials has fallen catastrophically," said President Valdis Zatlers,
who called for the dissolution of parliament.

In Lithuania, riot police fired rubber-bullets on a trade union march. Dogs chased stragglers into the Vilnia river. A demonstration outside Bulgaria's parliament in Sofia turned violent on Wednesday.

While American news has been transfixed on Barack Obama's coming inauguration and spends countless hours on pundit roundtables debating how long his "honeymoon" will last, the real world is still turning. Nearly every night on German television I see the riot footage. It is not just a few benign rabble-rousers. These riots are displays of society-wide malcontent with the results of the worldwide depression. Many of these countries were goaded into joining the EU with promises of greater economic stability. All they got was an enormous influx of foreign capital causing huge asset inflation - which has now subsequently fled and is leaving a path of destruction in it's wake. The Latvians, Greeks, Bulgarians, Irish and many others are now finding that they are worse off than they were before the EU, yet their own governments are toothless to do anything because of the many international treaties they signed.

The European Union itself is a representation of positive social mood. Now that many of the other symptoms of that high social mood are coming undone (rising prices, low unemployment, rapid growth) the logical conclusion is for the EU and by extension the Euro to come under increasing attack as well.

These three states are all members of the Exchange Rate Mechanism (ERM2), the euro's pre-detention cell. They must join. It is written into their EU contracts.

The result of subjecting ex-Soviet catch-up economies to the monetary regime of the leaden West has been massive overheating. Latvia's current account deficit hit 26pc of GDP. Riga property prices surpassed Berlin.

The inevitable bust is proving epic. Latvia's property group Balsts says Riga flat prices have fallen 56pc since mid-2007. The economy contracted 18pc annualised over the last six months.

Leaked documents reveal – despite a blizzard of lies by EU and Latvian officials – that the International Monetary Fund called for devaluation as part of a €7.5bn joint rescue for Latvia. Such adjustments are crucial in IMF deals. They allow countries to claw their way back to health without suffering perma-slump.

This was blocked by Brussels – purportedly because mortgage debt in euros and Swiss francs precluded that option. IMF documents dispute this. A society is being sacrificed on the altar of the EMU project.

Nobody thought to question these contradictions on the way up. Just as nobody really thought to question the trillions worth of promises made to the newly retired and the elderly in the form of Social Security and Medical Insurance. All of the economic "models" made by Harvard graduates suggested that everything would be just fine. All they needed to do was take the last 10 or 20 years of data and extrapolate that over the future. Presto! You're all going to be rich!

Oh. What's that? The models were filled with faulty assumptions? That can't be right. My Harvard PhD advisor says it's okay to make assumptions. He's wrong? Uh oh.

Many of Europe's economies and most of the world's financial system has been having an "uh oh" moment for the last year. As a result, small countries (ones we've been schooled to believe only exist in geography class) are erupting into anger and chaos.

Yet somehow, there is still a vast consensus that President Obama will fix everything. That some policy change in Washington will all of a sudden cause Europeans to start speculating on condos in Riga again. That MBS will be repackaged with new derivatives and home prices will bounce back. Does anyone else see how this common logic is absolutely insane? At least try to tell me that some science experiment will change the world. Or we'll find a miracle drug. Don't try to tell me we'll just go back to making the same stupid mistakes. More from the article:

Italy's treasury awaits each bond auction with dread, wondering if can offload €200bn of debt this year. Spreads reached a fresh post-EMU high of 149 last week. The debt compound noose is tightening around Rome's throat. Italian journalists have begun to talk of Europe's "Tequila Crisis" – a new twist.

They mean that capital flight from Club Med could set off an unstoppable process.

Mexico's Tequila drama in 1994 was triggered by a combination of the Chiapas uprising, a current account haemorrhage, and bond jitters. The dollar-peso peg snapped when elites began moving money to US banks. The game was up within days.

Fixed exchange systems – and EMU is just a glorified version – rupture suddenly. Things can seem eerily calm for a long time. Politicians swear by the parity. Remember John Major's "soft-option" defiance days before the ERM blew apart in 1992? Or Philip Snowden's defence of sterling before a Royal Navy mutiny forced Britain off the Gold Standard in 1931.

Don't expect tremors before an earthquake – and there is no fault line of greater historic violence than the crunching plates where Latin Europe meets Teutonia.

Greece no longer dares sell long bonds to fund its debt. It sold €2.5bn last week at short rates, mostly 3-months and 6-months. This is a dangerous game. It stores up "roll-over risk" for later in the year. Hedge funds are circling.
Traders suspect that investors are dumping their Club Med and Irish debt immediately on the European Central Bank in "repo" actions.

In other words, the ECB is already providing a stealth bail-out for Europe's governments – though secrecy veils all.
An EU debt union is being created, in breach of EU law. Liabilities are being shifted quietly on to German taxpayers. What happens when Germany's hard-working citizens find out?

Indeed. The German people are not stupid. They know they were being swindled by the south. But as long as unemployment kept falling, nobody had any reason to speak out. As I pointed out in Manufacturing Weakness Spreads to Germany, that is no longer the case. People are being thrown out of work here too.

Germany has a general election later on this year. I fully expect that at some point, the issue of Germany's ties with the rest of Europe will become front and centre. The euro cannot survive without Germany's support.

Those betting on the imminent collapse of the US Dollar are missing the boat entirely. The euro is the real problem child. And when it falls, US Dollars rise. Paper money is still the medium of exchange, and as long as it is mandated so by law, demand for that medium will continue. Conventional wisdom has it that the US Dollar is on the verge of an inflationary nightmare due to the exploding Fed balance sheet. Conventional wisdom is not generally correct.

Bernanke, Krugman Intellectually Bankrupt

You can see it in his eyes. You can hear it in his voice. A man so utterly shattered in his ideology that it appears he has given up all hope. Now, it seems he has abandoned entirely even attempting to make sense, and is grasping at straws. Maybe, just maybe, he'll say something that imbues confidence and the markets will react positively.

Following is an excerpt from Bernanke's Jan 13 speech at the London School of Economics:

Although the federal funds rate is now close to zero, the Federal Reserve retains a number of policy tools that can be deployed against the crisis.

One important tool is policy communication. Even if the overnight rate is close to zero, the Committee should be able to influence longer-term interest rates by informing the public's expectations about the future course of monetary policy. To illustrate, in its statement after its December meeting, the Committee expressed the view that economic conditions are likely to warrant an unusually low federal funds rate for some time. To the extent that such statements cause the public to lengthen the horizon over which they expect short-term rates to be held at very low levels, they will exert downward pressure on longer-term rates, stimulating aggregate demand. It is important, however, that statements of this sort be expressed in conditional fashion--that is, that they link policy expectations to the evolving economic outlook. If the public were to perceive a statement about future policy to be unconditional, then long-term rates might fail to respond in the desired fashion should the economic outlook change materially.

The entire speech was equally as nonsensical and can be filed appropriately under the heading of "you just can't make this stuff up!"

This is the man who was once considered to be the foremost expert on the Great Depression, which apparently was caused by a miscalculation by the Fed. If ever a similar situation were to come along, "it wouldn't happen again," he promised Milton Friedman and Anna Schwarz. The correct tools were in place to ensure that much.

Now that his toolbox is essentially empty, he has resorted to claiming some sort of godlike ability to jawbone the market back to "normal." He has officially lost his mind.

So now that we know (or are at least reasonably certain) that Bernanke and his ideologically similar minions (Krugman, Stiglitz, among many others) have been proven wrong, we need to focus on why in order to ensure the same thing isn't perpetuated all over again.

What made these people believe that pumping trillions of dollars into failing financial institutions would solve the problem? What made them think that by buying worthless assets, the financial system would revert back to it's old ways? And what makes them think that giving shovels to mortgage brokers and subsequently instructing them "dig," will cause any meaningful rise in production or employment?

All signs point in the same direction. And that is in the direction of an underlying principle from which all their other principles are derived: The General Equilibrium Theory.

According to this band of geniuses, an economy with relative full employment and low inflation is said to be "in equilibrium." But every once in a while, something strange happens and the economy goes into disequilibrium. Therefore, the central bank and the government need to step in and "fix" it. In order to decide how best this is done, the economists in question create complex mathematical "models" that tell them which policy action is more desirable, and precisely what effect those actions will have.

Starting from the beginning, this equilibrium theory is bogus. There is no equilibrium. The "normal" state of an economy is disequilibrium. It is always in a state of either oversupply or excessive demand. Prices are always either too high, or too low. Therefore, the models being created based on this false equilibrium are fatally flawed from the outset. [note: Joerg Guido Huelsmann gave a lecture on this topic, explaining that a paradigm of equilibrium is indeed useful, but not for what it is commonly applied to.]

This is important because when we are listening to our apparent "smartest people" on how to fix our problems, we automatically assume that they have a sound understanding of the problem and why it occurred. They don't.

As a function of their belief in this magical equilibrium, they are disinclined to consider the possibility of a multi-decade decrease in risk aversion. Nor do they consider the blowing of speculative bubbles because of too low interest rates. Nor do they consider changes in social attitudes toward debt, consumption or saving. They instead brush it off as some sort of statistical anomaly. If it can't be modeled, it's not worth considering. Hence, any unintended consequences of their current actions are not thought of. All that matters is getting the economy back to equilibrium. Once it is "there" they can worry about the problems that arise.

To them, the credit and consumption binge was "normal." It was the hallmark of an economy in equilibrium and a byproduct of what Bernanke termed "The Great Moderation." From his 2004 speech of the same name:

Few disagree that monetary policy has played a large part in stabilizing inflation, and so the fact that output volatility has declined in parallel with inflation volatility, both in the United States and abroad, suggests that monetary policy may have helped moderate the variability of output as well.

To suggest that the last 20 years was in any way "moderate" is absolutely asinine.

Nowhere was there a mention that risk premiums had been unnaturally influenced by these policies. Nowhere was there mention of an increased willingness of foreigners to lend the US money based on implicit government guarantees for Fannie and Freddie paper. And nowhere was there a mention of the possibility that previous bank and hedge fund bailouts were encouraging financial institutions to take more risk than they would otherwise. No, it was because the Fed and other central banks had become "enlightened." The amount of arrogance it takes to draw this kind of conclusion makes professional athletes sound modest.

Next, we shall consider a recent post from Nobel Prize winning economist Paul Krugman:

... Anyway, it’s true: the cost of an effective fiscal stimulus, in terms of adding to the government’s debt, can (and should) be much less than the headline cost.

Consider an increase in government spending; assume that the interest rate is fixed (a good assumption right now, because interest rates are up against the zero lower bound). Then textbook analysis says that if the stimulus is dG, the increase in GDP is 1/(1 - c(1-t)) where c is the marginal propensity to consume out of income and t is the marginal tax rate. Suppose c is 0.5 and t is 1/3; then the multiplier is 1.5, which is more or less the conventional wisdom right now.

But if $100 billion in spending raises GDP by $150 billion, and the marginal tax rate is 1/3, $50 billion of the spending comes back in additional revenue. So bang for the buck — increase in GDP per dollar of added debt — is 3, not 1.5. Since the main concern about stimulus is that it will add to government debt, it’s this bang for the buck measure, rather than the multiplier, that’s relevant. And 3 sounds a lot better than 1.5.

Take this a bit further: $150 billion is about 1 percent of GDP, which Romer and Bernstein say means a million jobs; so this says $50,000 per job, which is a much better number than the critics have been throwing around (plus many more workers with full-time rather than part-time jobs).

Bang for the buck also heightens the contrast between effective and ineffective stimulus policies. Stay with c = 0.5, t = 1/3, and look at the effects of a tax cut; the multiplier is 0.75, half that for public investment, but bang for the buck is 1, only 1/3 that for investment.

So thinking about how stimulus comes back via revenues is important.

Even though the crisis continues to grow, and the theories used to explain it come under increasing suspicion, our smartest economists are proclaiming that even MORE of their failed solutions need to be attempted, lest we go back to living in caves. They demand that massive projects need to be undertaken in order to "create employment." This is an idea that sounds good at face value. But unfortunately, it too fails to hold up to scrutiny. These economists see a correlation between productivity and employment. So they naturally go on to conclude that higher productivity causes higher employment. Unfortunately, correlation does not imply causation. Simply pumping money into make-work projects does not create employment. It just takes money out of the real economy (via taxation) and redeploys it somewhere else. In the hands of it's rightful owners, this money would create employment by itself (via spending or investing). So by taking it away from them, the government reduces employment somewhere else. Even if that money were saved or used to pay back debt, those savings represent future legitimate employment that will no longer be created once expropriated and used for ditch-digging.

What actually occurs in a healthy economy is higher levels of employment creating higher productivity based on doing a task that provides value to someone else. By seeing the equation backward, Krugman and the others prove that they have very little understanding of what labour is. And what they do understand is wrong.

People who were gainfully employed based on a fictitious economy are now being laid off. That is and always was guaranteed to happen. The laid off workers of auto companies, retailers and banks lost their jobs because the companies couldn't make a profit. Not because of some temporary drop in "aggregate demand" like the experts prefer to say.

The mainstream economists all agree that the way out of this depression is to get "aggregate demand" back to bubble levels. And why has aggregate demand really fallen? Not because of some temporary "loss of confidence." No. Demand has fallen because social mood is subliminally dictating to people that living beyond our means is no longer an acceptable social practice.

If Bernanke understood the changes in social mood, he would know that trying to prop up prices with 8 letter acronym programs will not work. He would know that wage controls would likely only lead to more unemployment. And he would know that no level of stimulus can induce people to spend like it was 2005. He would also know that precisely what he is trying to prevent (falling prices, falling wages, bankruptcies, etc) is what is needed to heal the economy. Demand will come back - when prices have fallen to their legitimate levels (and will likely be in new areas of the economy). Employment will return along with it.

Again, the suggestions of the mainstream economists, led by Bernanke, have absolutely no bearing on reality. The assumptions used to create their suggestions are methodologically flawed. And their results that will actually occur are not even close to what is promised.

We can only conclude that Bernanke, Krugman and the rest of them are intellectually bankrupt. The sooner they are removed the better. They would preferably be replaced by nobody. But if someone need be their surrogate, here is a list of capable suitors.

Olympic Sized Depression Hitting Vancouver

Western Canada had a lot going for it during the recent credit boom. Not only were debt spigots open wide like nearly everywhere else in the world, pushing up asset prices along with them. But the provinces of BC, Alberta and Saskatchewan all had their own commodity booms at the same time, further fueling the demand for housing. In BC the mining (and to lesser extend forestry) industries underpinned a robust economy. In Alberta, the rising price of oil made previously uneconomical tar sands projects profitable. And in Saskatchewan, skyrocketing fertilizer, grain and uranium prices created their own boom in major cities.

More so than anywhere else, the boom story in Western Canada felt legitimate. So even if the rest of the world were to undergo a contraction of sorts, this region would be supported by it's "strong fundamentals." This relative feeling of safety provided the boom mentality even more fuel than elsewhere. Unemployment got as low as 3-4% in some areas, redefining what most economists thought was "full employment."

But Vancouver had yet one more factor providing wind at it's back. They had "won" the right to co-host the 2010 Winter Olympics with Whistler (a nearby ski resort town). The resulting inflow of foreign investment was going to put the city "on the map" in terms of major cosmopolitan international cities. Tokyo, London, New York, Milan, Vancouver. Yes. It was ordained. The International Olympic Committee had declared it so. The provincial government even began an advertising campaign with the slogan "The Best Place On Earth." Old license plates bearing "Beautiful British Columbia" are now exchangeable for new ones with the olympic logo and the new slogan - for a fee of course. All of this is symbolic of a peak atmosphere of social mood. People were made to feel extremely lucky just to be part of such a place. As such, property values needed to reflect this newfound prestige. And of course, "there is only so much land."

Or so went the story.

Unfortunately, Vancouver residents have been shocked to learn over the last few months that gravity does indeed apply to them also. Sure as the sun rises, boom has turned to bust. And perhaps nowhere in the world has it manifested so spectacularly as in Vancouver. Where social mood was highest; it has furthest to fall. Here are the recent happenings:

BC Legislature to be Recalled for Special Session

The B.C. Legislature will be recalled for a special session to deal with Vancouver's request for permission to borrow more than $450-million to complete the troubled Olympic Village project.

Without legislative action, the city would have to hold a referendum to approve the borrowing - an option Mayor Gregor Robertson said would cause costly delays in dealing with the situation.

"They need a tool right now that they don't have without a legislative amendment," the Premier [Campbell] said.

"We will bring that in as soon as it's drafted. We'll bring it in. We'll take it to the House, and hopefully it will pass as quickly as possible."

Mr. Campbell said he hopes members will get beyond "traditional politics" in order to deal with the matter.

Vancouver's Credit Placed On Watch Due to Olympic Village Project

An independent credit rating agency has placed Vancouver on a credit watch and may even downgrade the city's AA+ rating as a result of potential debt coming from the beleaguered Olympic Athletes Village project.

Standard & Poor's on Tuesday issued a bulletin about the city's finances, saying the impact on the city's debt could be significant if it borrows money to fund the remaining construction of the village.

"We believe that there's going to be an event in the next three months that will have a negative impact on the city's credit profile," Stephen Ogilvie, an analyst with the agency, told CBC News.

Nortel Woes Could Hurt Olympic Sponsorship

Nortel Networks was already financially flailing when it signed on as sponsor of the 2006 Winter Olympics in Torino, Italy.

It was laying off workers in 2007 when it became a major sponsor for the 2010 Games in Vancouver and struggling to stay afloat when its deal with the 2012 Summer Olympics in London was announced last July.

Now that the company has filed for bankruptcy protection from its creditors, Nortel's sponsorships at the next two Olympics could be in jeopardy.

Only through incredible incompetence or incredible arrogance could a struggling company think it is a good idea to spend millions on sponsoring a circus every few years.

The olympics in Vancouver-Whistler are turning out to be an unmitigated disaster. All of the planning going into the preparations assumed that economic expansion was a given. There was no contingency for a worldwide business slowdown. Surely, the economists they had hired assured them that no such thing had any statistical probability of occurring, and therefore wasn't worth planning for. This arrogance was prevalent regardless of numerous olympic experiences gone awry over the decades (the Montreal 1976 summer games had debts only repaid 30 years later, in 2006).

I'm guessing the attendance figures the olympic committee have assumed will also turn out to be wildly optimistic and revenue for the games and small businesses alike will turn out to be far lower than expected.

I'll give my readers two guesses as to who will be paying for this financial disaster, but you'll likely only need one.

Elsewhere, the global credit unwind and commodity collapse have real estate prices reeling in Vancouver. Vancouver is the former home of the TSX-Venture Exchange. It is the largest collection of junior mining exploration and development companies. Most of those companies are still based in Vancouver. During the commodity boom, these companies absolutely exploded in value. Very few of them actually made any money. But the prospect of finding a huge resource deposit was enough to give many of those companies significant value. Now, with commodity prices 70% lower and credit markets basically closed, many of these companies are gravitating toward zero. Cash in the bank is disappearing fast and without financing, they are essentially holding companies for mining permits that have little hope of ever being used. The wealth lost in the collapse of these shares has been exceptional, especially when you consider much of it is contained to one city.



During the boom, company executives, investor relations representatives, even secretaries were paid modest salaries plus stock options. The tremendous wealth effect this had was a contributor to Vancouver's housing boom. Now it too has all but disappeared.

In only 8 months, home prices have fallen 19%. And the massive amount of speculative supply that was bought in anticipation of flipping it post-olympics is awaiting the market for the spring. This has all the ingredients for a spectacular crash of epic proportions. Already, wise property developers are trying to front-run the market.

On Sale: $350M of Real Estate in Lower Mainland

A Vancouver real estate developer is making an unprecedented move to offer a liquidation sale of $350 million worth of its condominiums throughout the Lower Mainland.

The marketing strategy by Onni Group of Companies is aimed at selling off hundreds of condos in its inventory.

About 375 unsold condominiums in cities such as Richmond and New Westminster will be offered at 20 to 40 per cent off, a real estate insider told CBC News.

Only time will tell whether those discounts will be sufficient to draw enough buyers. Judging by the absolute collapse in social mood, I don't know where the buyers are going to come from. Nearly everyone who could come close to affording a condo (and many who couldn't, to be sure) already bought one in the fright campaign of run-away prices. "If you don't buy now, you'll never be able to afford one," was common advice.



Prices of nearly everything got so out of control, that there is no telling where the bottom is on this market. The chart above traces out some very clean Elliott Wave patterns, which would suggest prices are heading all the way back to their "Wave 4" trough of '98. That would be a 50% decline from the peak - surely even more for condos in super-speculative areas (the Olympic Village, for example). How will the forthcoming property tax hikes affect prices? Will the inevitable post-games service cuts by the city make Vancouver an undesirable place to live in the future?

We are once again confronted by a region that thought, "It's different here." It wasn't. It never is. Speculative booms precede busts, just as inhaling precedes exhaling.

Technical Update

On January 2nd I was writing about the progress of the countertrend rally in US equity markets in Part 5 of my "Themes for 2009."

I am seeing some early signs of exhaustion in some indicators that I follow that may be hinting that the rally is already nearing it's end. Of course, none of this excludes the possibility of stocks moving higher, or even substantially so. It just makes it increasingly more unlikely.

Indeed, the markets pushed marginally higher over the next two days, thus extending the indicators to even higher extremes. But the S&P 500 has proceeded to lose 9% over the subsequent 6 trading days (including today's overnight session). The decline has been led by the financial sector, which has not taken kindly to Citigroup's desperation move to joint venture their Smith Barney unit with Morgan Stanley. My sources have been telling me that going the JV route is basically the last resort for a financials company that cannot sell assets for cash, stock or even for payment in installments. This is suggesting that Citi is essentially toast and will be nationalized "AIG style" in the near future. Wouldn't that be a nice inauguration gift for President Obama? And how many other derivative-juiced banks would go down with that sinking ship?



Above is a chart of the KBW Bank Index. It has been especially weak during this correction, not even being able to reach it's 50 day EMA or post an RSI reading much higher than 50. The relative underperformance of the banks does not bode well for the major averages. It's really hard to say how low this index can go. Surely every bank won't be nationalized. However, I do think that the current model for banking will not survive. What emerges will be much smaller regional banks offering traditional deposit accounts and conservative mortgages. I would be disinclined to go bargain hunting among the big banking monsters, even if this index were to plummet much further.



As for the major averages, I am leaning towards a fairly significant bounce from around the 820 area - perhaps all the way back up to 920. However, being in a bear market, the potential is great that we just plough through 800 on our way to new lows. Should that happen, my first target would be 600 for the S&P. There is also a confluence of support around current levels 866-871 that could provide a small respite.

As the markets were pushing higher, I used the opportunity to start collecting puts on a few companies I feel are in less than good shape. Among them were industrial companies with major financial exposure, Canadian banks and discretionary restaurants. (Send me an e-mail if you'd like to know specifically). The companies I chose mostly had large debt loads compared to their competitors or had over-expanded during the boom. I am expecting huge pressures on the Canadian banks this spring and summer as home prices fall dramatically.



Gold's 4% selloff yesterday appears to have confirmed a 4th lower high dating back to March's all-time high. I am sticking to my December 4th target range of $552-644 as the most likely destination for this next round of selling. At such levels, I would think about accumulating or increasing my holdings of physical bullion as a percentage of total assets.

That's all for now.

Manufacturing Weakness Spreads to Germany

Earlier this week I pointed out the atrocious numbers coming out of the Far East in Asia Coming Unglued. However, Asia is not alone in experiencing dramatic symptoms from the American consumer shift in psychology. Europe is being hit hard as well. But the areas one would expect to be the hardest hit, countries that experienced US-style binges on consumption (UK & Ireland, Spain primarily) are not where the only pain is being felt. Germany came out with a slew of horrific news this week. Their situation is an interesting one in it's own right, and I'll cover as much of that as I can today in addition to what it may mean for investment opportunities in the future.

First came the unemployment number, which was a worse than expected 7.4%

Then we learned that German exports fell by 11.3% year over year, and that factory orders fell by 27.2% compared to last November.

Paradoxically, the economies that had been operating with a trade surplus, and responsibly producing their way to increased prosperity are the ones being hit first by the credit crisis. We have seen this in Asia, and now Germany (Europe's most advanced economy and 3rd largest in the world). Common logic would have one assume that these economies would be relatively immune to a slowdown (this was the logic behind the decoupling theory). However, their economies being more oriented toward manufacturing, they are more vulnerable to sharp slowdowns when discretionary spending abroad screeches to a halt - not less. Germany is a manufacturer of advanced heavy machinery, pharmaceuticals and other high-tech devices. When businesses in the US need to trim their balance sheets, large capital expenditures like reinvestment in plant and property is one of the first to go. So we are now seeing the lagging effects of a manufacturing slowdown in German numbers. In contrast, consumption numbers in the US, although bad already, have not yet begun to feel the effects of rapidly increasing unemployment - payroll being the next major expenditure US firms are likely to cut back on.

From what we have seen, it appears that US firms and consumers began to rapidly decelerate their discretionary spending in the summer of '08. This has led to fewer overseas purchases of discretionary imported goods. The next step was for US firms to drastically reduce payrolls starting in November. The resulting joblessness is currently starting to have an effect on the bottom line of many US retailers (as evidenced by Wal-Mart this week) and the stunning declines in US consumption are sure to lag by a month or two after that. US Retail Sales numbers for December are scheduled for release on Wednesday the 14th. The consensus estimate is for a 1.1% decline. The number could surely be far worse than that, however it is the following month that I have my eye on; scheduled for release on the 12th of February. This is when I expect the numbers to start looking truly disastrous. I'm also watching the February 2nd employment number, as it will be restating much of the second half's fallacious birth/death assumptions.

So while the news out of the rest of the world appears to be worse than in the US (where the crisis apparently originated), I don't have any sanguine expectations that they will be less affected in even the short term. The relative strength they have shown to date is likely more a result of the type of service oriented economy they have as opposed to the manufacturing economies we see dramatically slowing today. As the effects of rising unemployment filter through the economy, the shocking numbers are sure to follow in the US as well.

However, even though the manufacturing numbers look horrible in Germany and Asia right now, it is to their long-term benefit that their economies were at least based on something tangible (even if that something was unsustainable US consumption.) The main difference between the suppliers of the US binge and the consumers is not in increased foreign exchange reserves as is often said. Rather it is in the capital that is found in the spare productive capacity. It is something that can either be used itself at some point in the future or it can be used as collateral for some other investment. Because of that, there is a chance the manufacturing hubs are the first ones to exit the depression whenever that may be. Additionally, the balance sheets of individual and corporate participants in Germany and Japan especially are in far better shape than those in the US. Therefore, it will take them far less time to repair themselves from falling asset prices.

From my perspective, the real issues determining how Europe and Japan (and to a lesser extent Canada, S.Korea, Australia and the US) emerge from the depression are more demographic in nature. Birth rates in these areas have been anemic over the last generation. And an aging population is typically a drag on an economy as higher taxes are required to support the elderly. This is especially problematic given the enormous amount of promises politicians have made in terms of social security and health benefits. Governments in many of these countries are going to have to massively cut their obligations to senior citizens. How feasible this will be is hard to say. Voters are not often known for electing themselves less money. To be sure, these problems have not just come out of the blue. They are expected. But they were not expected to come to a head for another 5-10 years. Now, with a worldwide depression setting in, government tax revenue projections are likely to fall short, accelerating the zero-hour date. This is something I expect to become a large issue over the next few years. It will be pitting the young vs. the old. Those that accept fewer benefits will likely be able to use their stronger capital position to rebuild and perhaps lead the recovery. Those that instead choose to raise taxes on the young, will not only see weak investment but they'll likely see their already small younger population move somewhere else - compounding the problem.

In summary, there are important differences between the world's major economies and how they are expressing the slowdown in their own ways. Somewhere, there will be a screaming investment opportunity. It will come from somewhere that a) has a large educated and robust young population b) has strong corporate and individual balance sheets c) low tax rates and d) open and accessible capital markets. I will be looking for opportunities in areas that demonstrate a good combination of those characteristics. Parts of South America (Chile especially) are looking good as of now. But any country can conceivably help themselves in most if not all of those areas. However, doing so may take some unpopular short-term decisions. I will be watching keenly where those correct decisions are being made and where they are not. When the time is right to take risk again, I'll be allocating my investments based on that. The world that emerges from all this will not closely resemble the old world - neither will my investments.

There Is No "Paradox" In Saving

Considerable ink has been spilled over a recent article in the Wall Street Journal titled, "Hard-Hit Families Finally Start Saving, Aggravating Nation's Economic Woes." And for good reason. The article, as it's title implies, seeks to perpetuate the myth that saving is a bad thing and if everybody just kept on spending like crazy, the economy would recover nicely and we'd all live happily ever after.

This, of course, is absurd.

To be fair, the article is a good one and well worth reading. However, the offending paragraph and the note on which the article ends, leaves me either wanting to bang my head against a wall or whine about it for all to see. Having chosen the latter, I offer the offending paragraphs:

Usually, frugality is good for individuals and for the economy. Savings serve as a reservoir of capital that can be used to finance investment, which helps raise a nation's standard of living. But in a recession, increased saving -- or its flip side, decreased spending -- can exacerbate the economy's woes. It's what economists call the "paradox of thrift."

This is not what economists call the "paradox of thrift." This is what Keynesian economists call the "paradox of thrift." Until journalists begin to point out the difference, I will continue doing it for them.

Keynesians believe that the future is made up of a whole bunch of short-terms. According to them, as long as we ensure that everything is hunky-dory in the short-term, nothing can ever go wrong. The arguments against this kind of swiss-cheese logic should be self-evident, however they are not. Not to the vast majority of economists that have infected our universities and governments.

To them, cumulative imbalances are strange and inexplicable phenomena. They come out of the blue, like monsters hiding in the closet. What's more, any explanations of the imbalance citing past missteps or oversights are quickly disregarded as it would pose a threat to their current legitimacy.

The article goes on to accurately describe how normal, middle-class families are cutting back on expenditures to compensate for falling net worths in real estate and the stock market. In order to leave a lasting impression of sinfulness in any reader who may be experiencing a similar situation, the writer finishes with:

This year, Mrs. Capp and her husband are resolved not to touch the $2,600 they have in savings, and to augment as soon as possible. "You look around, you see the closing stores, and you know someone needs to spend," Mr. Capp said. "Just not us."

The insinuation in all of this is that saving is wrong. That if one were a true patriot, he/she would spend everything they had to support the economy. Unfortunately, even a child could figure out how this is counterproductive. Once all the savings are spent, spending would eventually fall anyway. Eventually is now. We have been pushing off saving, and trying to spend our way out of recessions for decades now. So much so, that the savings rate actually dropped below zero - just as home prices in the US were peaking.

Mike Shedlock had a few words on the article in Families Start Saving; Does This Aggravate the Nations Woes? Here is what he had to say:

...In Austrian economics terms, saving is what is left over (not consumed) from production.

Keynesian theory suggests you can have something today and tomorrow which is of course as preposterous as having your cake and eating it too. In simple terms one cannot consume what one does not produce, at least not forever.

Spending now will only borrow from future production. The United States has been doing that for decades and all we have to show for it is an exodus of manufacturing jobs from the United States to China, and a housing bubble of epic proportion.

There is no paradox. The United States has borrowed itself into oblivion. Consumers have finally seen the light and are attempting to save in spite of horrible economic policy encouraging them to do otherwise.

Indeed. Politicians of all mainstream colours have been instructing people to do the exact opposite of what is in their best interest. Conservatives, Republicans, Liberals, Democrats, Socialists. They all have the same solution: Hair of the dog.

Kevin Depew also took issue with the same paragraph in From Generation Boom to Generation Save-a-Lot:

... While this part in the Journal article - "savings serve as a reservoir of capital that can be used to finance investment, which helps raise a nation's standard of living" - certainly is true, the real problem is blissfully glossed over into the next sentence on the "flip side" of savings, where "decreased spending... can exacerbate the economy's woes."

See, while decreased spending exacerbates economic woes, that's not the real issue. The real issue is related to first half of the equation; a reservoir of savings. We haven't had a "reservoir of savings" in this country in nearly two decades. Indeed, the central bank, by disguising that lack of savings with artificially low interest rates, is the reason this necessary step to repair consumer balance sheets and restore saving sis going to be so very painful.

The bottom line? Consumers are now saving and repairing balance sheets. This is a secular trend, not a temporary aberration, that will crush consumption for far longer than even the most bearish economists expect.

Meanwhile, even as asset price (stocks, junk bonds, etc.) deflation temporarily stalls, guess what is happening to the labor market and wages? They are deflating at a near-record pace. moreover, this is not just happening in the U.S., but globally. You do not get inflation from this kind of structural deflationary debt unwind, at least not for many, many years.

So, those who today are selling Treasuries, buying risk assets and hoarding gold in anticipation of "The Coming Great Inflation" will, ironically, be among those contributing to the elements of structural deflation in the not-so-distant future.

Depew hits this one out of the park. The savings rate has been below average for a long time. Now, as we return to the mean level of savings, and likely beyond (as mean reversion typically operates) the victims will be all sorts of trinket salesmen, doggy daycare operators, nail salons, and numerous other nonsensical businesses that only functioned due to society's unwillingness to save a penny.

If we are going to have a legitimate recovery, it is going to come from private savings. Trying to prop up asset prices as a means to encourage people to spend more is as intellectually fallacious as it is undesirable. Asset prices need to fall to a level commensurate with the level of true capital. Not capital "backed" by credit derivatives. Not capital "backed" by government guarantees. That is not capital. That is a liability masquerading as capital. Now the masquerade is over. Savings come from labour. From production.

We are going to have to work harder, consume less and save more. Lower wages are something we're going to have to expect. Once we have done this for long enough, and enough of the aforementioned nonsensical businesses have gone to business heaven, then we can get back to entrepreneurial people providing value-added goods and services to the population. Until prices fall enough for such a start-up to make economic sense, it simply won't happen. A butcher who gets his meat from a local farmer, thus providing a superior product, cannot pay $2,200 in monthly rent. Drop the rent to $900 and it might make sense. A copper mining company cannot pay $40/hour in wages and benefits to their miners. Not with Copper at $1.50/lb. Drop the wage to $15/hour and it might make sense.

This is what it is going to take in order for us to recover. There is no "reservoir of savings" to fall back on. Prices need to fall and savings need to rise. Everything our politicians and their economic advisers are doing is a direct attempt to prevent that.

Judging by their record, are you going to listen to them? I highly doubt many will. And that is precisely why hyperinflation is impossible now or any time soon.

Asia Coming Unglued

The news out of Asia has been absolutely atrocious. Here are a few recently released gauges:

Japanese industrial output down 16.2% in November
Japanese exports down 26.7% in November
Japanese Real wages down 3.1%
Economic contraction of 1.8% in Q3 after a 3.7% decline in Q2 (estimates are for -12% in Q4)
Japanese December sales down 22% to a 34 year low

Japan is literally falling apart. Their own deflationary depression had been propped up for years by the enormous consumption bubble in the west and the massive expansion in China that resulted from it. Bernanke and other "academics" have mistakenly attributed this phenomenon to Japan's government stimulus programs in the 90's and quantitative easing starting in 1999. Now, as the US consumer bubble collapses and the China bubble goes with it, we are left to see that they had only postponed the inevitable consequences of a mania gone bad. The west doesn't even have that luxury now. There's nowhere to export to - and even if there were, there's no manufacturing capacity remaining.

Today we hear that Toyota is to halt production for 11 days.

From the article:

"Analysts say drivers are opting to hold onto their old cars for longer and making more use of public transport, while younger people are losing interest in having a car."

(emphasis mine)

From a socionomic and generational perspective, this should come as no surprise. The young Japanese have inherited an incredible amount of public debt. Going out and buying a new Lexus would only serve to associate oneself with the recklessness of the past. They'd rather take the train or ride their bike.

But the carnage is not limited to Japan:

Singapore Q4 GDP down 12.5%
Singapore non-oil exports fall 17.5%
Taiwan November exports fell 28% - exports to China fell 45%
Taiwan industrial output contracts 28.35% in November
Korean November exports down 19% in November, 17.4% in December
Korean industrial output down 14.1% year over year in November
Chinese manufacturing contracts for 3rd straight quarter in December
Chinese electrical output contracts by 9.6% in November

These are not your typical recession numbers. They are all far worse than what was seen even in the Asian economic crisis of the late 90's. Asia is entering a full-fledged depression. The decoupling theory has now turned into one of the biggest shams of the decade. It turns out that much of the growth experienced there was artificial also. The notion that they would all be able to gradually shift to domestic consumption when the west slowed was based on nothing other than wishful thinking. They don't have the infrastructure to start consuming more. And they don't have the consumerist mentality to consume more. In fact, now that many are losing their manufacturing jobs, are experiencing huge losses in the stock market, and see the unravelling going on around the world, their natural inclination is to save more and consume even less. Go figure.

To be sure, I don't put much stock into any statistic coming out of China, nor do I for any country for that matter, but especially not China. So even if these numbers look terrible, I fully expect them to be far worse in reality. Social unrest in Asia is one theme I expect to be very prevalent this year. Already we are seeing violent clashes inside the Korean Parliament. And Japanese Premier Taro Aso, who's approval rating sits at 20% is rebuffing calls for his resignation. Are political troubles in China soon to follow? Even China's state-run media seems to acknowledge that possibility.

Whatever 2009 brings, we can be reasonably certain that any relative leadership will not be forthcoming from Russia or East Asia. However, there is a good argument to be made that China and the Tigers (Korea, Taiwan, Singapore) are in a similar position to inter-war America. Regardless of how bad things get, it is a distinct possibility that some of the best long-term opportunities may be found when it appears Asia is in irreparable chaos. Now may be a good time to start preparing some wish lists among the dual listed securities we have access to.

Themes for 2009 - Part 6 (Final Thoughts)

I am often confronted by readers who feel I am too pessimistic. I am told that "things have a way of working themselves out." Instead of always looking at the glass half-empty, I should instead look at it as half-full.

My response to this is usually the same. That these people are misinterpreting my point. What I am saying, is that what we have experienced over the last 10-15 years has not been desirable. That all of the thoughtless materialism and constant obsessiveness about money were in fact destroying the very institutions that made our various cultures great. Groups of friends were separated into social classes. We became suspicious of our neighbours instead of automatically trustworthy. Families were working longer hours to "keep up with the Jones'." Bigger, faster, sexier took over from efficient, practical and natural. This is what is collapsing.

So am I a pessimist to advocate a further erosion of that? Hardly. I'd argue that I'm actually an optimist - regardless of the nasty side-effects. With that in mind, here is a summary of some major themes I expect to be prevalent in 2009. I offer it with my usual caveat: Some of it will be right, some of it will be laughably wrong. Chaos theory ensures that much. There are any number of "Black Swan Events" that could come along and render some of these themes as not only wrong, but irrelevant to more important issues.

- Government attempts to "get credit moving again" will fail. The credit contraction (deflation) will continue even as governments and central banks do everything within the law (and even some outside) to encourage hyperinflation
- Crumbling corporate earnings as consumer psychology moves away from the "gotta have it now" mentality to "it can wait until next year"
- Municipal and State bankruptcies requiring federal bailouts in the US
- Skyrocketing unemployment. Official figures to reach 9% or higher in the US.
- 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
- Plummeting stock markets worldwide with losses of 50% or more in major indices as hype over President Obama wanes
- A wave of bankruptcies in retail, restaurants, airlines and financial services. Nationalization of the politically well-connected
- A continued strength in the US Dollar vs most other major currencies as European infighting escalates
- Declines in the price of gold but continued relative outperformance to other assets and most currencies
- Large declines for Canadian real estate, notably in bubble areas of the west and prairies
- Social "witch hunts" for those responsible for the common plight. Multiple scandals uncovered. Persecution and enormous tax increases on the extremely wealthy
- An increased focus on the family, on close friends and "time" in general

One reads a lot of "predictions" for the coming year around this time and these will probably be among the more dire that you come across. Keep in mind that I too would benefit very little if such events were to transpire. My own family and friends will be affected. No individual can come away from such a situation unscathed. Although society itself will be much healthier once all is said and done.

However, among other sets of predictions I see a striking pattern of unrelenting bullishness. The common citation for this bullishness is that there is too much negativity. I find it difficult to wrap my mind around that paradox. If everyone is so bullish, how can their reason be that everyone is bearish? Take the following anecdotal evidence. As of this writing, I am looking on Bloomberg.com and their videos section has four videos with the following titles:

Cantor's Pado sees bull market for US stocks in 2009
Jeffery Saut says, "worst has been seen" for stocks
Vitner sees "definitive bottom" for home sales in 2009
Analysts say Obama stimulus to "drive stocks higher"

The Wall Street Journal has the following article on strategist predictions for 2009. 80% of the 20 strategists surveyed see higher stock prices for 2009, many of them substantially so. This New York Times article does a better job than most in pointing out some caveats in the forecaster's methods, but still leaves the reader with optimistic conclusions. Clearly, the consensus is not for a continuation of 2008, and almost nobody is expecting an acceleration.

Another observation I have made over the last few days is the increasing use of the word "hope" by analysts and commentators on TV. They all "hope" that Obama's stimulus plan will have a positive effect. And they "hope" that corporate earnings will recover in the second half. Yet, when pressed, none of them can explain exactly how these things will happen. To me, hope is not a viable investment vehicle. I prefer to see strong balance sheets with increasing opportunities for growth when I look at buying companies. "Hope" does not often enter into the equation. It appears that these analysts, all of whom presumably own a great deal of stock, need the markets to rise in 2009 and are searching for what they think could be the catalysts for that to happen. Typically, such sophistry backfires.

Perhaps I'm wrong. Perhaps that black swan event turns out to be something revolutionary. Maybe CERN's Large Hadron Collider will teach us how to make infinite amounts of energy from nothing. Maybe we discover a miracle drug that renders sleep unnecessary. But really, do we actually want the bubble to reflate again only to come crashing down a few years later? Is that really a noble objective? I don't think so. I suppose that's where I differentiate myself between most other analysts and politicians.

Let me wish all my readers a healthy and happy New Year. Try to remember that net-worth and self-worth are not the same things. When it is all over with, even if that takes years, those who were part of the solution will be revered. Those who were part of the problem will be reviled. Keep that in mind.

Themes for 2009 - Part 5 (Equity Outlook)

It is official. 2008 was the worst year for the Dow Jones Industrial Average since the depths of the Great Depression. For the S&P 500 you have to go back to 1957 to find a worse year. The breathtaking daily declines of 6 and 8% made front page news around the world. Government interventions made the subsequent short-covering rallies even more violent. If there is one word I used more than any other, it was "wow!"



At times I would get that chill down my spine. The one you get when you realize you're living through history. That people 100 years from now would be writing entire books about what happened at that very moment. Every grueling tick of the stock market served as further confirmation that my worst fears were coming to pass. And that by extension, society as I knew it was about to change dramatically. But by their very nature, the chills are a signal of a fear of the unknown. To what extent will the events of 2008 affect those of the next decades? Nobody knows exactly. But we know they will.

As I wrote in the Macro Outlook, the psychology of investors, consumers and producers alike has been damaged irreparably. People will not go back to speculating on condos. They won't go back to buying new boats to impress their friends. And they will no longer accept mere representations of something real as the original. Instead, we will start seeing people go out of their way to categorically reject anything they view to be associated with the aforementioned. Golf club memberships will plummet. Gluttonous vacations in the tropics will become a rarity. Images of women walking out of shopping malls with 14 bags of new shoes will exist only in our memories. Taking it's place will be an increased emphasis on time with family and close friends. On health and well-being. On home cooked meals.

So what does this have to do with the equity markets? Well, for starters, there has been a noticeable trend of producers, retailers and policy makers to categorize this progression of behaviour toward saving as "irrational." As if it is only temporary. Soon to be revived by some other outside influence as it was so many times before. But it's not coming back. Not only because it can't, but because most people really don't want it to. As a result, the aforementioned parties are baffled at this sudden change in consumer behaviour. They have not adjusted proactively and are very slow in reacting - if they have reacted at all. Even those that have, seem to be making the wrong decisions. Take GMAC's new policy to reduce the acceptable credit rating to qualify for 0% car loans. Or a multitude of retailers offering 2 for 1 deals on their products. People don't want 2. They want 1. And they want it at a discount. The end result is for them to buy none - and wait.

This is going to have disastrous consequences for corporate earnings, which, believe it or not, are still expected to rise substantially in 2009 by most "analysts." It is my expectation that at some point in the coming year there will be a sudden realization. That zero percent interest rates are doing nothing to entice people to spend more. That no price will fetch a buyer for certain goods or services. And that the trillions of dollars in derivative contracts sitting off the balance sheets of major financial companies are not ever again going to be priced based on what their quantitative model says is "normal."

I am expecting a wave of nationalization in the financials, bankruptcy in the retail space, and massive retrenching of expenditures and expansion plans for nearly everything else. Stocks could fall another 50% or more from current levels in order to accurately reflect this new reality. And even at that point they have the potential to become so universally detested that they are sold down to absurdly low levels. Whether this happens in 2009 or 2010 is unknowable. But I don't see the markets gaining much upward traction given the social headwinds I described.

Since mid-November, I have been tracking (and trying to take advantage of) a fairly weak "Santa Rally." I talked about this in previous articles "Looking for Relative Strength" and "Time for a Santa Rally?." I am seeing some early signs of exhaustion in some indicators that I follow that may be hinting that the rally is already nearing it's end. Of course, none of this excludes the possibility of stocks moving higher, or even substantially so. It just makes it increasingly more unlikely. Consider the following charts:

Click on any chart to see an enlarged version.



This chart is of the volatility index. Previously this year, the index hit highs nobody even thought were possible. But it has now worked off enough of it's "overbought" condition to warrant a bounce higher (suggesting stocks will fall). There is a confluence of support around it's 200 day moving average and previous spike highs from mini-panics in January and March.



Next up is a chart of the 10 day moving average for the Advance/Decline ratio. This measures the amount of stocks rising on any given day vs. those falling. Typically, when the recent average of this ratio rises to a certain level, it signals an extreme in optimism. It is far past that level as of the close on Wednesday.



Similar to the last chart, this one indicates a potential extreme in optimism. This is a chart of the put/call ratio. It monitors the amount of total put options traded compared to the total amount of call options traded each day. The blue line is a 10 day moving average of that ratio. Previous major market tops have been marked by visits to this same level (the all-time high in Oct '07 and the recovery high in May '08).

Again, this does not mean the rally must be over. These conditions could go on to reach even higher extremes in the coming weeks (perhaps another round of Obamamania?). There are legitimate arguments to be made for the S&P to return all the way back to the "point of recognition," which I believe started back in early October on a gap down below 1075. But the indicators I am watching are saying that this is unlikely. I'm sure there are other indicators that could argue for higher prices. There always are.

I am expecting 2009 to see a continuation of the global stock market correlation. Unless you happened to be invested in Ghanian, Tunisian or Ecuadorian stocks, you probably didn't make out very well in 2008. There will be some exceptions again in '09, but large declines will likely be the rule. Certain problem areas could even see shocking declines, market closures and other drastic measures taken by foolish government officials. I'm specifically looking at Russia, China, Pakistan, the UAE, and some eastern European countries. I am more optimistic on Latin America over the long term, but even they might not escape a similar fate.

In my Mid-Year Review I made specific mention of Russia's stock market, which had enjoyed 6400% gains since the Ruble Crisis of '98. It has since experienced a gut-wrenching 78% decline, wrought with market closures and other interventions. The recovery since October has been especially weak in Russia. The economy is reeling from low oil prices, and what was once thought to be the "Putin Miracle" has exposed itself to be nothing more than a miracle of high oil prices. There are deep undercurrents of social unrest afoot, and this market could still go much lower.



A similar situation is unfolding in China, where it wasn't high oil prices that had driven the economy, but rather a manufacturing sector that exported cheap consumables to the US and Europe. Consumers cannot afford these items that are typically discretionary in nature, and even if they could, they don't care to purchase cheap representations of a real product - they want the real thing. Many had thought that China would be able to make a smooth transition to a domestic consumption economy, thus avoiding any serious economic consequences of an American recession. I always thought that to be a rather pie eyed assumption. Here is a country that makes millions of trinkets that Chinese society has zero practical use for. And not only that, but they don't have the infrastructure for a consumerist society. If the Chinese were going to start consuming more, it is something that would occur over decades, not months.

Demographically, China is a ticking time-bomb. They have millions more men than women (a nasty side-effect of the One Child Policy). And now those same millions are being thrown out on the street as their factories close. Jobless, unmarried men are not typically a jolly bunch, and I could see them kicking up a bit of a fuss.

Some analysts are going out on a limb and predicting a "massive" slowdown to 5% growth this year. Again, I think that is way too optimistic. I see actual economic contraction in 2009, and perhaps a 20-30% total contraction of the economy in the next few years. China could be the epicentre of this global unwind by the time all is said and done. Naturally, that's not something that even the 73% decline has priced in, and China could see a US Great Depression-style 90% decline. Another 60% down from these levels. Whether that proves to be the buying opportunity of the century, as was the 1932 bottom in the Dow, remains to be seen.



I could elaborate further on other markets, but the pattern is clear. Social and economic problems are abound, and they need to run their natural course before buying opportunities present themselves. I will be monitoring events closely. When I see the appropriate extremes in pessimism, I will try not to hesitate to act boldly. As difficult as that may seem at the time.

I'll be back with a summary of my Themes for 2009 early next week. Have a great weekend!