Best of the Net - Tuesday September 30, 2008

There was steady buying all over the world today, as renewed 'optimism' about the bailout bill eventually passing grew. Lost on most people was the simple fact that none of this is about the bailout plan. The markets didn't tank on Monday because of the bailout not going through, it tanked because there was a sudden sentiment shift on main street. People finally understood that the credit crisis was going to affect their jobs and wages.

I don't know whether the markets will continue rallying or not. But my suspicion is that another (or potentially much worse) day like Monday is in our very near future. And again, it won't have anything to do with bailouts. It will likely have more to do with earnings and economic growth estimates being revised downward all over the world. Although the propaganda machines will be hard at work blaming any negative market action on anything but the real issues. A CNBC commentator even went as far, yesterday to say, "Opponents to this bill are acting almost Timothy McVeigh-like in their opposition."

That's right. It's economic terrorists that are the root cause of our problems!

Kevin Depew had a good post today titled, "What Everyone Knows"

I have always found that bars are excellent sources of advice. Everyone at a bar has an opinion about something, and the liquid lubricant makes everyone feel a lot more comfortable about sharing those opinions. I have also found that , more so than any other place, any advice someone gives you at a bar - "liquor before beer; never fear." or "one more for the road!" or "just put some fingernail polish on it and it will go away," for example - is something you should DO THE OPPOSITE of with extreme prejudice.

Hearing yesterday's conversations about Wall Street, it is clear to me that there are two things everyone knows with certainty:

1) The dollar is going down.
2) It is too late to sell stocks.

I have yet to meet anyone outside of Wall Street (and few even on Wall Street) who do not believe those two things are certain.

Mr Practical had a letter to anyone under 20 today on Minyanville. His conclusion is that the younger generation should be careful in listening to the older generations. Read: Borrowing On Our Future.

Calculated Risk had some good analysis on consumption expenditures in Estimating PCE Growth for Q3 2008.

Best of the Net - 'Black' Monday September 29, 2008

In Wall Street, as elsewhere in 1929, few people wanted a bad depression. In Wall Street, as elsewhere, there is deep faith in the power of incantation. When the market fell, many Wall Street citizens immediately sensed the real danger, which was that income and employment - prosperity in general - would be adversely affected. This had to be prevented. Preventive incantation required that as many important people as possible repeat as firmly as they could that it wouldn't happen. This they did. They explained how the stock market was merely the froth and that the real substance of economic life rested in production, employment and spending, all of which would remain unaffected. No one knew for sure that this was so. As an instrument of economic policy, incantation does not permit of minor doubts or scruples.

- John Kenneth Galbraith from The Great Crash, 1929.

Today has the feel of a very significant day in history. Not because of the Dow being down 777 points. Not because of the bailout bill not going through. But because of the enormous change in sentiment that has accompanied those events.

For years, the average person has been relatively immune to that crisis from afar. There had been the subprime crisis, a housing crisis, an oil crisis, and now a credit crisis. For a large portion of the world population, these issues only affected "other people."

For years, we have been sold the mantra that "the fundamentals of the economy are sound." That there may be a setback, but no recession. Certainly not a depression. Only a lunatic would even mention such a thing. We've been told that numerous solutions would be the eventual cure, yet none has helped one iota.

Today something happened. People realized that this issue is not one that can be resolved simply by the government snapping their fingers. The average person has just seen all of their supposed smartest officials fail on agreeing to a solution. It tells people that there is no short term cure other than time. It tells them these issues were going to slow the economy, that many would lose their jobs. That realization is what caused world markets to crater in unison today. A simple change in sentiment. We've made the progression from denial to migration to panic. How far away will be despair?

Why do we keep making the same mistakes over and over? It's because we are conditioned to do so. All the John Kenneth Galbraiths and Murray Rothbards that experienced and understood the last crisis are gone. In their place are harvard graduates who say their quant model tells them this shouldn't be happening.

Days like today are actually a step forward, rather than a step back. The faster the process of price discovery, the faster our savings can be put to productive use. The more bad businesses that are destroyed, the more good businesses can eventually replace them. This is the natural evolution of markets. It will be painful, but it is necessary. The bubble cannot be inflated any larger than it was.

Todd Harrison had these words on the significance of today's dislocation.

Bennet Sedacca says, "Welcome to Deflation. I'd have to agree.

We'll see what happens tomorrow. But these bouts of major selling don't generally end in one day.

Best of the Net - Weekend Edition September 26-28, 2008

The circus continues in Washington this weekend, as some sort of "plan" involving a lot of money is attempting to be rammed through the US legislature regardless of massive public opposition. Here are videos of what some of the more sensible officials have stated in the last few days:

Burgess: watch video here

Bunning: watch video here

Shelby: watch video here

"Ticker Guy" watch video here

Kaptur: watch the video here she gives the wrong solution, but 'A' for effort.

Paul: watch the video here

I know this blog has taken a bit of a political focus in the last few weeks. I wish I could honestly sit here, and discuss with you what the best way is to effectively manage our personal finances. I wish I could tell you what stocks to buy, and which to stay away from. But the fact of the matter is, these developments are so much more important that it simply renders most other issues irrelevant. If government attempts to become the arbiter of prices, we end up in a different world. Plain and simple. The government will essentially be managing our finances. Not us.

This kind of interventionism is resulting in the very "all bets are off" mentality shift that threatens to destroy our markets. Certain people take losses, not by the rule of law, but by government decree. Others get 'rescued.' Government gets to decide who's who. Legal contracts previously signed by both parties no longer matter. This mentality shift explains why thousands of people all over the world are withdrawing their funds from banks. Washington Mutual, Bank of East Asia, Fortis and Bradford and Bingley have all been liquidated this weekend. Major bank runs are happening all over the world. People know that there is not enough physical cash to cover all deposits at any one time.

By attempting to bail out the system, governments all over the world are perpetuating exactly what they are trying to prevent. The more they try to intervene, the faster the loss of confidence will occur and the more it will spread. My prediction of "the Fed eventually being seen as an emperor without clothes" has come true. Not only is the emperor naked, but he is dancing around drunkenly and scaring all the guests.

If you have not already, make sure that you have no more than $100,000 in any one bank account. The assets that are most safe in a situation like this are short term government securities and physical precious metals.

Best of the Net - Wed/Thurs September 24/25

Volatility is still the name of the game in the US and most foreign markets, even though they have made a violent rebound from last week's lows. The elimination of short selling does not appear to be having the desired effect of instilling confidence in the markets. Any market participant could have predicted this, but apparently this common sense was not so 'common' amongst market regulators the world over.

Having said that, and knowing that one cannot 'legislate enthusiasm,' I would be remiss to not point out the extreme negativity in sentiment that usually marks intermediate term bottoms. When the words 'financial Armageddon' are used frequently, you know sentiment is getting extreme. Additionally, with the US and Canadian campaign trails heating up, one can expect all sorts of asinine promises for certain industries from desperate candidates. What else is bullish? The absence of important Q3 earnings releases for a few more weeks. And of course, the daily barrage of 'happy thoughts' from US legislators.

I'm probably more 'net long' than I have been in a year, but I don't foresee that to be the case for more than a week or two. And any of a number of potential catalysts could change my position on a dime. Caution is still the name of the game.

Meanwhile, economic fundamentals continue to deteriorate to little fanfare, as talks of the big-kahuna bailout consume the minds of investors. Paul Kasriel points out some of the terrible releases that have been filtering in.

Todd Harrison posted a good article focusing on the big picture and outlining the tug-of-war between hyperinflation and deflation. Indeed, the powers that be desire the former, but are their guns big enough to do it? The article is appropriately titled, "Shock and Awe."

Mike Shedlock has made it his personal mission to ensure this bailout does not happen. I applaud him for taking the time to do so and encourage my readers (esp. those Stateside) to visit his site and follow his instructions on how to help.

Best of the Net - Tuesday September 23, 2008

While the circus in Washington played out during the day, US markets had another relatively low volume day as "Turnaround Tuesday" failed to manifest. The markets saw their third day in five with significant sell-offs in the last half hour. The last half hour of trading is when hedge fund redemptions are done and share buybacks are suspended. Another signal in a long list suggesting that sentiment has changed for the worse.

Paul Kasriel had an update on his ongoing monitoring of inflation expectations. They have seen a modest relative uptick over the last week, as the price of oil has risen considerably. We'll see how this develops over the next month or so. It's not possible to tell whether commodities have been bouncing due to feelings that the bailout will work and stimulate growth, or if it is due to the expansion of the government's total debt and inflation fears. If the plan gets rejected (which it may) do commodity prices collapse again?

Bennet Sedacca doesn't like the prospects for a rally before the end of the year. Jeff Saut thinks otherwise. One of them will be wrong.

Best of the Net - Monday September 22, 2008

Perhaps we should consider Monday "Aftermath Day." With the Feds working overtime on weekends to put band-aides on cancer toomers, the last few Mondays have been a little crazy. It wasn't too long ago that a 48 point down day in the S&P 500 would be making the nightly news. Now it's just par for the course. Despite the large down move in prices, today was the lowest volume day since the Fannie and Freddie nationalization kicked off the fourth "mini-panic" we have seen this year. I think that is a feature we can get used to, as short selling being outlawed has eliminated much of the intraday trading opportunities for day traders. On the surface this may sound like a good thing. But remember, the opposite of liquidity is volatility. Another explanation is many of the big time participants in the market have taken their gloves and gone home as they no longer want to play a game that is so heavily rigged against them. Take the comments of Jeff Macke today,

Greetings from New York where I'm taking a mental and physical health day after a week of trying to explain, and make sense of, a world turned on its ear. Oil up $25? Investment banking effectively dead? Hank Paulson rolling up the financial world exactly as we roll into a new administration? Perfect.

I'm not in the mood to preach, whine or bark. I've been literally made sick, either from my own shouting or the death of the game as I knew it. Six of one, half dozen of another and Seven Deadly Sins. Right now we're trying to unwind two decades of Greed with two weeks of Fear. Doesn't work that way, Dante. It makes me wanna holler but it doesn't make me want to get long.

Here's what else I'm watching as I take a sick day from speech:
- I had market television on early then turned it to the Se7en, in honor of our Greed meltdown. My three year old boy, SuperFly, came down to see me. I left Se7en on. I'd rather have the lad watch smart, grizzly, thrillers than have him see the death of the free markets.

- "Value Hunt"? That's like finding which of the casino games has the best odd, if played "perfectly". The answer is craps. And the house still wins.

- A friend and reader asks what the best way to short crude, via ETF. "I don't know" is the answer. I'm not sure what you are allowed to short. The DUG isn't very effective and shorting the USO could be declared illegal tomorrow.

- I do know this, I don't have my dollar long ETF UUP anymore, but I'm thinking about getting some. This is global. This is strange. One currency takes down the others in a global world.

- General Moters and General Electric added to the short selling banned list. Both are down today. Of all the measures that embarrass me for out country on a truly personal basis, the ban on shorts and the short witch hung in general, will be judged most harshly by historians. You can't legislate enthusiasm. The degree of naivety required to believe otherwise is simply jarring when it comes from our "elected officials."

- What am I doing besides letting my child be exposed to hideous thrillers instead of a market gone bust? Nothing. It's a rigged game kids. Dig in and "Stop Trading"; this is going to take a while to unwind and I'd rather not pay for it in voluntary ways. Paying for it with my taxes is quite enough, thanks.

I posted that in it's entirety because I think it is indicative of the attitude most have toward the last month's insanity. It also seems to be indicative of most people's trading strategy. That is to "stop trading."

An illiquid market breeds fear and uncertainty. Fear and uncertainty inevitably lead to lower prices. Be careful.

Best of the Net - Weekend Edition September 19-21

Well, three weekends in September - three enormous bailouts. The most recent is unknown in size because it essentially allows government to resell what it has just purchased at any loss and immediately replace it with more garbage assets. Additionally, this recent measure allows the Treasury to buy assets from foreign financial institutions that do business in the US (nearly every financial institution does business in the US.) Another recent change in 'the plan' allows the Treasury to buy any other troubled assets. We're left to our imaginations as to what that means.

All over the world, short selling is being persecuted and subsequently banned. The results of this mean a massively heightened probability of stock market crashes.

Watching the market reaction late last week to rumours and announcements of these two measures, which shift the losses of Wall Street fat cats to the poor all over the world, was stomach turning. What this week will bring is unknown. All I know is it won't be 'stability.'

Lew Rockwell had some words and some book recommendations to help figure out where this crisis came from: Understanding the Crisis

Mike Shedlock had his take on the bailout.

I recommend readers watch Ron Paul's reaction to the news. Here is an interview he did today on CNN with Wolf Blitzer.

Yves Smith tells you why you should hate the treasury bailout.

I'm sure we'll be hearing about this enough as the week goes on, so I'll leave it there. Time for me to shut my brain off and watch some football - until tomorrow.

The Implications of Interventionism

The Implications of Interventionism

Once upon a time, there was a promised land that enabled people to live without tyranny and oppression; that allowed men (and later women) to endeavour upon any business they believed would make a profit - profits which would be gained by that proprietor and none other. So long as their doing so did not infringe upon another’s ability to do so, it was legal and was to be commended. Those people knew the risks involved in their journeys and accepted them. They took their life savings and jumped at the opportunity. Most failed. The consequences of their failures were unknown. But the opportunity was worth that risk. Those principles of self-determination were to be the founding of a civilization that would later be known as one of the world’s greatest ever.

Those principles that attracted people from the world over have been steadily eroded for the last 100 years, and just this last week, the final nails have been hammered in it’s coffin. The great grandchildren of those seekers of liberty have inherited precisely the tyrannical regimes their ancestors so bravely sought to escape and eventually fought against.

I write in reference to the trillions of dollars that have been taken from people who chose not to assume risk (either because the risks were too high, or they were too poor to take any risk), and have effectively been transferred to those who failed in their endeavours (usually those who were poor assessors of risk, or were wealthy enough not to care.)

For years, myself and a legion of others have warned against the under-acknowledgement of those risks. And now that they have come to fruition, we are being made to pay for those who chose not to listen. It is a classic transfer of wealth from the poor to the rich - the hallmark of tyranny of millennia gone by. It is imperative to understand that this is not a matter of political partisanship. Blame is to be laid equally upon all political parties.

The implications of these actions taken by US lawmakers and by central banks around the world reach far beyond this business cycle. They will be with us for many decades to come. We will look back on these actions in 80 years much the same as we look back now at the New Deal in America, the Treaty of Versailles in Europe or the Cultural Revolution in China. These are events of truly historic precedence.

What the long-term implications will be are completely unknown. Anyone who tells you otherwise should be avoided. But the immediate implications are far more predictable - and are not encouraging.

Playing God With the Free-Market

By now, anyone who has enough interest in this subject matter has read extensively of the actions taken by various government institutions (or pseudo-government institutions in the case of the Federal Reserve) over the last 14 months. The precise nature of these actions is not nearly as important as their overall magnitude. So I will not bore my readers with the details of each individual action.

What the actions, in aggregate, amount to are an attempt to fix the prices of certain assets above what the market thinks they should be worth. The assets in question are primarily real estate, equities, commodities and the derivatives attached to them. But the actions of the last 14 months cannot be properly explained without a historical look at previous interventions and their role in creating the problems that are now ‘requiring’ further interventions.

Starting in the early part of the 20th century, policy makers began to develop the previously unorthodox thinking, that it was government’s responsibility to ensure the economy’s balance between unemployment and stable prices. To do this, the government was to manipulate the cost of credit as a means to induce or restrict investment and therefore economic growth. Thus, the Federal Reserve was created in 1913. Furthermore, income taxes were also implemented that same year as a way to influence government’s control over the individual’s decision making. By either raising or lowering taxes, the argument was made, they could exercise further control over economic growth.

The first test of this new system was to come in the aftermath of the Great War. Economic growth slowed, and unemployment increased as debts from the war weighed on government balance sheets. The ‘solution’ was to lower interest rates, increase credit creation and stimulate the economy. This artificial inducement of growth led to the ‘Roaring Twenties,’ a time of great prosperity and speculation. It also led investors to make poor decisions with their savings that they wouldn’t otherwise make. These malinvestments are what eventually led to the contraction of the economy in early 1929, and the stock market panic later that year.

This is not to say that without the ‘easy money’ policies of the Fed in the 20’s, there would have been no contraction in 1929. But the magnitude of the contraction would not have been nearly as severe, and it would not have led to either the mania nor the ensuing panic in the stock market.

Once the precedent had been set for government interventionism, it was assumed and expected that Hoover and later Roosevelt were responsible for ‘fixing’ the economy in the aftermath of 1929. Collectively, those prescribed ‘fixes’ were what turned perhaps a long recession (or a double dip) that would have lasted until 1934 or so, into the Great Depression. Roosevelt’s desperation to stop the slide resulted in numerous schemes to support asset prices and encourage investment that would otherwise be seen as inefficient (all done under advice of John Maynard Keynes). Some of those included the New Deal I (1933) and II (1936), the Smoot-Hawley tariffs, the gold confiscation, and the creation of Fannie Mae in 1938. They all failed. R.B. Bennett attempted the same practices in Canada to even more disastrous consequences. Only the onset of WWII, and the establishment of munitions industries to be sold to the allies pulled America out of Depression.

But the failed policies of the 30’s were incorrectly seen as the saviour and they remained in practice. An effect even more material from this misguided conclusion, was the continued belief that any time the economy encountered recession more government ‘solutions’ were piled on top of the existing structure to counteract it (a system known as Keynesianism). All of these previous ‘solutions’ have resulted in increasing debt and an accumulation of malinvestment. None of these interventions of decades past are more easily evident than the recent collapse (and subsequent nationalization) of Fannie Mae.

The Great Depression Comes Full Circle

The continuing interventions in the free-market to prop up the previous decade’s malinvestment have led to a giant game between participants in the markets learning to anticipate the government’s next intervention and investing accordingly. Over the last 80 years ‘the game’ has morphed into nothing other than the well-informed (read: the already wealthy) making huge bets on government intervention (Pimco’s Bill Gross, for example.) This makes it such that unless one has connections to the subject of secret meetings of government officials, one cannot possibly know how to make an educated decision on his or her investments. This leaves only the wealthy to become wealthier and the poor to become poorer. A process otherwise attributable to the most tyrannical communist regimes the world has ever known.

This process has been going on gradually for decades now. So gradually, that most haven’t even noticed it until very recently (the frog in boiling water analogy comes to mind.) People had thought that the growing disparity between rich and poor, their increasing personal debt loads, the decreasing quality and availability, yet increasing costs of health care and education (public or private systems alike) were only temporary. Either that or they didn’t notice it at all due to it’s gradual onset or media propaganda telling them otherwise.

But with the recent weeks’ market volatility, government bailouts of major companies and now the creation of an enormous government fund to buy all of the problem assets at taxpayers’ expense, people are starting to see the forest for the trees.

One of the government’s most sinister policies (and one emulated all over the world) has been that which seeks to enforce an always rising level of prices. This mandated, or ‘targeted,’ level of inflation attempts to ensure that people do not keep savings, but rather spend their money for fear of otherwise losing purchasing power. This results in an artificial and continuous rise in asset prices (like real estate) as people fear being ‘priced out’ of the market forever. Those who have assets already (the wealthy) can benefit from this by accessing credit that the poor cannot (because they have no collateral) and using it to buy these assets and immediately become more wealthy. Essentially, mandated inflation is like a tax on the poor.

What has happened recently to disturb this process has been falling home prices in the US. It became so obvious in the aftermath of the Tech Bubble that the low interest rate policies of the Greenspan led Federal Reserve, were designed to spur a rise in real estate prices. And confidence was so high in the government’s ability to maintain steadily rising asset prices that buying real estate was such a ‘no-brainer,’ nearly everyone who had access to credit got into the game of speculating in it. Banks, brokers, individual investors, hedge funds, even car companies like GM or consumer goods companies like GE bet their entire existence on the belief that government could ensure asset prices would always rise.

As is always the case when confidence is too high, there was eventually too many homes for the amount of people to live in them, and prices fell. All of these companies lost on their all-in bet that was massively skewed in their favour.

In a free-market, they would all lose their shirts. Those that saw through this obvious gap in logic would be rewarded for their good judgement and be able to afford to buy their first home. They would have the savings required to start new businesses where the others failed and this positive investment would soon lead to another economic expansion. This is the life-blood of a just society. Where people can either reap the rewards or the penalty of their choices.

The recent government actions of the past 14 months have all amounted to taking money from those who were correct, in an effort to help those that were wrong. It is a death-blow to class mobility and to the founding principles of our societies.

Cards Are Stacked Against the Poor

Jeff Macke summarized this situation quite well on Friday when he wrote,

I think the market is now akin to those carnival games where the rim isn’t regulation size. Paulson is in the role of barker, telling folks to ‘step right up’. I’m stepping right out.

You can argue all day about whether what was done was right or wrong, good or bad. I just don’t play games for money when I don’t know the rules.

Indeed, the rules keep getting changed and the odds are decreasingly in the favour of the average person. So what will the natural result be? Much the same as it would be for anyone thinking of sitting down at a table where he or she knows there is a loaded deck. They will choose not to participate.

And why should we? Young investors and speculators such as myself feel betrayed. We see our opportunity for advancement, regardless of our level of education, as being under attack. Our natural conclusion will be to take our business elsewhere. I am personally scouting out locations around the globe to relocate - permanently. This is not a society that I wish to be a part of any longer. The values that I was taught made Canada and the US great no longer exist.

Note: this analysis is made without regard to my opinion on whether or not the government actions will succeed or not. That is a separate topic that I will address at a later date.

Best of the Net - Thursday September 18, 2008

Is it Friday yet? That was perhaps the biggest roller coaster ride I have ever witnessed, yet I fear that it won't be the last of it's sort. Why? Because the US Government insists on prolonging this unwinding for decades. They are following Japan's mistakes of the early 90's absolutely verbatim. The most recent action being a government backed effort to create a mortgage investment company that will buy all of the troubled debt securities and a possible outright ban on short selling. The name of the investment company is proposed to be the "Permanent Solution Trust." If that is not Orwellian, I do not know the meaning of the term.

Additionally, if these government hacks think that banning short sales will do anything to curb the slide in stock prices, they are about to find out the hard way what happens when prices fall and there are no buyers (because there are no shorts to cover their trades.) All in all, I am furious. I knew these guys were stupid. But THIS stupid? I've talked about a move toward socialism in the US and around the world for months now. Well this is it. We are here. The very little that remained of 19th century capitalism is effectively gone. Free enterprise has taken a back seat to government price fixing schemes.

In the end, this will all fail. Sure, things may be better a year from now than they otherwise would. But 10 years out, we will still be recovering from this mess. If the free market were left to deal with this and kick those reckless investors and bankers to the curb, a short and swift depression would give way to an eventual recovery. Now the depression could last decades as price discovery is delayed and distorted.

Yves Smith had his take on the proposed 'plans' in this article at the Naked Capitalism blog.

Mike Shedlock was talking about these moves with his article, Peak Insanity. Mike received a very good letter from a concerned reader, "CS" that he posted in this article. I highly suggest everyone read it.

Kevin Depew had an article focusing on money market funds and their potential pitfalls. Anyone holding 'cash' in a money market fund would be well advised to read Money Market Fund Investors Catch the Fear.

Best of the Net - Wednesday September 17, 2008

The carnage continues on Wall Street. Another 5% down day has taken all the US benchmark indices to new lows. The panic is starting to spill over into money market funds that are now "breaking the buck." Preferred shares are taking a beating as their formerly perceived safety disappears. The words "counter party risk" are now a mainstay in the mainstream media. Apparently, the "history begins this morning" crowd of analysts and pundits have just discovered the trillions of credit derivatives that are incestuously spread throughout nearly every financial firm and investment company on the planet.

What we have here is uncertainty. Nobody knows what anything is worth. Every few days an announcement is made that "funds are being injected." But after the initial relief rally, people are once again left to think, "Umm, I still don't know what this is worth." So they sell. The duration of those rallies is becoming exponentially shorter. Think about it. If it were March, and the Fed and the Treasury orchestrated huge bailouts, liquidity injections, and the SEC started talking about new short sale rules, what would the result be? We certainly wouldn't be closing at lows on panic selling. Sentiment has changed. The Fed is an emperor without clothes.

I'll leave you with some words from Todd Harrison over at Minyanville. Like myself and many others, the current market action is not surprising to him. Nobody knows exactly where this market is going to end up, but Todd has a refreshing longer term perspective that may be soothing to ailing investors. Read some of his articles of the past few days here, here, and especially here

Best of the Net - Tuesday September 16, 2008

Wall Street's wild ride continued today as expected. All of the catalysts we looked at yesterday came into play but are once again overshadowed by overnight news. AIG is now a branch of the US government. Yes, you read that right. The Fed has given an $85 Billion dollar loan in exchange for an 80% stake in the company. The process of market socialization is continuing at a rapid pace. At this rate, New York may need to be renamed "Paulsongrad" before the end of the week.

The level of backroom wheeling and dealing, secret handshakes, rule changing on the fly, law breaking at a whim, and overall disregard for the long-term implications of all this makes me ill. Today's Fed statement (of no rate cut) was obviously leaked early to some lucky firm that proceeded to sell the S&P 500 down over 15 points the minute before the official release. The Fed then 'coincidentally' made another statement only minutes later in support of an intervention to help AIG. The co-ordination and timing of all this can only be interpreted as an attempt to achieve maximum manipulative effect on the market.

Mike Shedlock was talking about loopholes the Fed used to get this deal done in Fed Bailout: Loophole 13.3 Mish also had a good piece on the 'price gouging' non-issue, titled, "Price Gouging and Keynesians in Drag." I agree with him that the recent 'outrage' over gas prices is outrageous itself. Ironically, the same folks decrying these price increases at the pump are the same folks screaming that something needs to be done about climate change. Well, this is the market's way of doing something.

Frank Barbera had a technical look at the resource sector, concluding that prices are so oversold that a bounce is coming in the near term. Read his WrapUp article here. I agree that it is likely to see a bounce in junior stocks that are selling at cash value or below in some instances. However, investors should note that technical analysis becomes less and less useful in times of such enormous volatility. If the TSX venture being down 60% is insane, how much more insane is 70%? 80%?

Again, market volatility should be high tomorrow. We'll see what curveballs are thrown investors' way by politicians this time. After striking out so many times, they may just decide to take their bat and go home.

Best of the Net - Monday September 15, 2008

Today was another disastrous day on Wall Street, and the pummeling is continuing in the overnight futures markets. It is never possible to tell how people will react to news, and that was the case last night. Today, investors decided not to "buy the news" and instead sold stocks like it was 2001. This is perhaps a pivotal sentiment change that suggests people are finally starting to understand that this credit crisis is not just cyclical, but secular. The media still have not figured this out yet and maintain that investors should "buy now because over the long-term stocks always go up." Never mentioned are the regular 15 year periods where stocks either move down or their value is eaten away by inflation. But I digress...

My thesis for a sentiment shift among investors is potentially playing out in real-time. If markets undergo another day of losses tomorrow (on a closing basis), I think it would be safe to say that investors no longer regard intervention by the Fed or Treasury particularly helpful. Standing in front of that are some potential rally catalysts. Before the market opens tomorrow, we will have Goldman Sachs releasing earnings, CPI numbers to mull over and a potential resolution to the AIG debacle. Later in the day, the Fed makes a decision on interest rates. If someone tells you they think they know what will happen tomorrow, run away. What we do know, is that S&P futures are pointing down 20 points overnight.

Kevin Depew took a moment to compare jellyfish to wall street firms. Curious yet? If so, read Five Things You Need To Know: It Was Fun While It Lasted

Lew Rockwell made a speech at a conference in Vancouver (that I regrettably missed, as it sold out) on The Social Imperative of Sound Money. This is a print version of the talk. It is well worth the read.

I also noticed that as of Friday, expected 3Q earnings have fallen yet again to -1.6% y/y. We'll see how Goldman's earnings tomorrow have an affect on estimates for the rest of the S&P.

Best of the Net - Weekend Edition September 12-14, 2008

Last Sunday I stated,

"Market reaction to this [Fannie & Freddie bailout] will be something that should be watched very carefully. Previous reactions have been positive, but as I mentioned a few days ago, the market will eventually begin viewing these events as a negative."

Well, as of 8pm PT on Sunday evening "eventually" appears to be "now." Lehman brothers looks to be facing bankruptcy as no deal could be reached without direct government guarantees. Bank of America has bought Merrill Lynch for a 70% premium to Friday's close. AIG is asking for government protection. And the Fed has lowered it's standards to accept a wider range of collateral for it's emergency lending programs. Initial market reaction in overnight futures? - 44.10 points for the S&P.

Whether this is "the one" is hard to tell, but the initial reaction offers a departure from the regular "buy the news" reflex. To be sure, we will be inundated before the open tomorrow with "breaking news" to attempt a sharp reversal. The reaction to the news is what I'm watching, as the news is assured to be another "spread around the losses" scheme that only prolongs the pain rather than fixing the problem (which they can't).

My best guess (we never really know) for the reason markets are tanking overnight is that they see Lehman's bankruptcy as a "credit event." Something that will result in the liquidation of suspect assets and a "price discovery" scenario for other financials holding similar assets. Whatever price Lehman's creditors get for these assets is what they're worth to the other banks and this means more heavy writedowns.

This all goes without mentioning Hurricane Ike which is responsible for destroying 20% of US refining capacity and causing gasoline prices to rocket worldwide. This is likely not going to treat the airlines or consumer discretionary companies very well tomorrow. Damage in southern Texas is still being assessed, but will definitely have significant economic ramifications.

All in all, it's been a terrible weekend and investors are voting with their wallets. Whether this indicates the shift from migration to panic is taking place remains to be seen.

The always dire John Xenakis had a good summary in plain english of the issues at hand and what he thinks this means. (Warning: Keep sharp objects away from you while reading John's analysis)

Best of the Net - Thursday September 11, 2008

Mike Shedlock had a good question today, "What has Paulson wrought?" With the bailouts of Bear Stearns and F&F already on the books of US taxpayers, IndyMac already taken over by the FDIC, resources have been stretched thin to withstand another major move. I have some similar questions:

How does the Federal Reserve justify bailing out one institution and not another (like Lehman, for example)? When does word of the backroom deals start getting leaked? Enough so that society in general intensifies their hatred toward the banking/corporate elites similar to how they did after the Enron and WorldCom scandals. How about after the elections for the least noticeable effect? Or the week of the election for the most effect? Take your pick.

Mike also raised a good point that one of the last resorts of the Federal Reserve will be to start printing. I agree that they will try something like this. But it's overall effectiveness will be minute compared to credit destruction.

Yesterday, Paul Kasriel answered the question, "Who holds debt sponsored by GSEs?" Today he had some good commentson Japan and how rapidly it appears to be slowing along with some other tidbits.

Best of the Net - Tuesday September 9, 2008

Today was a bloodbath in all North American markets, and all indications are that foreign markets will follow overnight. How many more days of 3% selloffs can investors take before saying, "no mas!"? Lehman Brothers, Washington Mutual, AIG, and Wachovia were all down big. I doubt any of these companies survive in their current form. As I mentioned on Thursday, the current feeling is negative, but not hopeless. And as long as hoplessness eludes Wall Street, potential for a major move lower remains. My next target for the S&P 500 is 1075.

I noticed that CNBC posted their updated earnings projections for the 3rd quarter. As of Sept 5, they stood at +0.8%. I don't think there's a snowball's chance in hell that earnings are positive in Q3. Back in April, Q3 estimates were +17.3%. In July, they were +12.6%.

Kevin Depew made me look bad by summarizing nearly all of what I had to say in Misperceptions About Inflation, with about 1000 fewer words. Read his Five Things You Need To Know: What Next?.

Kenneth Rogoff had a good article published by the Guardian on the topic of central bank balance sheet deterioration. With all the lending programs they have undertaken (temporarily) to support the mortgage markets. Eventually, these temporary measures will be rescinded and those hundreds of billions in supply of troubled mortgage securities will be back on the market.

Asset Class Analysis - Interest Rates

Misperceptions Surrounding “Inflation”

Sunday’s government bailout of mortgage giants Fannie Mae and Freddie Mac have spawned a large amount of disagreement around the motivations of such a move and it’s implications on the credit markets over the longer term. To be sure, the placement of these companies (who are essentially nothing more than unhedged investment firms operating with 50:1 leverage) is another step in the direction of interventionism and a furthering of the world financial community’s mantra of privatizing profits and socializing losses.

The argument is being made all over the financial media that the intention of the Fed and the Treasury is to reinflate the credit bubble, and that these attempts are further evidence of an impending hyperinflation in the US Dollar. But as has been the case during previous interventions of the last year, the credit markets do not believe this theory and refuse to discount the possibility of future inflation pressures by maintaining low rates on treasury bonds.

This article seeks to distinguish between the various points-of-view on the issue and will attempt to derive a thesis for the future movements of treasury and corporate bonds based on the best evidence.

Inflation: What is it?

As is the case for all of my analysis, I look at markets and economics through an Austrian Economic Theory lens. The contemporary definition of inflation is “a general rise in the price level.” Austrian economists reject this and say that rising prices are a symptom of the greater problem which is “an expansion of the supply of money and credit.” I believe this definition to be correct.

Prices can rise or fall for many reasons. Supply and demand factors can cause certain goods’ prices to fluctuate due to social changes, geopolitical issues, scarcity or overabundance, fear or greed and many other factors. Due to the complexity of markets we can never really know why prices are moving and in reaction to what.

For example, take the price of oil. Try to figure out how much of it’s historic rise in price is due to a depreciation in the dollar, how much is due to supply concerns (peak oil and geopolitical), how much is increasing demand from emerging markets, how much is (or was) reckless speculation, etc. There is of course no way of knowing.

So if we are not able to draw definitive conclusions over why prices move, how do we then conclude that all investors should take last month’s inflation report and use it to decide how well purchasing power will be preserved over a 1, 10 or 30 year period?

Additionally, by compiling a different basket of goods, one can derive a vastly different price picture. One example of doing so is substitution of the Case-Shiller home price index for the OER (Owner’s Equivalent Rent) that is used currently for the “shelter” portion of the CPI price basket. Making this adjustment on calculations going back 8 years, shows that price measurements during the housing boom were massively understated (as rent prices lagged behind) and are now massively overstated as home prices fall and rent prices have moved sideways. Current inflation levels using this method would be barely positive, whereas the reported number is around 5.6%. A big difference.

So in summary, the CPI measurement of inflation is extremely flimsy. It is laggy to an unknown extent, it’s composition is subjective (and has been changed numerous times) and it offers no insight into the future of price movements. There must be better ways to explain ‘inflation.’

Do the Fannie/Freddie/Bear Stearns bailouts constitute “money printing?”

The case is made by many that in response to all of the problems facing our economies, the Federal Reserve, foreign central banks, and the US Treasury are acting in coordination to pump up the money supply. They are achieving this by simply “printing more money.” Whether people say this metaphorically for “credit creation” or not is important. There is only 1.2 Trillion dollars worth of physical US Dollar notes in circulation. This is a penance to the size of the debt markets, which is akin to saying that we use a debt based currency (or a fractional reserve banking system - basically synonymous.) Even if this physical money supply was inflated by a large number (say 50%), this would not have nearly as much effect on the overall supply of money and credit.

The US (and foreign) governments could elect to go further into debt to try and support these markets, but ultimately the size of the credit markets are too big to bail out. An increased supply of government debt in circulation will only seek to anger the biggest investors of those bonds - foreign governments. The amount of politics needed to undertake any huge increase in US debt would be prohibitive for it to make an impact. However, these are politicians we are talking about. So I wouldn't be surprised to see them try. Even so, the psychological effect wouldn't be felt until much later.

This is what the bond markets know when handicapping future credit conditions. Those that are stuck looking at last year's prices get stopped out of their short treasury trades.

What is a “credit crisis?”

The basis for our economy is fairly simple: Expand the amount of debt in the system in order to facilitate investment that will yield a positive rate of return. The positive rate of return is supposedly ensured by technological innovation and production efficiencies, but also by the rising credit levels that eventually boost asset prices. The people that purchase the debt (savers) are coerced by this cycle into switching sides (going into debt), as they have a negative real rate of return on their savings (think 1997 or 2004 - rising home and stock prices that are far higher than any bond yields). In other words, the creators of debt attempt to monetize their way out of debt by creating more of it. This is the root cause of the growing disparity between the rich and the poor.

This process was all moving along nicely until sometime in 2006, when all of a sudden home prices began to fall. “Not to worry,” said the government. “It would only be temporary,” and “won’t have any residual effect on other markets.” By August 2007 that perception changed. A year later it had spread to every corner of the globe, leaving no market untouched. The perception that asset classes will always rise faster than the cost of credit used to purchase them had suffered a material shift. The willingness for savers to switch to being indebted disappeared. The always increasing pool of greater fools had run out. “Peak Credit” had arrived.

This seemingly benign development is considered to be a “credit crisis.” The tumbling asset values create a circular chain reaction of delinquency, liquidation and further falling asset prices.

What the Fed and the Treasury do seem to understand, is that they only have power over the psychology of the investor, and at that their power is limited. They feel that by improving investor sentiment toward asset prices, they will be able to cure the disease of falling asset prices. Each major intervention has been with that as it’s goal. They know that they cannot create enough credit themselves, because the overall size of the credit markets dwarfs even their enormous balance sheets combined. This is the rational side to the Fed’s and the Treasury’s interventions.

What these two institutions can’t seem to grasp yet, is that savers are not interested in investing because they feel that asset prices are going to drop lower and they are better off waiting. Banks have the same feelings about lending. The Fed is pushing on a string. Eventually, the asset markets will stop going lower and investors will come back. But reassurances by government officials aren’t going to expedite this process. What is required is time (for banks and consumers to repair their balance sheets) and price (low enough to make risk/reward decisions less complex.) Until those conditions are met, this deflationary spiral cannot be reversed - only prolonged.

In failing to see this reality, and in insisting that they have more influence over people’s investment decisions than they actually do, Paulson and Bernanke are throwing away their own savings (taxpayer’s savings) by using them to purchase assets that are destined to fall further in value. They are throwing good money after bad. In doing so, they risk prolonging the eventual sentiment shift by shrinking the available pool of capital to invest. Bank of America’s purchase of Countrywide is another example of this, as are the sovereign wealth fund’s investments in banks back in the spring (they are now down 25-50% from that time.) By trying to fight a secular shift in sentiment, the opposite effect is occurring; investors see a smaller pool of savings and therefore a more distant resolution to the problems and the result is more risk aversion - not less. This is essentially a verbatim repeat of the Bank of Japan’s mistakes that have resulted in an 18 year battle with sluggish growth.

So quite apparently, there is a declining appetite for credit risk with no signs of reversing. How can an increase in the supply of money/credit occur under these conditions?

- no increase in the supply of physical currency can offset credit losses
- no amount of credit creation is possible without a change in sentiment
- sentiment cannot change until time & price allow it to change
- the supply of savings is increasingly being wasted in a fruitless effort to support asset prices

Had Bernanke and Paulson done nothing starting in August of 2007, and continued to do nothing, the outcome may have been different. If they allowed major institutions to fail, and for asset prices to then reach fair value sooner, the pool of savings could have been deployed much sooner, and a legitimate recovery could then take root. But they obviously felt that the monster they had helped create (a massively intertwined and overleveraged credit machine) would be forever beyond repair. At that, they may finally be correct on something.

What this means for bonds

To those that view my presentation of the credit markets to be heresy or overly pessimistic, there will likely be continuing confusion to the treasury markets, which have thus far been beating a deflationary drum. Forward expectations for price inflation have fallen to cycle lows and as savers refuse to invest their money in risky assets, demand for treasuries increases. This puts downward pressure on yields. Until I see fundamental changes in the asset markets, I don’t foresee this to reverse any time in the near future. If housing prices or equities prices were to reach much lower levels, perhaps savers will come out of the woodwork. But housing inventories are sitting at all time highs and the US stock market is trading at ~25x reported earnings. So we are a long way off from a potential bottom in terms of asset markets.

The opposite should continue to be true for issuers of corporate bonds who will struggle with risk-averse investors. Rates on the corporate side should continue to rise as delinquency risk rises. Banks still needing to raise capital to continue doing business will likely fail. Borrowing money at 10% and lending it out at 6% is not a winning business model.

In other words, spreads should continue to widen and stay wide for a long period of time. The next move for central banks is likely more rate cuts.

Best of the Net - Monday September 8, 2008

There was a flurry of good musings on the "big picture" implications of Sunday's government Fannie & Freddie takeover. Among the journalists in indepentant media that I trust (and those that have been correct in anticipating all these problems,) there doesn't appear to be much disagreement over "what has changed?"

The answer is "not much." Bad loans are still bad loans, and moving them from one place to another does nothing to change the situation. The stock market cheered the move, albeit unevenly (Lehman and WaMu down big), but the bond market hardly budged - signaling that most traders do not believe the moves will result in the ability for banks to start making more loans.

To read some good material on the topic, there was a number of well written articles on Minyanville today. In no particular order, read Bennet Sedacca's "Fannie, Freddit Rescue Not a Cure-all", Kevin Depew's "Five Things You Need To Know: Treating the Symptoms, Ignoring the Disease", Andrew Jeffrey's "Fed Pushes Fannie, Freddie Shareholders in Front of a Train", John Maudin's "For Banks, Size Does Matter" Part 1 & Part 2.

I feel like I've read a small novel on the subject yesterday and today, yet most of it is pretty repetetive. So I'll leave it there for now. If I find anything else on a separate subject matter, I'll post it.

Best of the Net - Weekend Edition September 5-7, 2008

The expected nationalization of the US housing markets took another step forward Sunday morning, as Fannie Mae and Freddie Mac have been officially placed under conservatorship of the US Government, and that the Federal Reserve and the FDIC would be "working with" some banks who own preferred stock as large portions of their reserves. Investors owning common stock have been essentially wiped out. Preferred stock holders appear to be next on the totem pole, while investors in debt - like foreign central banks - will attempt to be made whole.

The details are somewhat convoluted. And whenever an event like this happens the early hours are filled with rumour and hype. A reasonable consensus on the exact nature of the bailout and it's immediate consequences will become clearer on Monday. Market reaction to this will be something that should be watched very carefully. Previous reactions have been positive, but as I mentioned a few days ago, the market will eventually begin viewing these events as a negative.

(Update: Mike Shedlock had this to say on the plan: Paulson Rolls Dice at Taxpayer Expense, Yves Smith posted his interpretation and initial thoughts, and "Calculated Risk" said bluntly "Expect more bank failures.")

Additionally, Tim Iacono had some good questions about the percieved inverse relationsip between the US Dollar and commodities that the market treats as gospel. Tim argues the same things I did in Gold: What Have You Done For Me Lately? I.e., a falling dollar is not a necessarry condition for gold or other commodities to rise - that they will do so based on their own individual supply & demand situations.

Best of the Net - Thursday September 4, 2008

Calculated Risk had an update on Price to Rent ratios in the US. He thinks a bottom may be forming in the US housing markets toward the end of 2009. I still think that would be a best case scenario, but I'm not one to question CR. He's been bang on for many years when it comes to the US Real Estate markets.

Bill Gross, manager of the world's largest bond fund, stopped short today of calling for a complete move toward socialism and Soviet style government control over the economy. He just simply asked for the government to aid him by purchasing hundreds of billions of dollars in troubled mortgage assets. But as Kevin Depew points out in today's "Five Things," Gross is the last person anyone should be listening to on the subject. Read the article here: Five Things You Need To Know: Pimco's Gross Lets the Freak Out

Bennet Sedacca had some humbling charts for comparison to today's situation. He notes the 'expanded flat' formation that we just witnessed in the S&P has been followed by some pretty nasty moves in the past. The years? 1987 and 2001. Read Bennet's article, "Comparing Bubbles: Will History Repeat Itself?"

A crash is a very rare event, so predicting one is difficult (and often foolhardy). However, I would be remiss not to mention that the structural (discussed ad infinitum for 2 years), psychological (the government won't let "it" happen), fundamental (trading at 25+ reported earnings) and now technical frameworks are in place for such an event to occur. Today's action, although one of the sharpest selloffs this year, seemed entirely calm and orderly. It's as if the market were saying, "Woah, this is bad. Good thing it can't get much worse, eh? So is the government going to step in Friday or Monday with some help?"

Although government intervention is not something that should be taken lightly, I am beginning to think that the market has a) discounted that it will happen already or b) no longer believes that it can be of assistance. In either case, the result could be a stampede for the exits on the next round of bailout talks. This is the essence behind one of my Themes for 2008 - The Federal Reserve will be seen at some point in 2008 as an emperor without clothes

Looking Ahead to Deflation

In today's Best of the Net post, I recommended three articles that address a similar issue, but in different ways. The issue is of expansion/contraction in the supply of money and credit, aka. inflation.

To summarize the themes of the three articles, I have put together a graph that explains things in fewer words. Click on the graph for a sharper image.



This is a process that has been going on for some time now, but as mentioned by Shedlock, inflation numbers are currently overstated and are on their way down. The Federal Reserve, by looking at a flawed method of calculating and defining inflation, is wrong in their recent hinting of higher rates to come. As this deflationary process continues to feed on itself, the next move in rates will be lower - not higher.

Best of the Net - Wednesday Sept 3, 2008

Mike Shedlock disected the CPI inflation numbers and deemed Real Interest Rates Are High. He notes correctly that the "Owners Equivelant Rent" (OER) portion of the CPI number has for years massively understated inflation numbers, and since home prices began to fall, is now massively overstating inflation. The bull market in Treasuries will continue, argues Shedlock. Shedlock's 'reconstructed' version of the CPI (with Case-Shiller home prices substituted for OER) would drastically change the GDP adjustments, puting the US in recession now.

Chris Puplava has a well thought out explanation for why the US Dollar is rising. To summarize: the rest of the world is slowing, putting downward pressure on foreign rates. This is something I have argued for continuously. That a weakening Euro will cause the dollar to rise. Figure 7 in his article illustrates perfectly that the US dollar is anticipating the spread between Foreign Central Bank rates and the US benchmark rate to close and possibly invert. This would have a further downward pressure on commodity prices, and by extention headline price inflation data. But is this a good thing for the economy and stock prices? Be Careful What You Wish For.

Kevin Depew's Five Things You Need to Know: Tale of an Insomnious Scofflaw spoke of the "rear-view mirror", and consumer balance sheets.

Best of the Net - Tuesday September 2, 2008

At the Campaign For Liberty's "Rally For the Republic," Lew Rockwell tore a strip off the establishment in one of the best speeches I have ever seen. Watch both parts of the speech on YouTube: Part 1 and Part 2

John Mauldin had a good 2 part series on the Credit Crisis and some signals to look for when it may be in it's dying days. He concludes that we are a long way off that day. Read Part 1 here and Part 2 here.

Frank Barbera had a good technical look at the equities markets, determining that in order for a definitive technical sign of an intermediate term top in the S&P 500, we still need either more time or higher prices to make that signal. He argues for a muddle-through phase as the Republicrats campaign for which of their two candidates will become president.

Asset Class Analysis - Gold & Precious Metals

Gold: What Have You Done For Me Lately?

Much debate has recently swirled around the non-mainstream internet media about the future of the precious metals markets. Differences in opinion usually stem from disagreements on the directions of inflationary pressures and/or credit risk. This entry is devoted to distinguishing between the various view-points and to arrive at a thesis for the intermediate and long term directions of the precious metals.

What is Gold?

The mainstream view on the utility of gold is as a price inflation hedge. However, a proper definition of inflation is required. I use the Austrian definition of “an expansion of money and credit.” So, gold declining through the 80’s and 90’s while inflation was positive would prove to dispute the consensus. A better argument can be made for gold as most valuable during times of hyperinflation or deflation. Some view gold to be money, some as a commodity. It has both characteristics.

Background

The price of gold, denominated in dollars, was historically fixed at approximately $20/oz (1833-1931). During the Great Depression most western countries left the gold standard so they could dilute the money supply and pay for economic mega projects like the New Deal, and later, WWII. In some cases (ex. The USA), gold was confiscated from the public. It traded at approximately $35 until 1971 when the gold window was closed and dollars were no longer convertible to gold. Gold proceeded to nominally increase twenty-fold over the next nine years. The reasons for this were dramatic increases in the money supply and increasing indebtedness of major nations - again commonly to pay for foreign wars. This resulted in spiralling higher prices and, perhaps more importantly, higher expectations for future inflation. Much of those future expectations turned out to be unjustified as the dollar lost ‘only’ approximately half of its value during the 70‘s (according to government collected price data). The Volcker Fed raised interest rates to 18% leading to a 20 year period of decelerating inflation (disinflation) and a collapse in the gold price.

On an average yearly price basis, adjusted for inflation, gold lost approximately 80% of it’s value over those 20 years and bottomed in 2001 around $250/oz. It began a new secular bull market on the back of the collapse of the tech bubble and massive credit creation by the Greenspan Fed. The subsequent rise in public debt and perceived credit risk has helped the gold price stabilize at a historically high nominal value, demonstrating price acceptance (unlike in the previous bull market that only saw one year of average prices above $400).

Viewpoints

Spending vast amounts of time sucking up information as I do, I have come across quite the array of differing opinions on the precious metals markets. Although I have noticed there are 3 primary camps in which those people fall.

The first (and most numerous) are the “Cinderella Crowd”, confidently proclaiming the economy to be safe and sound and that nothing but good times are ahead. They usually view gold as a barbaric relic of the past, with no actual value. I don’t spend much time listening to these folks. They’ve been wrong at every major turn for the last 3 years and the quality of their analysis seriously lacks credibility. These are the Ben Steins and Larry Kudlows of the world. They are shills for the status-quo, for neo-conservatism, and for Keynesian Economics. Unfortunately, if I were a new investor, these are the guys that would pop up first on any internet search or on TV.

If you were to dig a little deeper, you may find some very smart folks who have been talking about some of the problems facing our economies for many years. Guys like Peter Schiff, Doug Casey, and Jim Puplava were talking about the housing bubble long before it peaked. They forecasted the economic slowdown we are now experiencing back in 2005 (or earlier) and correctly predicted much higher commodity prices far before it was ‘cool’ to do so. They have correctly pointed out that the Federal Reserve will try to do anything to prevent this crisis from escalating and therefore will attempt to create immense amounts of inflation in doing so. The result, according to this camp, will be a 70’s rerun of Stagflation that will eventually evolve into a Weimar-style hyperinflation. Gold will be a great investment in this environment, and has an infinite potential for price appreciation.

Another, far smaller, crowd has been arguing the same problems facing us, yet see a different outcome. Analysts like Mike Shedlock, Steve Saville and Kevin Depew feel that the Federal Reserve is not as mighty as the previous group believes, and that they will ultimately fail in their inflation campaigns. This group has been calling for a severe repricing of risk and assets leading to the opposite outcome - deflation. In their opinion, gold will return to it’s historical utility as a safe haven and as a “no default asset”. The price of gold may rise depending on many factors, but chances are it will nominally outperform other asset classes in this situation.


The Facts

There are four primary factors that one should understand thoroughly before investing in any specific asset class. Structural, Psychological, Technical and Fundamental. By ignoring any of these potential catalysts the investor is flipping a coin.

Structural

As we have witnessed over the last year, the US economy (and the world economy by extension) is on uneasy footing. Enormous government deficits, growing income disparities, rising costs of food and energy, falling asset prices, rising unemployment and slowing consumption trends are just a few of the problems facing us. This is all happening when the driver for our economy, the “baby boomers” are planning their retirement and becoming less productive. There is a sense of scramble in the eyes of the boomers, as much of their wealth was tied up in their homes. Their plan was to sell the home when they retire and live on the proceeds combined with whatever meagre pension they have accumulated. The problem with this finely crafted plan should be self-evident, but apparently was not. In order to sell your house, somebody needs to be willing and able to buy it.

With credit conditions deteriorating weekly, banks are becoming less and less willing to lend. And with home prices falling so dramatically, younger generations no longer have the urgency to move up or make their first purchase. This is having further downward pressure on home prices (and commercial real estate) as supply mounts from completed construction and foreclosed homes. Just recently, the supply of unsold homes reached a record high level, suggesting that prices are likely to continue lower until the supply/demand curve is tilted the other way (or until it is perceived to do so in the near future).

Most people would agree that the health of the housing market and the profitability of banks are closely intertwined. Many of the loans banks have made are real estate oriented. This is not a problem if banks only lent out as much as they had in deposits being held. However, banks and mortgage brokers typically lend out more than 10x the amount they take in. So if their loan portfolio drops by more than 10%, they are technically insolvent. In order to hide this inconvenience, banks have resorted to storing their problem assets on opaque off-balance sheet vehicles and have resisted acknowledging their depreciating values. The Federal Reserve has also made it easier for them to temporarily exchange their troubled assets for safer Treasuries. Credit spreads have been widening constantly, meaning the cost of borrowing money is rising for banks and other leveraged businesses. This is a recipe for mass failures of large and small banks and many other credit dependant businesses.

Such potential financial turmoil is a bullish development for gold, should it unfold the way I think it will. But such a deflationary banking crisis may not see the price of gold rise as much as it simply stays stable while prices of most other assets fall.


Psychological

The consensus on Wall Street is that most of the major problems are behind us and that financial companies will lead a huge rally in the equities markets in Q3 and Q4 2008 on the back of astronomically higher earnings. Looking at the credit markets, I fail to see how this is possible. The same analysts’ consensus for Q2 was off by an enormous 30%. So it is possible that “the worst is behind us” mentality is already priced in, leaving much upside potential.

However, it is important to understand that gold (and other commodities) have experienced massive price increases already since 2001. It has been a decade where profits for investors are few and far between, meaning some investors may take the opportunity to experience profits and sell their gold exposure. Central banks that hold large reserves are susceptible to such thinking as well.

On the other hand, there is a very prominent feeling on Wall Street that groups gold with all the other commodities and labels them a “bubble”. The price patterns of crude oil can be compared with other stock bubbles like the Nikkei of the 80’s or the Nasdaq of the 90’s and a convincing argument can be made that it is a bubble. A subsequent decline of 20% in the price of oil had many calling for a burst of the bubble and a “new bear market in commodities.” While this may be true, we should note that crude oil regularly has corrections of 20%, as does gold. Additionally, the supply/demand characteristics of oil has not been consistent with the bubble label.

So, while the overwhelming sentiment toward gold is currently bearish, not much should be read into that observation. With disappointments pending on financial earnings projections, gold’s value could decouple from that of other commodities and the Euro and start acting more like money and less like a commodity.

Technical

The failure of gold to make new highs in June/July and it’s subsequent correction of 25% from the March highs suggest that gold may be in for some continued downward pressure towards key moving averages and retracement levels.



As can be seen from the chart above, there is a confluence of technical support levels between $670 and $735. Gold has broken it’s 50wk EMA decisively for the first time since the bull began in 2001, suggesting that a lower level will now become support. It is possible that gold has just made a “V” bottom and will quickly revisit the highs, however the advance of the last two weeks has been on low volume and may not be significant.

The most likely outcome, in my opinion, is a long period of sideways price movement between $650 and $900. This would enable the longer term moving averages to catch up and will provide a solid base for the precious metals to advance in the autumn of 2009.

The work of Tim Wood, bi-monthly wrap-up contributor at Financial Sense, would agree with this analysis. Tim has studied cyclical moves in the price of gold and has identified a fairly prevalent 9 year cycle. It is possible to see a year or more of sideways to negative price movement before seeing the resumption of a “Super Cycle” move higher lasting toward the end of the next decade.

Fundamental

Although there has been a shortage in the availability of small denomination gold and silver coins, there is no shortage of the metal itself. To test this, one can simply buy a futures contract and take delivery. The likely cause of this disconnect is increased buying from small investors and increased selling from hedge funds who owned futures contracts.

As I mentioned earlier, many investors buy gold to hedge against heightened expectations of future inflation. Although inflation readings (as measured by the BLS in CPI and PPI releases) have been very high of late, this is a rear-view mirror perspective. Inflation expectations (as measured by the differential between the 10 year US Treasury and 10 year TIP) are at 5 year lows (see: http://www.northerntrust.com/popups/popup_noprint.html?http://web-xp2a-pws.ntrs.com/content//media/attachment/data/econ_research/0808/document/dd082008.pdf), signalling bond traders fear lower price movements, not higher. This would make sense with slowing consumer spending and contracting credit conditions.

Another factor affecting the price of gold, and one I mentioned earlier, is it’s perceived role as nothing more than a hedge against the US Dollar. Over the long term, it serves as common sense that the value of one thing relatively static in supply will rise in relation to something that generally increases in supply. However, this has not always been the case, as the demand for gold as an asset rises and falls for other reasons than as a dollar hedge. Financial distress in Europe could see greater demand for gold in Europe and a weaker Euro. This happened in 2005 where the Euro fell by ~15% to the dollar and gold rose ~20%. As I write this on Sept 2, the day’s trading is evidence of this possible shift in perception. The Euro has made a new 7 month low and closed weak, while the price of gold opened above it’s August low and rallied strongly as the day progressed.



Thesis

I hate making conclusions as to price direction of any assets, because I believe it is impossible to do so. Chaos theory ensures that even one small unexpected event from across the world can have important directional implications for all markets. However, we are able to determine the highest probability outcomes based on historical behavioural patterns. Therefore, I prefer to label my analysis as a working thesis, always adaptable to external changes.

With that in mind and with the above factors taken into account, I believe the most likely outcome for the precious metals markets is to be for a fairly prolonged period of stagnant prices. This period would likely be accompanied by relative underperformance of other asset classes due to the financial problems that will persist in the global economy. This process has been underway for the last 6 months (dating from the March 08 high) and may persist for as long as another 12 months. After such a period, the technical and psychological components to the precious metals markets will be more amenable to another multi-year period of rapidly rising prices.

Best of the Net - Weekend Edition Aug 29-Sept 1, 2008

Brian Pretti has a great article devoted to some very important measures of the US equity markets. He talks about declining corporate equity buybacks, negative year-over-year margin debt growth, slowing public domestic and foreign equity purchases, and an increase in "total cash on hand" for Mutual Funds. These statistics shed further light on the idea of a secular move lower in stock prices. Read Brian Pretti's article here.

Prieur du Plessis was talking about the Investor Psychology Cycle. He believes we are somewhere between the denial/fear/panic phase. I'd estimate we're still dealing with denial.

Yves Smith had a good piece on some of the ideas being tossed around at the Fed symposium in Jackson Hole, WY. There appears to be very little consensus on "what to do" from the banking cartel. Read some of the suggestions in Troubling Signs From Fed's Jackson Hole Conference.