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The Fed is confused. Washington policymakers are confused. The markets trade confused. And pundits certainly speak as if they are confused. Truth be told, the current fixation on every word and nuance from the FOMC has become a farce – a mere heedless distraction from the critical financial/economic issues of the day. Clearly, the Fed lacks a policy/analytical framework other than mindlessly reciting its commitment to “fight inflation”. It is institutional “brain” has been corroded by an extended period of concurrent relatively stable “core” inflation and extraordinary asset inflation, not to mention years of Greenspan obfuscation.
The Federal Reserve is simply not institutionally prepared for the unfolding challenging environment, although the same could be said for policymakers and the public generally. The Fed is left floundering in the shallowest of central banking doctrine, bereft of any substance as to the key underlying forces driving the economy, the markets and, increasingly, inflationary pressures. At the same time, the Fed’s benign neglect of credit bubble excesses is buttressed by the view from the White House to the Halls of Congress that domestic and international growth are the only avenues for rectifying imbalances. It is quite dangerous dogma, yet the markets are happy to play along.
The Bernanke Fed today plays a dangerous game of sheep in wolf’s clothing, talking tough on (“core”) inflation while praying it can stay soft on excess. Highly speculative marketplaces at home and abroad savor in the gamesmanship. Markets recognize that the Fed will now talk the talk when speculative excess pushes the envelope, although they remain confident that the Fed will obediently retreat when markets come under sufficient pressure. Participants simply wait patiently for a signal from the Fed – as they believe they received last week – and get right back to their business.
I do read commentary that the Fed and global central bankers have been “withdrawing liquidity”. I do not see it. For starters, the vast majority of global liquidity these days emanates from private-sector debt growth and securities leveraging. Keep in mind that credit is growing at double-digit rates across the globe. The Fed’s balance sheet has become virtually irrelevant to the global liquidity-creation process, and the Fed has not been selling securities to reduce liquidity in the system (and they would have to sell a large amount today to offset record Credit growth!). For central banks to actually “tighten” policy would require an overall global rate environment sufficiently restrictive to induce private borrowing and leveraging restraint. I am still waiting.
The Fed does, however, hold (held?) a potentially powerful “stick” over the marketplace. It maintains the capacity to surprise the markets with more aggressive rate hikes, which would likely entail significant credit market disruption and speculator de-leveraging. At times, this threat can be quite effective in dousing greed and instilling some fear in frothy global equity and commodities markets. But I believe it is important to differentiate this dynamic from the actual tightening of general liquidity conditions for markets and credit systems. Credit markets are much better indicators of the prevailing liquidity backdrop than equities. Not only might the Fed’s potential “stick” not cajole lenders and credit market participants into restraint, it may very well even embolden them with the view that market turbulence will hold the timid Bernanke Fed at bay. Furthermore, the potential “stick” will lose much of its effectiveness over time. The stick loses all its punch come the perception that it will not be used. And the sophisticated players are definitely keen to Dr. Bernanke’s well-documented repugnance to “bubble popping”, and they must today relish that initial missteps have spurred the new chairman to kowtow to the markets.
So, if there were ever a time to step back, take a deep breath, and do a reality check – it is right now. We all read and hear assertions that the Fed is overshooting and inflation is not a serious issue today – and certainly will not be a problem when the economy slows (that for some time has been right around the corner when housing markets and consumption weaken). This is a myopic view certainly not atypical in the face of changing environments and key inflection points. It does, however, completely disregard a growing list of potentially momentous developments with respect to the future inflationary backdrop.
I suggest that prospects for an unexpected upsurge in intermediate-term inflation risk is high due to an extraordinary confluence of major developments, including (1) unfolding constraints on supply and rising global demand for energy and other commodities, (2) spiraling healthcare costs, especially for baby-boomer retirees, (3) various wars, including the ongoing “war on terror”, (4) untenable government liabilities, and (5) myriad issues related to global warming – to mention just a few. Unless the credit system buckles, there are endless sources of demand for finance waiting in the wings, regardless of the housing market. It is the confluence of developments I hope readers will ponder.
When I contemplate the future, I see a U.S. economy that will have no option other than massive restructuring. As an economy, it appears today that we will have little alternative than to consume significantly less oil, produce much more of various types of energy domestically, use energy much more efficiently and cleanly, consume fewer imports, and produce more manufactured goods for domestic consumption and export. This will entail a radical shift away from the service sector to the more arduous (and surely less “productive”) task of producing real things. Again, this is all a very tall order, even without devastating natural and man-made disasters. I would expect such a huge undertaking to entail great dislocation and pack quite an inflationary punch. The new patterns of the flow of finance will strain limited resources and greatly disturb prevailing pricing dynamics. There will be no alternative to massive government deficits at all levels. In such a scenario, we should expect the Fed and Congress to take extraordinary measure to underpin the credit market on the grounds of national security, openly stated or otherwise.
I have read the argument that credit bubbles always end in deflation. This is factually inaccurate, and we can look to Argentina and Indonesia as recent examples of bursting bubbles and the inflationary havoc wrought by collapsing currencies. Any thoughtful prognostication with respect to the future course of inflation must incorporate a view of the dollar’s prospects, as well as global currencies generally. Currency values are always relative, and we have already witnessed over the past two years how inflating (devaluing) foreign currencies can stabilize the nominal value of the dollar. We have also seen how concerted currency debasement can have a striking impact on oil and commodity prices. With a structurally maladjusted, energy glutton, and import-dependent economy, along with an overheated credit system and massive prospective government deficits, one can easily envision the dollar as a structurally weak currency for years to come. And I certainly expect China and Asia to face similar inflationary pressures, ensuring an inflationary bias for imported energy and goods prices for some time.
The least unfavorable course today would be to impose a meaningful slowdown on the highly imbalanced and overheated U.S. economy, setting the stage for a major redeployment of resources. Ironically, a U.S. recession is today seen as absolutely unacceptable, with policymakers (including our new Treasury Secretary) espousing the notion that the U.S. and our trading partners can grow our way out of imbalances. We need Washington to step back – do a reality check – and come to the recognition that the current global financial and economic boom is very much the problem and not the solution. I won’t hold my breath. I also will not be lining up to buy U.S. bonds anytime soon.Link here (scroll down to last subheading in page content body).
IS THIS THE PAUSE BEFORE DEFLATION LEADS GOLD THROUGH THE OLD HIGHS?
In October 2005, I penned a story entitled “Will Gold Pause Yet Again as Inflation Turns to Deflation?”. The basic premise was that inflation fears would cause a spike in gold prices, but as those fears abated due to lack of substantiation, there would be a retracement period during which investors who were not in the sector previously would have a second chance to take part – before worries about deflation (the real deal) took the yellow metal to new heights. Indeed, remarks in Don Coxe’s latest issue of Basic Points, “Global Cooling”, seem to indicate that hedge fund participation in the name of a phantom inflation was the reason for gold’s abrupt upsurge: “As we learned in a recent trip to visit clients in Greenwich and Manhattan, quite a few ‘new converts’ came aboard for the wrong reasons. They saw commodities soaring for the first time since the 1970s, read of the return of inflation and of Bernanke’s inability to handle it, and decided that they needed to invest in inflation hedges. … the obvious beneficiaries of such stagflationary sentiments were the precious metals.”
At the time, we were at the tail end of what we described as a “two-year pause for gold equities, something that may change if the inflation scare takes hold of investors’ imaginations.” That is what we just witnessed as gold soared through the $700 mark despite a relatively firm greenback. This leads us to our other statement of October 25th 2005, a day when gold closed at $464 an ounce, “The question is, if gold breaks the $500 mark on the back of what would appear to be an engineered inflation scare, and if nearly all of the new money coming into gold is from players seeking protection from said inflation, what will happen when it is shown to have been ‘tamed’?” The answer is that the new money that pushed gold to $725 fled just as quickly as it entered, and the metal came off to test its 200-day moving average in the face of tightening from the major central banks of the world. But with Bernanke now hinting that rate increases will soon stop, and gold having taken its lumps as the fast money exited, the second chance “pause” that we referred to in October may now be upon us.
As we also remarked in October, “It is unclear if or when the inflation threat will cease to be a worry, and deflation will emerge as the new menace. It is also impossible to know how long the intervening period could be.” Either way, we do believe that this is the beginning of what we called, “the next frustrating pause … in that period after the inflation scare passes, and while the market digests the new reality and adjusts for deflation.” We think that this transitional period, because it involves a learning curve as hedge funds et al adjust to and digest the new reality, could take some time. Therefore, the change in sentiment, and the bounce, will not happen overnight.
With gold having tested its 200-day moving average and bounced back over $600, an end to fed tightening near, and a softening of the global economy in sight, the next 6 to 12 months (or so) I believe we will see the second part of our thesis borne out. Fears of inflation will turn to fears of deflation, and the yellow metal will decisively breach the old high. In the meantime, we would look for gold to remain in a band between maybe $550 and $650 per ounce, and for the developer and junior mining equities to continue to trade from sluggishly, to mildly bullishly.Link here.
Gold vs. real estate: Which should you own?
Gold pays no interest. At least properties pay you rent. Therefore you should own properties. That is the conventional wisdom. Yes the first two statements are true. But we need to be careful about drawing the conclusion that you should own rental properties. Now is one of those rare times in history where – even after collecting rent – holding real estate will cost you more than holding gold.
Yes, gold pays no interest. But do not forget, the cost of owning gold is darn near zero. Meanwhile, Marc Faber gave an example of a typical home speculator in his newsletter last month, concluding that, right now, a home buyer/speculator has a negative cash flow of more than 5%. The assumptions Faber used to come up with that negative 5% cash flow figure were conservative. For example, maintenance costs were assumed to be 1% of the value of the home (sounds low to me). And annual property taxes were assumed to be 1.1% (mine are nearly twice that). If you can earn a rent yield of 8% or more of a home’s value, these numbers are not so bad. But you cannot get that kind of rent anymore ... Steve Leuthold, a legendary investment analyst, looked at rental yields over the last 45 years. He found that rental yields are lower now than at any time in history – by a wide margin. Steve puts the current level of rental yield (after expenses) as a percentage of the home price, at about 2.5%. Abysmal.
I am not sure, but I think that figure does NOT include property taxes (which are about 2% where I live), or insurance (which eats up the rest of the yield). Also, importantly, that figure does NOT cover interest on a mortgage, NOR the high cost of buying and selling a house. If Leuthold is right, and landlords are willing to accept rent (after maintenance costs) of just 2.5% of the value of a home, then most rental property owners are losing money ... and lots of it, if they have got big mortgages on these properties.
So, which real asset would you rather own right now? Gold, which pays no interest but has virtually no cost of ownership. Or you have real estate, which yields 2.5% net after home maintenance costs but loses money when you add up the total cost of ownership. Everyone owns real estate. Nobody owns gold. I prefer to own assets that nobody owns, like gold. And it is more attractive than real estate, on a yield basis. You sure do not get that opportunity every day.Link here.
HOLD ‘EM OR FOLD ‘EM?
Jesse Livermore was perhaps the most famous stock trader of the early 20th century. He made and lost millions of dollars in his day. And, for the record, that was a lot of money 100 years ago. Livermore was most famously immortalized in Edwin Lefevre’s thinly veiled biography Reminiscences of a Stock Operator, probably one of the best and most helpful books on trading and investing ever written. One of Livermore’s trading rules was “Be right and sit tight.” He also said this is one of the hardest lessons for any investor to learn. In other words, Livermore suggested jumping on board a major trend and then having the courage to hold on to make the really big gains.
Clearly, energy is just such a major trend. Demand for oil and gas is booming while the world’s ability to expand supplies and production is, at best, limited. The great commodity bull markets throughout history have lasted for at least 15 to 20 years – this current up-cycle has more than a few good years left in which to run. But that does not mean there will not be corrections. Long-term readers are well aware that we have seen three significant energy corrections during the past 12 months. Each pullback lasted between one and three months and resulted in prices 15% to 25% off the highs for most stocks in the group. Each pullback also represented an excellent buying opportunity as the group subsequently rallied to new highs.
The important thing to remember is that no great bull market has been immune to such corrections. Even the Nasdaq in the 1990s and gold in the 1970s saw corrections of as much as 30 percent in the context of a longer-term trend higher. These corrections make following Livermore’s “Be right and sit tight” rule so difficult. All too often, investors panic and get shaken out of the market during these corrections, thereby missing out on the even greater returns to come. At the same time, investors are correct to want to protect their gains – making big money on a stock only to watch it evaporate is a sad strategy indeed.
By late April even energy bears were giving up and jumping into the sector. Greed and the desire not to miss out on big gains were the prime emotions driving the market. Technical analysts term such action a “blow-off top”. Normally this sort of parabolic rise and fall leads to a correction that lasts for a few months. It seemed rather odd to be speaking of a downturn with oil near $75 and energy stocks breaking to new highs. While the fundamentals for the group are undimmed longer term, I am not convinced we have seen the lows of this correction. It has been a long time indeed since the oil and oil services names have corrected 30%. I suspect we are currently in the middle of such a cathartic sell-off that will end in a bout of panic-driven selling. Eventually this will offer another top-notch buying opportunity, but we are not at that ideal buy point just yet.Link here.
The pause that distresses.
“Oil stocks are cheap,” our column of June 20th observed. Oil stocks are less cheap now. The XOI Index of oil and gas stocks has rocketed 15% since that column appeared. In response to this dazzling rally, long-term investors in oil stocks should probably pat themselves on the back and take a long nap. But short-term traders might want to consider a different course of action. “Oil prices may be nearing a short-term top,” warns Jay Shartsis, a seasoned options pro with R.F. Lafferty in New York. “The rising oil price is drawing traders back to the long side of the crude market. The current 21-day dollar-weighted put/call ratio for crude futures is at about 30 cents traded in puts for every $1.00 in calls. This is a lot of optimism.”
In other words, even though crude touched a new all-time high, futures traders are showing very little interest in buying put options on crude oil. Such high levels of complacency – and greed – often presage a selloff. To put the current option readings in perspective, Shartsis notes that crude traders last December were trading $1.75 in puts for every $1.00 in calls. A sharp rally in crude followed December’s extreme bearish option readings. But futures traders have not cornered the market for excessive optimism. Oil stock investors are also displaying high levels of greed, and low levels of fear.
But please remember, Shartsis is an options trader, who operates on a very truncated time horizon. He measures investment success – or failure – in days and weeks, not months and years. Long-term investors, therefore, should probably ignore the short-term sentiments swings that Shartsis identifies so expertly. What is more, long-te on in the Rude column of June 20th: “Large cap oil stocks seem downright cheap – both in relation to the prices of crude oil and gasoline, and in relation to the rest of the stock market. …” Net-net, trade around the oil stocks in your portfolio if you wish, but do not be too eager to trade out of them completely.Link here.
JUST HOW SUPER IS THE COMMODITIES SUPERCYCLE?
If a week can seem a long time in commodities then six weeks is a dim distant memory. So when commodity prices have plummeted some 15-35% in less than 30 trading days, and gold is “only” around the $570/oz. mark, it is easy to forget that prices are still significantly above last year’s levels. But they are. And recent data confirm that the arguments underpinning the strong commodities bull run – the supercycle – are still in place.
The current supercycle dates from around the turn of this century (Jim Rogers, in his 2005 book Hot Commodities, dates it from 1998 and expects it to last for at least 15 years). It has been driven so far by Chinese demand, though the other BRIC economies (Brazil, Russia, India, China) will also play a part in the future. Citigroup, used data from 100 years or more to demonstrate that supercycles are associated with an increasing intensity of use (IOU) of materials – this being the amount of any commodity used per unit of economic activity. For example, the chart below, taken from Citigroup’s report, shows the trend in the intensity of usage of copper in four major economies. The U.S., Germany and Japan have each in turn followed a cycle of rising IOU, followed by a plateau of at least 10-20 years, followed by a decline. In China’s case the IOU is only just beginning to rise strongly and is still well below the peak levels seen in the more mature economies. Citigroup contend that it still has a long way to run.
Turning to the supply side, there were not any long-run supply deficits in the previous supercycles. Rising prices spawned the requisite increase in supply, albeit at higher prices. This time around, however, there are a number of reasons as to why the supply response may be slower than before. Thus with the world’s most populous country on a materials usage upswing, producers unable to over-invest even if they wanted to, and inventories of metals mostly low or falling, the auspices for a continuation of the fundamental supercycle appeared good – a point which, by May, had been fully anticipated by the market and by the speculative and investment funds which had flowed into commodities, spurred by the relatively low interest rate environment.
The current commodities cycle has been distorted by investment funds. Nonetheless, underneath the froth recent data, surveys and analyses of supply-demand fundamentals all continue to indicate that the current underlying cycle is indeed super and that it still has a long way to run.Link here.
HIGHER PRICES, HIGHER RATES: THE 1ST-TIME HOMEBUYER SQUEEZE
What a difference a year makes when you are in the market for a new home, especially if you are a first-time buyer. Thanks to a combined jump in mortgage interest rates and home prices, a starter home in many areas of the country could cost you several hundred dollars more per month today than if you bought it last year. Nationwide, median home prices rose at annual rate of more than 10% in the first quarter of 2006, according to the National Association of Realtors. Meanwhile, rates on adjustable rate mortgages, the most common for first-time buyers, are up more than a percentage point.
The rate of home-price gains varies widely from market to market. In Gainesville, Florida, for instance, the median sales price of existing family homes rose 31%, or about $50,000, to $210,100 between the first quarter of last year and the first quarter of this year, according to NAR. The percentage gains were more muted – but still high – in richly-priced markets like the New York City-Northern New Jersey area, where the median price rose 11.2% to $458,500, an increase of about $46,000. So for the first-time home buyer in Gainesville or New York, those price and rate increases can mean an extra $400 to $450 in monthly payments to own a home. That assumes you put down the same amount this year on the home as you would have last year.
If you cannot put down 20% – as many first-timers cannot – your monthly bite is likely to be larger because you will have to take out a bigger loan and you may have to pay for private mortgage insurance, which can run up to $50 for every $100,000 in mortgage debt. Remember, too, the additional costs cited here do not include the cost of homeowner’s insurance and property taxes, which also have been on the rise in many markets, as have utility costs.
Most first-time home buyers ratchet down expectations about what kind of home they can afford once they figure out how much a home will really cost. But in markets where they are quickly feeling priced out of the market, they are looking to less expensive neighborhoods far from their original preference. In Gainesville, for instance, a lot of first-time home buyers are choosing communities up to 20 miles from where they really want to live, or they are opting for condos or attached housing, said Gene Ritch, president of Coldwell Banker MM Parrish in Gainesville. In New York City, where 6-figure-earners with fat savings accounts are at risk of being priced out of former drug dens, moving away from a desirable neighborhood is nothing new. But first-time home buyers are also more likely to opt for fixer-uppers rather than move-in condition housing if it gets them “into the game,” said Corcoran senior vice president Wendy Sarasohn.
In terms of financing, banks are willing to offer 100% financing so long as a buyer has good credit and liquid assets equal to 5% of the purchase price, said mortgage broker Melissa Cohn. Some are even willing to finance 103%, in order to cover the buyer’s closing costs as well. ew York-based certified financial planner Stacy Francis of Francis Financial is not a fan of 100% financing or interest-only loans since the point of buying a home is to build equity sooner rather than later. While these loan structures may pay off in a booming housing market, buyers run the risk of owing the bank should they have to sell when prices are down. At the very least, if prices flatten, they will have to pay for the selling costs, such as a realtor fee.
Ideally, Francis likes her clients to spend no more than 30% of their gross income on housing in high-cost markets like New York City. And she would like them to shoot for a 20% down payment. If that is not possible, she recommends 5% to 10% down and having enough in liquid assets left over to cover three to six months of expenses, plus the costs of closing, moving, new furniture and bigger utility bills. Another option, of course, is to drop the search for now and work on building a bigger down payment either by saving more or taking a second job, Francis said. And if a first-time buyer lives in a market where home prices have showed signs of cooling, it may pay to wait a little and rent in the meantime.
One way to gauge whether it pays to rent or buy is to compare the cost of buying the house you are considering with the cost of renting something comparable. Gary Eldred, coauthor of Investing in Real Estate, suggests that if the monthly cost of owning a home – including mortgage principal, interest, insurance, homeowner’s association fees and maintenance – exceeds the cost of renting a comparable home by 25% or more, you are better off renting. That is because the price of the home is not likely to appreciate enough over the next several years to justify the financial sacrifices you would need to make to own it.Link here.
North Carolina beach housing market goes from sizzle to fizzle
North Carolina’s once-hot beach real estate market has turned frosty. At the north end of the coast, years of double-digit appreciation and booms in speculation and in giant, multimillion-dollar rental houses have ended. In April and May, the number of existing homes sold on the Outer Banks plummeted by more than half compared with the same months last year. On the southernmost stretch of coast, sales in Brunswick County have dropped about the same amount. In Carteret County on the central coast, the 15% fall in May and the 34% drop in April look cheerful by comparison. But according to locally compiled statistics, sales on Emerald Isle are down more than 60%.
Marcia Parrott, a broker in Nags Head, has seen downturns before. But, like the thousands of others who make their living from Outer Banks real estate, she cannot help but wonder what is happening. “Are we in a correction?” she said. “Are we – I hesitate to use the word ‘collapse’ – totally falling apart? Or are we having a soft landing, which is what I heard someone say the other day.” Real estate on North Carolina’s inland coast – the sounds, rivers and estuaries – is exploding. But Parrott’s best guess is that the falloff in Outer Banks property is a correction. She said it was overdue, given the number of speculative houses that builders and developers put on the market, and the number of investors who jumped for quick profits after years of 15 to 20% annual increases in home values in some parts of the Outer Banks. “Our prices went up too fast and too high,” she said. “We needed this.” Their company had begun advising some clients not to sell without a pressing reason but to wait for a better market.
Prospective buyers have caught on to the downturn and are routinely offering 10 to 15% below asking price, even though they know the seller has already dropped his price, sometimes more than once. In one recent case, broker Mark Petty said, a potential buyer even offered less than a previous offer, apparently betting that the first potential buyer would walk away. Many sellers have resisted lower prices, but Petty thinks prices will fall to what they were a couple of years ago before they start up again. Homes in the $500,000-and-under range are still selling, he said, but there is a glut of oceanfront homes. In some cases, speculators who had hoped to “flip” a property – sell it for a quick profit – have been left with one worth less than they paid.
Bernard Helm, president of Market Opportunity Research Enterprises, a Rocky Mount firm that tracks residential trends, said that the hot market in recent years was due not just to demand but to the low cost of borrowing, with interest rates low and lenders eager. Interest rates have risen in recent months. Soft markets in the places where many Outer Banks buyers are from – such as northern Virginia and the Northeast – are also partly to blame.
Real estate is a huge industry on the Outer Banks. The downturn is hurting thousands of brokers, appraisers, builders, mortgage brokers and, indirectly, the rest of the local economy. When Petty got into the business a little over a decade ago, there were 400 to 500 brokers on the Outer Banks, he said. Now there are about 1,100, including many who have not been in the business long and perhaps thought the market would always be booming. “It’s probably a rude awakening for them,” he said. John Hunter, an appraiser in Kill Devil Hills, said that in 26 years of valuing real estate from Ocracoke north to Virginia he has weathered at least three cycles in property values. This time, he said, the market has a better foundation to build on when it swings back because there are few buildable tracts of any size on the barrier islands, so supply will be tighter. For now, though, he is seeing such things as a seller who turned down a $1.5 million offer a year ago accepting $1.2 million recently.
Income from summer rentals is important for many homeowners on the barrier islands. Hunter thinks the nature of the downturn will become clearer in the fall, once people who might have been thinking about bailing out ponder that long stretch of winter mortgage payments. But, “If you just wait until the next cycle, you’ll be glad you did,” he said. Still, many on the beaches wonder when that cycle will come. “If I knew that, I wouldn’t be so worried,” said Marcia Parrott.Link here.
GOVERNMENT DEBT: TERMITES IN THE HOUSE
Recently I had the pleasure of having lunch with the Comptroller General of the U.S., David M. Walker. He heads up the U.S. Government Accountability Office (GAO), the government’s internal watchdog. As he was about to give a talk on out-of-control government deficits, he had in his briefcase a chart on the size of the government’s obligations over time. Our discussion about those obligations over lunch was followed by an email exchange, and Walker kindly helped me source additional GAO data, all of which allowed me to confirm my analysis of the budget with projections from the Congressional Budget Office (CBO). I have also met with Douglas Holtz-Eakin, head of CBO, who can competently recite the situation of six different budget projections without notes. The combined scenarios of the GAO and CBO provided me with the basis to create the following projection of the U.S. budget.
A clear picture emerges of a government completely out of control. Projected debt soars to impossible levels against projected GDP. Importantly, the source is not some crazy hand-waving blogger. These are the government’s own projections—and we all know they have every incentive to accent the positive. If this is the best they can do at this point, then you know things are not just bad, they are calamitous. I have looked at the assumptions, as has David Walker, and it is more likely that the assumptions have underestimated how serious the situation could become, maybe by a significant margin. This glimpse at the future clearly shows that the debt of the U.S. will, in the foreseeable future, go from being a troubling yet manageable fraction of the economy to being several times the size of economy. That cannot happen without serious repercussions.
Who is responsible for this sin of profligate spending? You could start by pointing a finger at the House of Representatives as they are constitutionally charged with holding the purse strings of the U.S. government. They voted for the spending and programs we are now saddled with, they pass tax programs, and vote in the big supplemental bills that fund the wars. And it is not just the modern politicos that are responsible, but a failure to pursue sound monetary policies that extends back decades. Why do they do it? That answer is easy and reflective of human nature. They do it to curry favor with their constituents in order to get reelected. Which further points the finger at us, the American public, who instead of voting the bums out for wasting our money and handing a legacy of debt to our grandchildren’s grandchildren, happily pocket the pork belly doled out and reward the most prolific spenders with our votes.
The bottom line is that debt and deficits are baked into the cake, exacerbated by the demographics of retiring baby boomers and a government that not only shows no intention of slowing its spending, but quite the opposite. In fact, like a penniless smoker breaking a child’s piggy bank to buy a pack, the debt-addicted government has already spent the supposed “Trust Funds” of Social Security and Medicare. The government is closer to bankruptcy than anyone who has not studied the situation can guess. It is the loss of any constraint on government spending that has let the genie out of the bottle. The track is now laid. The long-term future of the dollar is not in question. And to the extent that it is the basis of all other currencies, the reserve currency of the world’s central banks, all currencies are doomed.Link here.
CONSUMER CRUNCH UPDATE
This analysis brings our “Consumer Cash Flow”, “Real Estate and Money Supply”, and “The Interest Rate Conundrum” papers up-to-date. In simple terms, U.S. economic growth is completely dependent on consumer and government debt creation. We will track the consumer side effects and show them in the consumer accounts.
The latest 2005 economic statistics show that consumers depended on new debt for more than 90% of their cash flow during 2005. In 2006, we expect new debt to account for 95% of cash flow. Our “Interest Rate Conundrum” paper was absolutely correct that long-term interest rates now control consumer spending instead of economic investment. In April, mortgage interest rates reached levels that should constrain household debt flows. We also demonstrated in our March, 2006 update that consumer liquidity was falling sharply. After a brief respite at the end of March, consumer liquidity has resumed its downward trend. Liquidity has fallen to 3 weeks worth of funds on our preferred measure.
Finally, our “Real Estate and Money Supply” paper created a diagram showing that consumer money supply now flows backward. Historically, household incomes were sufficient to generate a cash surplus after consumption and debt service. Now, households have a large cash deficit. The conclusion of our March, 2006 update has not changed: The key to the consumer’s future is now home resales. Since home resales peaked in the summer of 2005 and are in a downtrend, we expect a further slowing of home resales and a decline in M-2 growth.
Our 6-step process assumes that new home construction will not slow until after home resales have entered a continuing and persistent decline. In April and May, we have seen the first evidence of new home construction weakness. This weakness could indicate that we have reached Step 5 of our economic process. In our interpretation of this process and current monetary circumstances, the Federal Reserve MUST continue to raise short-term interest rates in order to prolong the opportunity for U.S. households to access long-term debt at high levels. If the Fed does not raise short-term interest rates, we would expect long-term interest rates to increase and cause a significant slowdown in the accumulation of real-estate based debt. A debt slowdown would hasten a recession.Link here.
HEDGE FUNDS FORAY INTO BANKING TERRITORY
Some large multistrategy hedge funds are beginning to look more like mini banks as they stray from their usual haunts in stock and bond markets to new areas which include financing and insurance. Motives include the hunt for higher returns after years of weak performance, which have persuaded some hedge funds to explore new areas like infrastructure financing and private equity, where many have been active for several years now.
Their forays into traditional banking areas have been aided by large banks, many of which recently have shown little or no interest in small- or sometimes even medium-sized companies. Banks have preferred to focus on blue-chip companies, where they see the greatest rewards and left a niche which today is being exploited by hedge funds. “Private loans would be the most common or typical situation. Loans to small companies which do not have access to larger banks,” said Nicolas Campiche, who heads a group that selects hedge funds for Pictet et Cie clients. “It’s a game of higher yield for hedge funds and for the companies it’s probably a more flexible access to financing.”
The process of getting a loan from a hedge fund is likely to be much less bureaucratic than from a bank. “The decision maker can be accessed directly. Hedge funds are very quick at assessing the situation and making decisions,” Campiche said. “It enables companies to grow and … that’s beneficial to the economy in general.”Link here.
SECURITIZATION MAY BE SKEWING CASH-FLOW STATEMENTS AS WELL AS BALANCE SHEET
Securitization of customer receivables – a popular source of cash financing for many companies – often causes dramatic swings in a company’s operating cash flow, and may be being used by some to manage cash-flow volatility, a new report says. Securitization has occasionally come under fire because it is a form of financing that typically does not appear on the balance sheet, and thus can mislead investors about a company’s leverage. But the report by the Georgia Tech Financial Analysis Lab focuses primarily on an aspect of securitization that is rarely considered: Its impact on cash flow.
Even though banking regulations typically require securitizations to be renewed every 364 days, they are generally viewed in the market as a source of long-term financing. Yet the report calls that conventional view into question, noting that, in fact, “companies actively move in and out of their securitization programs,” or change the securitized amounts – with corresponding swings in operating cash flow. “It’s almost like a drug,” says lab director Charles W. Mulford, a professor of accounting at Georgia Tech. “It’s an easy source of cash. You see companies weaning themselves off and then going back on again.”
A good example of that behavior, says Mulford, is Halliburton. In 2003, on track to post a negative operating cash flow of $595 million, the company terminated its securitization program, causing operating cash flow to drop even further, to $775 million. The following year, Halliburton entered into a new, $519 million securitization, boosting operating cash flow from $409 million to a reported $928 million. Last year, the company again terminated its securitization program. Had it not done so, its reported operating cash flow of $701 million would have exceeded $1.2 billion. “A securitization can be used to increase or decrease operating cash flow in any reporting period,” the report notes. “Thus, a securitization can obscure financial analysis based on sustainable cash flows from operations.”
Securitization is a process whereby companies sell receivables – money owed to them by customers but not yet collected – for cash. The buyer, typically a special-purpose entity (SPE) created expressly for the purpose, raises funds for the purchase by issuing commercial paper backed by the future stream of money to be collected. The commercial paper often attracts a better rate than the company could by issuing CP of its own, because the sale puts the receivables out of reach of the company’s own creditors in the event of bankruptcy.
Mulford is careful to note that securitization is an accepted technique. “I’m not saying you should not do it,” he says. “It is a cheap form of financing. But users of financial statements, beware: The increase in operating cash flow that you see will beget a reduction at some future date.” The report also gives high marks to several companies that went beyond GAAP requirements to highlight the impact of their securitizations on operating cash flow, leverage, or both. “While not compulsory,” the report notes, “these companies nonetheless decided that investors may be misled if such disclosures were not made.”Link here.
STOCK-OPTION TIMING SCANDAL COSTS ALL INVESTORS
If investors think they are safe from the scandal involving the suspicious timing of executive stock option grants, they may want to consider this. Even if they are not invested in companies caught up in that mess, it could still cost them big. That is because this controversy could lead to big changes across corporate America in the policies for directors’ and officers’ insurance, which is used to shield top executives and board members from personal losses for the decisions that they make while on the job. Not only are rates expected to rise, but insurers could also be more restrictive in the coverage they offer or what they pay out in claims. Who will get stuck with the tab for such changes? Shareholders at public companies all around, of course.
D&O insurance, which is renewed annually and is paid for by the company, is already expensive. Companies with market capitalization of more than $10 billion paid an average premium of $4.3 million for D&O insurance in 2005, according to Towers Perrin’s Tillinghast consulting division. Since the insurance typically reimburses the company or its top officials for expenses such as legal costs or regulatory fines, a plethora of future claims could be on the horizon because of the option-timing controversy. More than 50 companies – from industry bellwethers like Apple Computer and Home Depot to many smaller technology companies – are facing questions about whether they manipulated the timing of options grants to boost their value to the recipients and properly disclosed what resulted in outsized and potentially illegal profits for many executives. Shareholders have already started filing lawsuits, some naming board members or corporate officers for their alleged breach of fiduciary duties.
All this is sure to be spooking the insurance industry, which paid out hundreds of millions of dollars in D&O claims following the business scandals in the early part of the decade that led to the collapse of some big names in corporate America. Insurers paid $35 million alone in D&O insurance to cover claims of the former board members of WorldCom, the former telecommunications company that imploded in an $11 billion accounting fraud in 2002. D&O rates surged nearly 72% from 2001 to 2003, and then started to retreat, falling 10% in 2004 and 9% last year, according to Tillinghast.
But the decline in rates may be short-lived. Companies that have acknowledged some link to the controversy could find it “difficult to obtain renewal terms at palatable rates and may be forced to accept potentially restrictive terms,” said Kevin M. LaCroix, who advises clients on D&O liability issues at OakBridge Insurance Services in Beachwood, Ohio. And others, even if they have no connection to the scandal, could face higher rates as the insurance industry tries to cover itself in the face of increased risk. Some liken this scandal’s potential effect on the business world to what Hurricane Katrina did to insurance rates for anyone living near a coastline, regardless of location.Link here.
CLEAN WATER CRISIS
Clean water is quietly becoming one of the most critical resource issues in the world economy. Researchers at the Center for Strategic and International Studies predict that by 2025 water will be the most grave resource problem in the global economy. In many parts of the world, it is already an undeniable problem of growing importance. First, there is the issue of polluted water. This is already the biggest cause of sickness and death in the world. Second, there is the problem of getting it where it needs to be. Population growth has not followed the location of water resources. The most obvious example is China, which has more than 20% of the world’s population and only 7% of its water. And a good chunk of China’s population is in the dry northern regions. India is no better off. The World Bank’s recent report on India warned, “Unless dramatic changes are made – and made soon – India will not have the cash to maintain and build new infrastructure, nor the water required for the economy and its people.”
Peru, in miniature, shows all the growing pains of emerging markets. These are problems confronted on a much bigger scale in China and India. The ruins and relics of ancient civilizations riddle the lands of Peru, once the heart of the magnificent Inca Empire. After the fall of the empire, the country endured the heel of Spanish conquistadors and centuries of Spanish rule. Since 1821, Peru has been an independent country. Its abundant material riches, the goods of the earth, are what sustained the Incas and attracted the Spaniards. Yet this mostly poor country has never seemed able to harvest these bounties into a consistent prosperity.
Peru is best thought of in three pieces. There are the dry coastal plains in the west, providing a plentiful fishing area with the vast South Pacific Ocean at its doorstep. Then there is the middle part of the country – the jagged, ice-capped Andes, chockablock full of minerals and metals. Finally, there are the lush Amazonian lowland jungles in the east – filled with copious amounts of fresh water. And here is the problem. More than 70% of Peru’s 28 million people live on the narrow coastal plains in the west, the busy hub of Peru’s industry and its export agriculture. The watershed flows east, where the Andes mountains divert all rivers toward the Atlantic. Nonetheless, the water issue seems to be nothing more than an engineering problem. Simply move water from the wet east to the drier west.
Yet political toxins – namely, populist politics – poison the easy solutions. The state owns and runs most of Peru’s water system. Government investment has severely lagged the growing and pressing need for water. Lima, the capital city, is often threatened with water shortages and rationing. About one-quarter of all Peruvians have no access to piped water. About half have no access to sewage. The crisis here, as in many parts of the world, is reaching a breakpoint. They need the investments in water infrastructure now. Estimates for Peru range north of $4.5 billion, just to bring it only to regional standards.
It will not be easy in Peru. One reason is the hostile political climate. It is election season. A controversial challenger has scored an early season victory, ensuring a place in the runoff election in late May. His name is Ollanta Humala, a 42-year-old former army officer. He is a populist rabble-rouser in the spirit of the region’s best rabble-rousers, like Hugo Chavez of Venezuela and Evo Morales of Bolivia. Humala’s solutions are the same tired ones tried by dictator wannabes over the years. Raise taxes – particularly on foreign mining and oil companies. Nix existing trade pacts with the U.S. Legalize coca, used in the production of cocaine. Give the government greater reigns over business. Have we not seen this movie before? If Humala wins, then Peru too falls to populist politics – joining Venezuela and Bolivia. Indeed, much of South America cannot seem to shake its neo-Marxist ghosts. Investors will need to keep a close eye on these developments.
These populists do not come out of the ground from nowhere. They grow in seedbeds of frustration and poverty. Unfortunately, poverty is still widespread in South America. Peru is no exception. Amid this political swirl, private companies are working on solving the problems. Some places have already made great strides. Ten years ago, in Colombia’s two principal cities, for example, more than 1 million people had no water access and most had only intermittent access. Today, 98% have running water and 90% have sewage lines. The government essentially hired private companies to run the service. Yet it maintained a controlling stake in the business. This brought world-class water technologies and managerial talent to Colombia’s water systems. The result paid off.
In Brazil, 63 concessions serve 7 million people in medium and small municipalities. Other large cities in Honduras and Ecuador rely on private water providers under a variety of contract and concession models. This is the same way many airports, marine ports and toll roads operate. Perhaps a similar system of concessions will play a role in Peru. The problem is that such an idea is a hard sell politically. The outcome of the Peruvian elections will surely have some impact on the debate. Then again, the crisis is becoming so acute that Peru, as with most governments, will not have a choice.
Getting clean water to growing populations is the nut that has to be cracked. Whether you are building a new suburb in the States or piping water through the Andes, there is a tremendous amount of build-out required. The construction of these waste and water systems means that companies providing the tools and building blocks have a long bull market ahead of them. The wind is fully in their sails. One interesting sector to look at is the pump industry. The pump market is a $27 billion industry, expected to grow to $31 billion by 2007. The industry is highly fragmented, filled with lots of little and big fish. The defining trend lately has been for the big fish to swallow up the little ones.
Beyond the drive for building water infrastructure, a number of other factors also propel the industry. For example, new regulations require landfills process leachtate – the contaminated fluid produced in landfills. This requires the installation of systems that collect and pump this stuff so it does not seep into your groundwater. The drive for water filtration in residential and commercial properties has also created a boom in specific kinds of pumps, used in the process of purifying drinking water. And in developing markets, including India and China – and Peru – pumps are needed for building water and wastewater systems.
The result of all this consolidation is that only a few major publicly traded independents remain. If you are thinking like an investor, your ears should have perked up by now. Beyond the independents, there are pump operations in diversified manufacturers. Two interesting, but illiquidly trading, possibilities are Met-Pro Corp. and Robbins & Myers. The pump industry is a little-known corner of the market, buried in the inky crevices overlooked by the big-money investors. It seems clear to me that the pump industry should have a place in the sun for years to come.Link here (scroll down to piece by Chris Mayer).
WORLDWIDE MARKETS AT CROSSROADS
The financial markets worldwide are at major crossroads. I believe we are on the threshold of social, economic and political changes that only happen once every few centuries. The impact is likely to go beyond most bearish assessments in both scope and time. The very fact that most financial institutions and mainstream media do not share such a view is actually supportive, as history has demonstrated most of civilization was caught unprepared at key points of history. The next 5 to 10 years is going to be one of those key points.
With regard to the financial markets, there is a gigantic monster whose actions are about to rock the financial world like never before. Move over boogeyman and say hello to Mr. Hedgefunds. No matter at what area of the markets you look, the footprint of the behemoth is evident. For now, most are not complaining as their slash-and-burn way of investing has been overall beneficial to the “Don’t Worry, Be Happy” crowd’s way of thinking. But I believe we are about to see the monster exposed and what we will find is widespread misdeeds and over-leveraging unlike anything ever seen or imaginable on Wall Street. Stay Tuned.
Back in the early to mid ‘90s when I was a legend in my own mind, I actually thought I could predict market movements on a regular basis. And when a market went against my prediction, it was the market that got it wrong and not I. Therefore, while my flesh would like to gloat about another good call on gold, I am going to move on after a very short pause. Ah, that felt good. The last correction went a long way in setting the stage for us to not only get back above the recent highs around $735, but gave us a better base from which to challenge the all-time highs. Just before the correction began (and we stepped aside), there were people literally knocking each other over to exclaim their new or updated bullishness for the precious yellow. And the media, especially the ones who do not normally even give gold a quote, were issuing one glowing article after another. Sure enough, the correction takes hold and before you know it, tirades about how the end-of-the-gold-bull-market-world are everywhere. It is critical to recognize how fast we went from severely overbought to oversold, yet gold did not violate any long-term uptrends or see any significant changes in the bullish fundamentals that remain intact. Most of these folks now bearish will not have the intestinal fortitude to reverse their positions again or anytime soon. This can help prevent us getting frothy again too soon.
Silver is usually more volatile than gold and recent history has been no exception. But thanks to its “kissing-cousins” relationship with gold, one cannot see new all-time highs for gold and not think that silver will at least track gold up percentage-wise. Platinum and palladium have had the best overall balanced supply and demand picture, and therefore have offered the least risk of serious losses for the foreseeable future. This also meant they would not see anywhere near the upside percentage move gold and silver can (and should). Two things have happened that make me even more bullish on the PGMs. First, palladium has corrected back to the $300 area and now offers at least a 30% up move over the next 12 months. And second, the sharp sell-off finally in the overvalued South African Rand has made the South African PGM producers attractive as a group.
It is critical for you to separate precious metals from base metals. The bullish argument (and it is a good one) is that China and India devour all base metals production and therefore prices can only go higher. The bearish argument contends that the combination of a slowing U.S. and world economy as a whole more than offset the strength from China and India. The other part of the bearish argument is not one being discussed at any great length and is often hard for the novice investor to grasp, but it is the core of my bearish stance. I mentioned earlier that hedgefunds have been moving in and out of markets in a slash and burn style. They have become the absolute single biggest force ever in the history of world financial markets. They are not dumb, and I believe as a group have correctly recognized and taken advantage of the three bubbles we have had since the 1990s.
The first was the general stock market of the 1990s. After that one burst, the funds then saw real estate as a path to riches and it, too, became a bubble that is now bursting. Last year, they grasped the bullish argument for commodities and have now caused a metal like copper to reach bubble status. (Remember, bubbles usually last longer and go higher than most first imagined.) The problem is that most speculators come on board when the bubble is evident and do not get out before it blows up. The very fact that it is harder to find a needle in a haystack than find a base metals bear among our industry and investors that play it, worries me to near-death. I believe 2006 should signal the cyclical highs for metals like copper, zinc, nickle and the like. It does not mean they collapse, but their upside is limited if not already fulfilled while precious metals and uranium have clear sailing ahead … outside of the secular bull market corrections we have endured so far.
Do not assume that a metal price going up automatically translates into a mining company stock doing better. There are many factors influencing the miners that were not around – or were not acute – in the past bull markets. It has been my feeling that the junior resource market is likely to have a good run in the second half of 2006. I think the next 30-60 days is a period of accumulation and a good run up in the juniors should unfold as fall arrives. But as always, selectivity will be key.Link here.
A perversely perfect time for overlooked circumstances …
Vacations and summer sluggishness make this is a perversely perfect time for several overlooked circumstances to emerge on the financial horizon. See if you can spot the common thread:
The common denominator is widespread certainty about the markets and financial system – specifically, what will and will not happen in the near and intermediate-term future. “Aggressive complacency” is one fitting way to describe this psychology. That is the theme in the just-published July issue of the Elliott Wave Financial Forecast. Extreme psychology usually creates exceptional opportunities.Link here.
ANOTHER RATE HIKE, ANOTHER EURO RALLY?
If you had a misfortune to trade major currencies last week, the lack of volatility probably bored you silly. Not that the week lacked economic data. There was plenty of news: The “slightly hawkish comments by European Bank President Jean-Claude Trichet” (WSJ), a jump in business and consumer confidence in Germany and the U.S., a drop in the U.S. existing-home sales. But with the Fed’s June 29 rates announcement overshadowing everything else, none of that news seemed to matter, and the EURUSD went sideways for most of the week. The lull ended at 2:15 PM on Thursday, June 29. When the Fed said it was raising rates for the 17th consecutive time, the dollar went into a freefall, sending the EURUSD flying. Between Thursday afternoon and Monday morning (July 3), the EURUSD gained close to 300 pips – a huge move.
Wait, does the fact that the Fed keeps raising rates not mean that “the U.S. economy is strong”? Don’t “higher interest rates make dollar-denominated assets more attractive for foreign investors”? Are not both of these factors “good” for the dollar? Yes, yes and yes. Shouldn’t the dollar have rallied last week then, not the euro?
It “should” have. But the Fed’s hawkish policy has become a double-edged sword. If before the dollar bulls cheered every new hike, now they shun it – because“further interest-rate increases will cool growth in the world’s biggest economy” (Bloomberg). The dollar is stuck between a rock and a hard place: higher U.S. rates are “dangerous”, lower ones are “unattractive” Yet, even though rates have become such a dubious indicator for the dollar, forex traders seem to be putting more emphasis on them then ever before, bringing the markets to a standstill in the days and hours before the Fed speaks, like they did last week.
How does Elliott wave analysis measure up in a difficult situation like that? Well, you be the judge. For several days before the June 29 rate hike, our Currency Specialty Service, with varying degrees of confidence, told the readers to remain bullish on the EURUSD. The pair’s Elliott wave pattern was begging for another leg up – and it finally came on June 29. How the Fed’s next interest rates decision might “affect” the dollar’s position seems to be anyone’s guess. Judging by the recent market action, this “indicator” is quickly losing its relevance. Besides, what truly moves the forex markets is not the news – it is traders’ reaction to the news.Link here.
FED WATCHERS, BEWARE YOUR BELIEFS
The primary basis for today’s belief in perpetual prosperity and inflation with perhaps an occasional recession is what I call the “potent directors” fallacy. It is nearly impossible to find a treatise on macroeconomics today that does not assert or assume that the Federal Reserve board has learned to control both our money and our economy. Many believe that it also possesses immense power to manipulate the stock market. The very idea that it can do these things is false. A few years ago, before the House and Senate Joint Economic committee, then-Chairman Alan Greenspan himself called the idea that the Fed could prevent recessions a “puzzling” notion, chalking up such events to exactly what causes them: “human psychology”. In August 1999, he even more specifically described the stock market as being driven by “waves of optimism and pessimism.” He was right on this point, but no one is listening.
The Chairman also expressed the view that the Fed has the power to temper economic swings for the better. Is that what it does? Politicians and most economists assert that a central bank is necessary for maximum growth. Is that the case? This is not the place for a treatise on the subject, but a brief dose of reality should serve. Real economic growth in the U.S. was greater in the 19th century without a central bank than it was in the 20th century with one. Real economic growth in Hong Kong during the latter half of the 20th century outstripped that of every other country in the entire world, and it had no central bank. Anyone who advocates a causal connection between central banking and economic performance must conclude that a central bank is harmful to economic growth.
For recent examples of the failure of the idea of efficacious economic directors, just look around. Since Japan’s boom ended in 1990, its regulators have been using every presumed macroeconomic “tool” to get the Land of the Sinking Sun rising again. The World Bank, the International Monetary Fund, local central banks and government officials were “wisely managing” Southeast Asia’s boom until it collapsed spectacularly in 1997. Prevent the bust? They expressed profound dismay that it even happened. The truth is that directors cannot make things better and have always made things worse. It is a principle that meddling in the free market can only disable it.
People think that the Fed “managed” the economy brilliantly in the 1980s and 1990s. But the deep flaws in the Fed’s manipulation of the banking system to induce and facilitate the extension of credit will bear bitter fruit in the next depression. Economists who do not believe that a prolonged expansionary credit policy has consequences will soon be blasting the Fed for “mistakes” in the present, whereas the errors that matter most reside in the past. Regardless of whether this truth comes to light, the populace will disrespect the Fed and other central banks mightily by the time the depression is over. For many people, the single biggest financial shock and surprise over the next decade will be the revelation that the Fed has never really known what on earth it was doing.Link here.
ICELAND’S CENTRAL BANK RAISES BENCHMARK RATE TO 13%
Sedlabanki, Iceland’s central bank, raised its benchmark interest rate by three-quarters of a point to 13%, more than expected, to cool inflation that is accelerating at more than three times the bank’s target pace. Six of seven economists questioned by Bloomberg had expected the bank to add half a point, while only one forecast three quarters of a point.
Inflation in Iceland’s $13 billion economy quickened in each of the past four months, stoked by the krona’s 23% decline against the euro this year. The currency plunged after Fitch Ratings Ltd. on Feb. 21 cut its outlook on the island’s sovereign debt rating, citing a record current account deficit, foreign borrowing and an overheated economy. “This is a relatively confidence-building move,” said Lars Christensen, a senior strategist at Danske Bank A/S in Copenhagen. “It seems like they’ve decided to do everything they can to contain inflation and that we can also expect 75 basis points in September.” (A basis point is 0.01 percentage point.) In intial trading after the news, the krona was little changed against the euro strengthened 0.2% to 75.18 against the dollar.
“Inflation looks set to rise further,” said Beat Siegenthaler, a senior strategist at TD Securities in London. “Assuming that Sedlabanki has to be concerned about inflation expectations, they will sound hawkish” in the bulletin. Inflation will probably accelerate to 8.5% this month from 8% in June, Siegenthaler estimates. He sees inflation quickening to 9% in August. The increase is the 14th since May 2004 and comes after policy makers raised rates by three-quarters of a point at their last two meetings. Inflation accelerated to 8% last month, the fastest pace since March 2002. It has exceeded Sedlabanki’s 2.5% target since April 2004. The central bank will probably raise rates again at its September meeting and then once more before the end of the year, said Peter Schlaikjer-Bruhn, chief Nordic economist at HSH Nordbank AG in Copenhagen, estimating that the repurchase rate will peak at 14% this year.
Investors sold the krona after Fitch cut Iceland’s debt outlook to negative and Danske Bank A/S a month later said the economy may contract as much as 10% in two years. Concern about the current account deficit, equivalent to 16.5% of GDP last year, and debt of almost three times the size of the economy, also fueled the selloff. The krona is the second-worst performer in the year to date after the Zimbabwe dollar of 62 currencies tracked by Bloomberg. Iceland’s benchmark index of the 15 most-traded stocks dropped 11% in March, after the Fitch and Danske reports. The yield on the 7% note due 2010 has soared 240 basis points this year to 10.34%.Link here.
THE GREATEST CON IN THE HISTORY OF MONEY
“It is only in periods of decadence that truth becomes complicated.” ~~ Henry Miller, American writer
The history of money and banking is a history of thieves, scoundrels, and scumbags. Today, I want to tell you about their greatest con. Money was once a very different thing than it is today. Money grew out of the free, spontaneous, and evolutionary process of the market, like language or common law. Governments did not create it. That came later. Later, governments seized and monopolized the creation of money – just as they too came to monopolize the creation of law. These were long, torturous processes.
In man’s early history, all kinds of things acted essentially as money. But over time, gold evolved to dominate. The market – that is to say, the people – chose gold for a variety of reasons. It was durable, portable, divisible – and rare. Banking, too, was once a very different thing than it is today. Banks began as simple safekeeping houses for customers to hold their money (i.e., gold). The banks paid no interest on these deposits. They did not loan them out. They kept the gold in a vault, and that was that. The bank offered other services, such as simple cashier services and facilitating payments involving third parties. Customers paid banks for these services. It was all a pretty simple and straightforward business. This was the case in ancient Greece. Athenians did not look at banks as sources of credit.
Nevertheless, unscrupulous bankers sometimes could not help it. Cheating was so easy – and so profitable. So they sometimes took deposits and loaned them out. Cheating? Yes. See, if I placed my gold with you to store, it was against the law for you to take my gold and lend it out. This was a basic violation of property rights. In fact, we have records of an early trial featuring a depositor suing a banker because the depositor was unable to get his gold – since the banker had lent it out and could not collect it. Today we call this embezzlement. But for many sad reasons, we do not apply the term to bankers. We call it “fractional reserve banking”. This is the greatest con ever foisted upon a money-using public.
The long history of banking is one of a fight between that depositor and his unscrupulous bankers and thieving governments. For over 2,000 years, the depositor has fought a losing rear-guard action, as the bankers, in cahoots with their governments, found new ways to prop up their dubious legal claims – and slip their fingers into savers’ pockets. Today, the bankers prevail. As a result, our money is a wasting asset. Our savers lose their savings to inflation. Our economy endures recurrent booms and busts. Our government pursues wars and spends money at a level that a pure gold standard would never sustain or permit.
Therefore, the cure for our monetary ills has a definite atavistic flavor. That is part of its charm and part of its strength. We are not hoeing new ground here. As the great economist Murray Rothbard wrote, “The only coherent long-term solution: a free banking system with a 100% reserve requirement, the abolition of the central bank, and the establishment of a pure gold standard.” Basically, restore the creation of money to the market. Some people believe in the return to a gold standard. But what they support is, unfortunately, “a spurious gold standard rooted in fractional reserve banking” (Rothbard).
There is a long line of great thinkers who tried to impart the public with the knowledge that fractional reserve banking was a terrible mistake. The great Austrian economists Ludwig von Mises and Murray Rothbard are among the more recent. A great new book that deals with all of this is Jesus Huerta de Soto’s Money, Bank Credit, and Economic Cycles. This book supplants all monetary treatises before it. De Soto also gives full treatment to the idea of a 100% gold standard – with no fractional reserve banking and no central bank. The final 100-page chapter alone, titled “A Proposal for Banking Reform: The Theory of a 100 % Reserve Requirement,” is alone worth the price of the book. The advantages of such a system are numerous, and Huerta de Soto’s exposition is brilliant.
A 100% reserve standard prevents the cyclical economic crises that arise from credit creation. Malinvestments, those widespread economic errors that cause cyclical crises, occur when there are distortions in the economic fabric. An economy has only so much real savings; credit makes it appear as if there were more. That is why we see economy-wide busts. The house of cards built by fractional reserve banking reaches its natural end. Importantly, in the words of Huerta de Soto, a 100% gold standard “would not avert all economic crises and recessions. It would only avert the recurrent cycles of boom and recession which we now suffer.” Huerta de Soto writes, “People fail to see that rapid, exaggerated economic expansion is always likely to have an artificial cause and must be reverse in the form of a recession.” A 100% standard prevents the contractions and inflations of money supply that wreak havoc.
Banks would not disappear. A 100% standard merely ensures that only voluntary savings back loans. Banks could still lend money, but it would have to be via explicit contracts with savers. Banks could still take deposits for a fee, and offer ancillary services (cashier, records), safe deposits boxes, etc. Credit availability would decrease. Again, a 100% system guarantees that only “that which has been saved would be lent.” The current housing bubble, with its ridiculous price increases, would be impossible under such a system. Housing would be more affordable, and our reliance on credit severely lessened.
Who loses? A 100% gold standard penalizes those who benefit from fractional reserve banking – banks and the government, chiefly. It protects savers – such as older people and those living on fixed incomes. For all these reasons, a 100% gold standard is the only gold standard worth pursuing. Will it happen? As with most revolutions, things have to get really bad before people consider radical change. The American poet Charles Bukowski said it best: “True revolution comes from true revulsion; when things get bad enough the kitten will kill the lion.”Link here.
A business so profitable, it makes the government suspicious.
British banks have recently been so profitable that the U.K treasury actually commissioned an inquiry into this extraordinary profitability. England’s HSBC Bank, e.g., had a net profit margin of 31.9%. Compare that to J.P Morgan’s 15.5% net profit margin. Barclays Bank and Lloyds Bank are also extremely profitable with margins of 22.2% and 26.0%, respectively.
According to the study by Don Cruickshank, “Excess profits arise when prices are consistently above costs across the output of an economic market. These excess profits translate directly into excess profitability, measured as the rate of return on the capital employed in the production of those products and services. Thus an indicator of persistently high prices relative to costs is persistently earning a rate of profit which is higher than the cost of capital employed.”
There are other reasons why British banks are so profitable. Equity analyst Ganesh Rathnam says, “Arguably, size provides a huge competitive advantage in consolidated markets. Unlike the fragmented U.S. market, five banks dominate the U.K. Lloyds TSB, Barclays, HSBC Bank, Royal Bank of Scotland, and Halifax Bank of Scotland all control well over 80% of market share.
“Counterintuitively, net interest margins are about one percentage point lower than the average of U.S. banks. Deeper analysis suggests that while these banks don’t compete with each other on price, the net interest margins’ low level prevents new entrants from earning an economic profit while maintaining the incumbent banks’ high profitability. In other words, these dominant players seem to exercise their oligopoly powers tacitly to prevent new competition from breaking into their market.”
According to Rathnam,“qBanking infrastructure plays a big hand in shaping the competitive dynamics. Unlike the U.S. market, banks in the U.K. and Ireland have nationwide platforms. A customer switching cities or counties in the U.K. need not switch banks as would a customer of TCF Bank moving to San Francisco. Unsurprisingly, customer churn rates are in the low to middle single digits, and market-share figures tend to stay constant over time.”Link here.
CITIGROUP, GOLDMAN, MERRILL BAMBOOZLE BONDHOLDERS
It began as an everyday bond sale. It morphed into an exercise in escapology. And everyone involved – the managers of the issue, the borrower and the investors – should be thoroughly ashamed of themselves. On June 14, Citigroup, Goldman Sachs and Merrill Lynch announced the sale of €300 million ($384 million) of floating-rate notes by Bank of Cyprus Ltd., the biggest lender on that Mediterranean island. Five days later, the bank said it might bid for Emporiki Bank of Greece SA. On June 22, Bank of Cyprus offered €3.78 billion for Greece’s 6th-biggest lender. Investors who had signed up to buy the new bonds gulped – not many borrowers execute takeover bids equal to their own market value without damaging their credit ratings.
Here is what should have happened as soon as the acquisition plan was revealed. Citigroup, Goldman and Merrill should have scrapped the bond sale, citing a material adverse change in the borrower’s circumstances. All orders for the new securities would have lapsed, leaving Bank of Cyprus free to revisit the market with a new deal once it had resolved its expansion attempt. Instead, the sale managers tossed a few bones to investors. They raised the interest rate on the notes by 0.03 percentage points, to 33 basis points above 3-month money-market rates. Buyers, who were scheduled to pay for their notes on June 22, were given an extension until June 29.
On June 23, the inevitable happened. Fitch Ratings put its A- credit rating of Bank of Cyprus on review for a possible downgrade, citing “the negative impact that the eventual acquisition will have on BoC’s regulatory capital ratios as well as the integration risks involved in the operation.” Again, rather than pulling the deal, the managers tweaked the terms. This time, investors were promised a further 3 basis points per cut for any rating downgrade triggered by the Emporiki purchase by the end of this year. Three-year euro-denominated bonds sold by financial companies in the BBB rating category – which is where Bank of Cyprus is headed – offer about 12 basis points more than those with ratings of A or A-, according to Bloomberg indexes.
The bond managers say they were unaware of Bank of Cyprus’s takeover plan when the bond sale was announced, and unconvinced that it would mount a full bid. They also say their job is to get the financing done at a price buyers are willing to accept. If investors are reluctant to cry foul, that is their problem. Given the track record of European investors, the lack of protest is not surprising. The wider issue is one of best practice. No one disputes that the outlook for Bank of Cyprus’s creditworthiness has deteriorated in light of its ambitions. The bond managers, though, are convinced they were right not to cancel the sale.
I disagree. The inability of bondholders to stand up for their rights is a perennial feature of the securities industry. The problem for buyers of the securities is that they risk trashing the value of their bonds or being excluded from future new issues by badmouthing the transaction. Bank of Cyprus is not unique in blindsiding bondholders. With returns so paltry and spreads so tight in recent years, it is easy to buy off disaffected fund managers by waving a few extra basis points in the air. That does not make it right.Link here.
TAKING THE MARKET’S TEMPERATURE
Since the market has engaged in some pretty volatile gyrations over the past several weeks, I thought this would be a good time to stop and take the market’s temperature. That is among the most important benefits that technical analysis can bestow upon you – to let you know what the current trend is and what action is likely to give you the greatest chance of success.
I think we are at a very interesting juncture in the market right now. We had a bullish first third of the year, with all of the major indexes scoring solid gains. That was followed by a severe sell-off that began in early May and lasted throughout nearly all of June. That sell-off wiped out most, and in some cases all, of the profits earned in 2006’s first four months. Suddenly, stocks began to climb late in the day on Wednesday of last week – and followed through with a monster gain the next day. Then, just a few days later, equities suddenly turned tail yesterday and dropped dramatically, erasing a sizeable chunk of the week-old rally. So where are we, and what should we be looking to do in the days and weeks ahead? As always, to try and answer these questions I took out my technical toolbox and began searching for some clues.
After looking at the daily chart of the Russell 2000 Index, I believe this is a good time to use rallies to raise cash and trim back your positions. Keep in mind, if you are a long-term investor I am not suggesting you liquidate your core holdings. But in general, the technical condition of the Russell 2000 Index suggests that the small-cap market contains some risk over the short-term. Let me tell you why …Link here.
A GHOST I HAVE NOT SEEN FOR A WHILE …
Yesterday I saw a ghost I had not seen for a while. It tried to scare me, but I just chuckled. Maybe this ghost forgot how well I know it. It was the same old tired haunt, invoked by “higher oil prices”, which supposedly “took some of the recent optimism out of the stock market, knocking down the Dow Jones Industrial Average.” In other words, the same people keep seeing the same ghost for the same reason. “I DO believe in spooks, I DO believe in spooks, I DO, I DO, I DO believe in spooks!!” Obviously, the oil-up stocks-down ghost is nothing if not tenacious. Still, facts are hard things. Take this chart, for example.
Cool, huh? It comes courtesy of the Energy Information Administration (EIA), yet the past 26 years of massive (and ongoing) growth in proven crude reserves is not the half of it. Other reading I did made it abundantly clear that historically, two things have always been true about the world’s estimated oil reserves. (1) The experts chronically underestimate the size of those reserves, and, (2) the actual size of the world’s proven oil reserves has increased every year for as long as records have been kept. As the chart shows, today’s proven world reserves have more than doubled since 1980, to some 1.3 trillion barrels. 20 years from now, the EIA estimates that the figure will be 2.96 trillion – an estimate, mind you.
So, do not be scared of no ghosts. Fear is an emotion, and emotion is an investor’s worst enemy. What is also true is the collective emotions of others create opportunities, which are recognizable.Link here.
GET RICH ON THE GENERATION SWITCH
My grandparents thought they were making a sensible decision by avoiding stocks. If you had lived through the Depression, and through an entire generation (the 17 years from 1930-1947) when stocks lost money, would you ever consider buying stocks again? Probably not. Yet stocks rose by more than 500% in the following generation, from 1947 to 1965 (18 years). Folks who invested in stocks during the 1950s and made that 500% return started to believe the opposite of my grandparents – they believed that stocks always go up. This boom ended with the “tronics” mania, the 1960s version of the dot-com stock craze. For the next generation from 1965 to 1981 (16 years), the Dow Jones Industrials stock index was flat. Folks who invested in the 1970s learned – like my grandparents did before – that you could never make money in stocks. You needed real assets, like real estate and gold. It is funny how it all goes in cycles …
Almost like clockwork, that 1970s generation of investors who saw the Dow go nowhere learned to avoid stocks, and then missed out on the greatest stock boom in history. Stocks soared from the end of 1981 to the end of 1999 (18 years). When you look at it over history, a rough pattern starts to emerge. It is a pattern where every 17 years or so, the investing generation switches. One investment rises by triple digits, while the other loses money. Again, it is not clockwork, but it is interesting. I can show this “switching” to you in a simple table. I have put together stock prices versus commodity prices. Take a look … triple-digit gains in one generation, losses in the next.
|100 Years of Investment Generations|
|* While stocks had a small positive return for 1965-1981, if you adjusted the number for inflation, it would be quite negative.|
The simple idea here is that we are into a new investment generation now. If the last investment generation ended around 1999 – and the pattern holds, then we could see stocks do poorly for about 17 years … or until 2016. I will admit the evidence from a statistical standpoint is a bit flimsy, as we are only going back five generations here. But the generational idea makes sense … and the numbers do fall into place. Legendary investor Jeremy Grantham sees it too: “It is absolutely no coincidence the great speculative bull markets of the 20th century occurred [when they did: 1929, the late 1960s, and 2000]. They fell exactly where you’d expect they would … Why? Let me describe the nature of a [stock market] bubble: First a real bubble needs above all to get rid of the old fogies. So you can’t have a bubble five years after a bust. … A bubble needs to rotate serious investment professionals out of their jobs. …”
So far, we are on track. Stocks (as measured by the S&P 500 index) are down about 15%. Meanwhile, commodities prices (as measured by the CRB Index) are up 46%. Some commodities like oil and gold are up significantly more. The point of this essay is not to get you to invest now in commodities based on that table. The point today is that, sometimes, it is good to be in stocks, and sometimes it is not. Now is probably one of those times when it is not. And just exactly what should you buy instead? Oh man, have I got a Big List of things to buy for you.
The Big List has been our cheat sheet for the last few years. The idea behind it is pretty simple. We are buying up what worked during the last generational switch. The last stock market peak was the late 1960s. A few years after that, gold, coins, commodities, and other assets started to soar. So we took The Big List as our blueprint. Here we are, a few years after a stock market peak once again, and the exact same things are working. It is uncanny. The exact same things that did well in the 1970s have done well again today – oil, gold, silver, stamps, etc. – practically in the same order. And I believe there is plenty more to come.
They say history does not repeat itself, but it rhymes. I believe we are only at about the year 1972 on this list. From 1972 to 1981, stocks were horrible performers. And the things above did well for another eight years after 1972. Of course, it may not be exactly eight years. But that is a reasonable ballpark guess. Based on the size of the boom that we just went through in stocks, and how it captivated everyone, it will probably take the full 10 years to shake everyone out of believing in stocks, and into believing in The Big List. When folks finally start believing in gold and other commodities, it will be time to buy stocks with everything we have got. But until then, we have still got hundreds of percent upside in the Big List. Make sure you are on board.Link here (scroll down to piece by Dr. Steve Sjuggerud).
CORRECTIONS OR BEAR MARKETS IN ASSET PRICES?
Based on the number of e-mails I receive and the types of questions I get asked, I have a fair idea of how investors are positioned. It is my impression, therefore, that the recent sudden sell-off in asset markets came as a surprise to the majority of investors and caught them – at least temporarily – on the wrong foot. The most frequently asked questions came from India, where the market sold off within a few days by 20% from its high (it has since recovered modestly), and from Middle Eastern investors who were stunned when their stock markets declined by about 50% from their peak in late 2005 (see Figure 1). The decline in the Middle Eastern markets is remarkable because it occurred in an environment of near-record oil prices and at a time when liquidity was still increasing.
The best explanation I have for the decline in those markets is that, whereas Middle Eastern liquidity is still plentiful, the rate of growth has been slowing down. As my friends at GaveKal Research pointed out, “Bull markets, to keep going, need an ever growing stream of liquidity; for copper to rise 10% from US$2,000/ton to US$2,200/ton takes a little amount of money while a rise from US$8,000/ton to US$8,800/ton usually takes a lot more. In that respect, bull markets are like drug addicts whose next fix/liquidity injection provides diminishing returns. To get the same effects, the fix/liquidity injections need to always get bigger. … Or serious withdrawal follows.”
The diminishing rate of liquidity growth aside, there may have been other reasons why stock markets in the Middle East tanked. The best time for equities tends to be at the end of an economic contraction or at the beginning of an expansion, when there is plenty of excess capacity. It is at these times that there is maximum liquidity in the system and, in the absence of heavy capital spending, stocks soar. But once an increasing quantity of money is channeled from the financial sector into real economic activity – in the case of the Middle East, into grandiose residential and commercial construction projects and Ferraris – stocks frequently begin to stall or to decline abruptly. I mention this fact because the consensus among investors is that the global economy is booming.
It is certainly the case that the boom is unprecedented in the history of capitalism. The expansion is reaching just about every corner of the world and almost every sector of its economy – admittedly at different intensities. Still, as I have repeatedly pointed out in earlier reports, the current global economic boom is characterized by huge and growing imbalances. Steve Roach believes that these imbalances can be solved benignly, but I believe there will be some serious rebalancing consequences.
It is important to understand that even when central banks expand liquidity at an ever-increasing pace (Weimar hyperinflation, Latin America in the 1980s, Zimbabwe now), liquidity does tighten temporarily from time to time, as price and wage increases outpace money supply increases. So, whereas the German stock price index rose in paper marks from 100 in 1913 to 26 trillion in 1923, there were 20% short-term corrections (lasting usually just two months) in 1920, 1921, and 1922, and a 25% correction in 1923 (in U.S. dollars. However, the index fell from 100 to a low of 2.72 in 1922, before recovering to 26.80 in December 1923.) As stated above, in order to sustain a bull market in asset prices, an everincreasing pool of liquidity is required and this is, in the short run, impossible for a central bank to achieve – even if its intentions are “to print money”. In the example of the Middle Eastern stock markets referred to above, the prime drivers of liquidity are obviously oil production and oil prices.
From Figure 4, we can see that between 2002 and 2005, oil production soared from 25 million barrels a day to around 31 million barrels. The increase in production was accompanied by strong price increases, as crude oil prices rose from $19 a barrel to $70. However, at the end of 2005, oil production began to decline moderately and oil prices no longer rose. So, whereas liquidity was still plentiful, the rate of increase declined and led to a relative tightening of monetary conditions, which I suppose explains the dismal performance of the Middle Eastern stock markets over the last six months. Aside from the Middle East, it is apparent that liquidity conditions around the world, while still expansionary, are less expansionary than in the 1999-2005 time frame. We could argue that while an absolute tightening has not yet taken place, a relative tightening has been in force for the last 12 to 18 months.
Now, whenever central banks create excess liquidity, symptoms of inflation will show up somewhere. Sometimes wages and consumer prices will react the most to expansionary monetary policies (for example, the 1960s and 1970s), but in today’s world where, given the low wages in China and India, an almost unlimited labour arbitrage can take place, easy monetary policies drive asset prices such as homes, commodities, equities, art, and so on, higher, while wages and consumer prices rise only with a lengthy time lag (once commodity prices begin to be passed on in the prices of finished manufactured goods). Therefore, it should come as no surprise that, when liquidity growth is slowing down, asset prices begin to cave in first. This is especially true of equities, since the stock market discounts economic events well ahead of time. In this respect, it is interesting to note that while home prices in the U.S. have continued to rise nationwide, homebuilding shares peaked out in the summer of 2005.
But, as I have repeatedly pointed out, it usually pays to listen to the market. And in this respect, we should take rather seriously the sharp break in equity and commodity prices, as well as in some of the emerging market currencies, that we experienced in the second half of May. The break may prove to be only of very brief duration with new highs to follow, but the impulsive nature of the break suggests differently – at least for now. Precisely because we are in a global boom, liquidity is likely to become tighter for a while and that, as just outlined, in such an environment equities and other asset prices are vulnerable until liquidity conditions improve once again.
I have to confess that I did hesitate for a long time before deciding to commit to paper the following observations, as they will undoubtedly cause some confusion, given the views I have expressed in earlier reports. However, there are times when, within a long-term view, short-term considerations become more significant. From a longer-term perspective, I still maintain that central banks – especially the U.S. Federal Reserve – will have no other option than to print money and that, therefore, in the long run, asset prices will continue to increase – at least in nominal terms. My concern remains the same: before the final debt crisis hits, we might see very high rates of inflation - most likely hyperinflation, with all asset and consumer prices soaring … amidst falling real incomes.Link here.
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