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WELCOME TO MURPHY’S MARKET
Unless world population starts to die off fast or people develop a taste for living low and being cold a lot, the energy and resource plays are still going to work over the long haul.
Back during the "buying panic" of August 1982 we recall Alan Abelson quoting some pundit who ascribed the market action to institutions who "panicked and bought without thinking." Abelson supposed that behavior distinguished them from individuals, who "had to think before they panicked."
Byron King, editor of Outstanding Investments, has some considered words for those wondering what the heck to do with their stock holdings at this point, suggesting that you think before panicking. And of course his favored resource stocks are all better values now.
"Markets Routed in Global Sell-off," was the banner headline of the Financial Times this week. It seems like anything that can go wrong will go wrong. It is Mr. Murphy's market, right?
How bad can it get? It is already bad, but can it get worse? Markets go up and they go down. That is what markets are all about. Still, it is one thing to live through a market pullback or correction. It is another thing entirely to experience a total rout. It is like what happened during Napoleon's retreat from Moscow. There is no relief from the suffering.
Evidently, the world wants its money back. It is selling. In fact, a lot of people want out of the market right now. Are you one of them? I do not blame you if you are looking for a way to bail out. But before you pull the "Eject" handle, let's think this through.
Sure, it is easy to wish that you sold your stocks six months ago. But you did not. Neither did I -- at least not all of them. Why didn't we sell? Were we focusing too much on the long term? Did we miss some sell signal? Where is that bell that they are supposed to ring at the top of the market? What the hell were we thinking, that we are bulletproof or something? Well, before we get too far ahead, let's look back and see how we got here.
From the end of 2006 to July 2008, oil steadily increased in price. Also, between late 2006 and July 2008, the U.S. dollar declined in value, particularly against the euro. Both run-ups -- in the price of oil and the value of the euro against the dollar -- were too much, too fast. The apparent strength in both oil and the euro (and the weakness of the dollar) masked the fact that the trading numbers were outrunning the pure economic fundamentals.
Here is the key set of points. The eurozone economy was not that good last year. The dollar and the U.S. economy were just not that bad. Oil was just not worth that much. Despite the Peak Oil thesis -- in which I believe strongly -- the world really was not coming to an end last summer. (And it didn't.)
So by this past July, oil was too expensive and the dollar was too cheap. I said so both in writing and on Fox Business News and other media. ... [B]y the second week of last July, oil was selling at $147 per barrel and the euro was over 1.6 relative to the dollar. Too much.
What happened, then? In mid-July, the dollar began to strengthen, due to central bank intervention. And the price of oil fell. Both changes were rapid, even abrupt. A surprise? No, not really.
I expected the dollar to strengthen, and I said so. And I expected the price of oil to decline from the $140s to about $100-110 per barrel, with a possible excursion down into the $90s per barrel. I actually thought that a stronger dollar and declining oil prices would be "good" for the overall world economy, because this would leave more money in the pockets of consumers -- especially energy users.
But now in hindsight, it appears that the run-up in oil prices from 2007 to mid-2008 sapped household and consumer income across the world. The oil run-up and simultaneous dollar devaluation were enough to trigger the mortgage crash. Of course, the mortgage crash was coming, and it was always just going to be a question of causation. Now it is up to history to assign naming rights to the meltdown.
Let me use a different analogy. The dollar decline and energy run-up did not give just a chest cold to the world's credit-driven economy. The yearlong decline of the dollar and rising oil price gave the world economy a case of tuberculosis. And it is a strain of TB that is resistant to all the usual antibiotics.
So here we are. The world economy is sick. And I mean really sick. The markets are coughing up blood. None of the usual remedies will work. There is no magic pill. From here on out, it is trial and error. It's hit or miss. And the prognosis is grim.
Let's get back to whether or not to sell your stocks.
First, I am certain that it is painful for you to watch your investments decline. You worked hard for the money with which you bought stocks over the years. And now the value of those stocks is falling. It just stinks.
This market meltdown is not like Goldilocks sneaking into your kitchen and eating your porridge. No, this is like Goldilocks breaking into your house and burning the place down using magnesium flares as accelerants. Years of hard work are just turning into smoke and ashes right before your eyes.
I have to say that declining markets are plenty painful for me. It hurts twice as much because I edit Outstanding Investments. That is, I have both money AND a reputation at stake in this process. Agora Financial does not give out personal investment advice. But the last thing I want to do is offer up a bum steer when it comes to helping you make your financial decisions.
Outstanding Investments has a straightforward investment thesis. We invest in energy and resource plays because over time -- we believe -- energy and resource investments will become more valuable. There are a number of reasons for this, including geological scarcity, past underinvestment and increasing future demand. But it is a basic idea, and we think it works. At least, it has worked for the past six years or so.
For the past few years, OI has been selecting investment ideas in companies that appear to have bright futures in a looming era of rising energy and resource demand. And many -- most, really -- of the investment ideas did well. Some did very well. A lot of readers made a lot of money. Whether it was oil, gold, refineries, cement or energy infrastructure, it seemed like we were investing in places where the world was going. Right?
But now it seems like the investment locomotive -- energy, resources and related infrastructure -- has derailed. Energy prices are declining. Energy-related stock plays are down. Commodities are down. Mining and infrastructure stocks are in the dumps. The falling tide is leaving us high and dry.
But does that mean that the whole OI investment thesis is unraveling? Not so fast, pilgrim. Let's keep on thinking this through.
Before you do anything precipitous -- like sell your last stocks and stuff the cash into your mattress -- let us ask a few more questions.
If you sell out now, what price will you get? A low price, right? So if you sell now, you will leave a lot of value on the table. That is, most things in the world of energy and resources are underpriced compared with their intrinsic value. I do not care how bad the market looks just now (and it looks awful). Go out and try to find an oil field somewhere, or build an oil refinery, or find an ore deposit and build a mine. Cannot do it, can you?
So if you sell out now, just be aware that you will be getting a relatively low value. You will be leaving long-term value behind. If that is what you want, then that is what you ought to do. Just understand the point.
Which brings up the next set of issues. How badly do you need the money? How soon do you need it? How scared are you of further declines? How much risk can you handle, especially going forward? What kinds of reassurance do you need?
The markets are down. A lot of Elvises have left the building. And who is left to do the selling? Just you? Nope. Whatever you think, you are not alone. There are still a lot of people holding their shares. What do they know? And what is their reasoning to hang on?
From what I have seen, the biggest sellers -- the market drivers who are taking the express elevator down to the subbasement -- are people who have lost control of their money, if not their investment destiny.
People are selling to meet margin calls. The wildest sellers are traders who are just plain behind the eight ball. It is more than being scared by what is happening. Heck, we are all scared in some way or another. I was not around in the 1930s, so I have no firsthand experience with the Great Depression. I know only what my parents and other relatives and friends told me. It was pretty bad for a lot of people.
But right now the serious sellers are people who cannot afford to be patient. A lot of the sellers in the energy and resource field are hedge funds. These firms are meeting redemption calls from investors who want out. The hedge funds just plain need cash. They have to sell. And a lot of those funds are throwing everything over the side, even the life rafts and the emergency rations.
When you look in the mirror, is that you? Are you like a hedge fund in panic mode, selling everything just to raise cash? Do you fit into this "sell-sell-sell" model? Do not feel bad if this is what you have to do. Just be honest with yourself.
Meanwhile, the U.S. -- and the world, really -- has been dealing with a credit crisis for over a year. Which makes me wonder if there is a turnaround coming sooner, rather than later. I do not know that. I do not have a copy of the Financial Times from next March. So I just cannot say if we are closer to the bottom than to the top.
How soon do you need your funds? If you need cash within the next 12-24 months to pay bills like those for college tuition or a nursing home for a relative, then maybe you ought to just take the hit and get out of the market now. There is no shame in being safe. Look after your needs.
But do you have a longer horizon? Are your "down" stocks in your IRA or 401(k)? You cannot take it out without penalty until you are 59 1/2 years old. Then consider riding it out. And maybe with these low valuations on most stocks, it is even time to go shopping -- but certainly not blindfolded. Nibble away.
In a lot of respects, the world is on sale right now. Heck, a lot of stocks in the OI portfolio have turned into dividend plays. Can they maintain their dividends? That is a good question. Can they sustain earnings? At the same time, if you were management at these companies, would you risk further tanking the stock by cutting the dividend?
And let us look ahead a year or two. Commodities in general have been plunging in price since early July. The dollar has been strengthening. Will that continue? Can it continue? Why should the dollar stay strong? Does the number $700 billion mean anything to you? So sure, the strong dollar can continue and commodity prices will stay weak. But at some point, the dollar will start to decline in value. And commodity producers will have to cut back on operations by closing mines and mills and smelters. Then they regain pricing power.
And if the world has the vast recession that many people are forecasting? Then global demand should decline in the near and further future.
But there are 6.5 billion mouths to feed on this planet. The world will still have to produce a lot of materials to satisfy basic demand. That is just built into the equation of human survival. And what will happen to pricing power as some layers of high-cost output go away?
For example, the world petroleum industry will lift over 31 billion barrels of oil this year. Even if world demand dropped by, say, 5% -- as if the world airline industry simply vanished -- the world would still lift nearly 30 billion barrels. And as the current economic woes cause new projects to slow, annual depletion will overwhelm annual new output from new fields. There will be less oil.
That is, looking ahead, the world may never again exceed the oil output levels that we will have in 2008. Indeed, it will require heroic efforts just to keep global oil output flat in the future.
So this brings us back to that OI investment thesis. Energy and resources are getting scarcer and ought to become more valuable going forward. Hey, too bad the world financial system is busted. But that just means that there is an opportunity to buy good stuff really cheap.
No, I am not saying that you ought to go out and buy stock with both arms or back up the pickup truck and start shoveling. You need to be very cautious right now. But do not panic, either.
Sell if you need to sell. Buy if you want to take on the risk. We are in for some rough economic times. But unless world population starts to die off fast or people develop a taste for living low and being cold a lot, the energy and resource plays are still going to work over the long haul.
Until we meet again ...
ON A RETURN TO NORMALCY: DOW 8,500
The excitement, if you will, of the market action of the last couple of months might obscure that what has happened is just a return to normality. The DJIA is once again selling at its typical price/earnings ratio relative to its normalized earnings. This is the thesis of Geoff Gannon, editor of the "Gannon on Investing" blog and self-professed intrinsic value investor. It makes good sense.
By Gannon's reckoning, in every year during 1996 to 2007 the Dow was more expensive relative to its normalized earnings than it had been in any year from 1935 through 1995 -- even during 2002-03. As noted by Martin Hutchinson in the posting below, in 1995 under the Alan Greenspan Fed, money supply (as measured by M3) started growing faster than nominal GDP. Not just coincidentally, the great asset bubble started gathering size a year later. Greenspan's famous "irrational exuberance" speach came in 1996 as well. His instincts and timing were actually quite good, even if he was stangely unaware that it was his doing.
It might not feel like it, but yesterday marked the Dow's return to normal. Normal valuations that is.
A little under two years ago (December 2006), I wrote a series of posts on normalized P/E ratios. In my most important post in that series, "In Defense of Extraordinary Claims," I argued that future returns would not match historical returns, because normalized valuations from 1996 to the present were too high:
Stocks are not inherently attractive; they have often been attractive, because they have often been cheap.
That statement neatly sums up my argument. Buying stocks blindly worked during most of the 20th century because stocks were cheap during most of the 20th century.
That all changed in 1996. In every year from 1996 through 2007, the Dow was more expensive relative to its normalized earnings than it had been in any year from 1935 through 1995. The closest comparison was 1965. But every year: 1996-2007 was more expensive than 1965.
As a result, historical return data from the 20th century was an inappropriate guide for expected returns on an initial investment made at any point from 1996-2007. We were in unchartered territory.
Not any more.
Yesterday, the Dow dropped below 8,750. That number is the point at which the Dow would be trading at the average 15-year normalized P/E ratio for 1935-2005. In those seven decades the Dow posted a compound annual point gain of 6.6%. Back it up 10 years to 1995, the last year before the paradigm shift I wrote about and you still get annual point growth of 6.2%.
So at yesterday's close of 8,579 the Dow is priced to grow at a quite historical 6 to 6 1/2 percent a year.
That may not sound like much to those weaned on the 1982-1999 bull market. However, it is a lot better than the "new paradigm" market that began in 1996. Since we broke into unchartered territory 12 years ago, we have done something like 3.4% in point terms. And over the last 10 years: zilch.
Here is what I wrote about the possibility that the post 1995 (i.e., permanently higher normalized P/E) environment could be maintained:
Is it possible that the surge in normalized P/E ratios beginning in 1995 was simply the culmination of a crisis within the investment discipline? Maybe normalized P/E ratios have reached "a permanently high plateau" now that a new paradigm has taken hold. ...
Maybe. If we really are in a new era, the old historical return data is not relevant -- it applies only to an era of low normalized P/E ratios. New, higher valuations must necessarily lead to new, lower returns. On the other hand, if we are not in a new era, the old historical return data is relevant -- and normalized P/E ratios must fall.
And they have fallen. Like a rock.
And saved us a lot of time. 8 1/2 years by my calculation.
Without a severe multiple contraction, the Dow would have had to move sideways for something like 8 1/2 to give us the same future return increasing effect of the fall from just under 14,280 to just under 8,580.
Of course this only makes sense if you believe as I do that in the long-run your returns in stocks are derived from the relationship between the price you pay and the earnings power you get for your money.
What about earnings power impairment? Will the current financial panic and the (possible) resulting global recession not cause a major contraction in earnings power?
Not really. Actual earnings will be impaired. However, "normalized" earnings will not move much (certainly nothing like the 40% drop in price) -- unless we see conditions considerably worse than anything post 1935.
The Dow has been outperforming its expected earnings for a very long time (since the early '90s). That was never going to last.
The Dow's actual earnings overshoot and undershoot its "expected" (i.e., 15-year normalized) earnings quite frequently; however, the overshooting and undershooting have tended to cancel each other out over long periods of time as you can see here:
From 1935-2005, the percentage difference between the Dow's actual earnings and its 15-year normalized earnings ranged from -62.12% to 65.14%. The average (mean) difference between actual and normalized earnings was 0.44%. The median difference was 0.09%.
The swings have been huge, but their net effect has been small. Basically, the Dow's EPS chugs along at about 6% a year. Although it has managed some remarkable hot and cold streaks (none longer than the one that is ending now) it is basically a mirror image of underperformance and overperformance.
The Dow gives you 6% earnings growth. What you get depends on what you pay. Starting today, you are paying par. You have not had that chance in over 10 years.
What do I mean by par? Since the Dow is now at (actually a bit below) its average 15-year normalized P/E ratio for 1935-2005, your long-term returns should match the Dow's long-term EPS growth. Both should be around 6% (ex-dividends).
Long-term future returns should once again be similar to long-term historical returns.
Could the future be different from the past? Maybe. But I would not bet on it.
The last 10 years turned out to be nothing new. Just a detour on the road to normalcy.
THE WALL STREET BUST
We are today witnessing the acute stage of bursting credit bubble dynamics.
Last week Doug Noland expressed the hope that Congress would come up with some bailout bill that would slow down the bleeding, even if it could not possibly staunch it. This week he explains that with the complete bust of "Wall Street Finance," which depended crucially on the torrent of low-grade credits emanating from the investment banking industry being accepted as "money," that $700 billion cannot possibly offset the credit destruction now happening:
"[O]ur maladjusted economic system will only be sustained by somewhere in the neighborhood of $2.0 trillion of new credit. It is simply not going to happen."
As for what this all means, the crystal ball is fogged over:
"I have a very difficult time seeing a way out of this terrible mess."
Several years ago at a conference honoring the late Milton Friedman's 90th birthday, Ben Bernanke delivered the keynote speech. Not yet the designated heir apparent to the Federal Reserve chairmanship, Bernanke fancied himself to be a Great Depression "buff." Addressing Friedman's contention that that economic catastrophe was caused by the Fed failing to provide the system with enough liquidity, Bernanke promised: "You are right. We did it. We are very sorry. But thanks to you, we won't do it again."
Bernanke has yet to recant, as far as we know. We, in our infinite wisdom, think Bernanke is off-target, as do Noland and the Austrian economists. The issue was and is not some the banking system capital and liquidity. It is a maladjusted and unsustainable bubble economy that cannot be sustained without continuously accelerating growth in credit. Failing that, and we are getting exactly the opposite now, the house of cards (which is how President Bush characterized our economy) tumbles down. And all the king's horses and all the king's men ...
I still owe readers a thorough analysis of the Q2 2008 Flow of Funds. For now, I will just point out some data relevant to The Current State of Acute Fragility.
Looking back, total non-financial debt (NFD) expanded $578 billion during 1994. By 1998, NFD growth for the year had surpassed $1.0 trillion. Non-Financial credit increased $1.153 trillion in 2001, $1.415 trillion in 2002, and $1.676 trillion in 2003, before reaching the $2.0 trillion milestone in 2004. Incredible as it was, debt expansion then surged over the next fateful three years. Growth rose to $2.319 trillion in 2005, $2.428 trillion in 2006 and then to last year's record $2.561 trillion.
Importantly, this historic credit Inflation inflated asset prices, incomes, corporate cashflows/earnings, government revenues, and various types of spending throughout the U.S. and global economy. It was a self-sustaining bubble bolstered by ongoing credit excesses, asset inflation and resulting purchasing power gains. But NFD growth slowed sharply to an annualized $1.726 trillion during this year's first quarter and then sank to $1.127 trillion annualized during the second quarter. Credit growth is now in the process of collapsing.
At this point, there is clearly insufficient credit expansion to support inflated asset markets, incomes and household spending, corporate cash flows and investment, and government receipts and expenditures. Lending markets are frozen, securitization markets broken, corporate and muni debt markets in disarray, derivatives markets in shambles, and the leveraged speculating community is engaged in panic de-leveraging. As a consequence, the over-indebted household, corporate and state and local sectors now face a devastating liquidity crisis.
We are today witnessing the acute stage of bursting credit bubble dynamics. It is an absolute debacle, and there is little our well-intentioned policymakers can do about it other then try to slow the collapse. To be sure, there were momentous effects to both the economic and financial structures during the bubble period between 1994's $578 billion non-financial debt growth and 2007's $2.561 trillion. It is also worth noting that financial sector debt expanded $462 billion in 1994 compared to $1.753 trillion in 2007. Mortgage debt almost doubled in the six years 2002 through 2007 to $14.0 trillion, while financial sector borrowings rose 75% to $16.0 trillion. This credit onslaught fostered huge distortions to the level and pattern of spending throughout the entire economy. It is today impossible both to generate sufficient credit and to main previous patterns of spending. Economic upheaval and adjustment are today unavoidable.
Over the years I have chronicled this historic bubble in Wall Street Finance. It is worth recalling today that Wall Street assets began year 2000 at about $1.0 trillion and ended 2007 at $3.0 trillion. The Asset-Backed Securities market surpassed $1.0 trillion in 1998 and ended 2007 at $4.5 trillion. Government Sponsored Enterprise assets surpassed $1.0 trillion in 1997 and ended last year at almost $3.4 trillion. Agency Mortgage-Backed Securities surpassed $2.0 trillion in 1998 and closed 2007 at almost $4.5 trillion. "Fed Funds and Repos" reached $1.0 trillion in 2000 and ended 2007 at $2.1 trillion. This bubble in Wall Street Finance was one of history's most spectacular credit expansions. It also comprised the greatest use of speculative leverage ever.
Despite last summer's collapse in private-label MBS and related markets, the faltering Wall Street bubble nonetheless persevered up until the Lehman collapse. While it was problematic that overall system credit growth had slowed markedly, there remained key sectors of credit and risk intermediation that remained very much in expansionary mode. In particular, GSE-related obligations, bank credit, and money market fund assets had expanded rapidly in spite of the subprime collapse. Importantly, the speculator community had maintained easy access to cheap finance. As I have noted often, despite the unfolding bust in mortgage and risk assets, market faith in "money" and the core of the system had held steadfast. This all ended abruptly three weeks ago with the Lehman filing.
Today, confidence has been shattered, and Wall Street Finance is a complete and unsalvageable bust. The spigot for trillions of finance -- that for years fueled the asset markets and U.S. bubble economy -- has been essentially shut off and dismantled. In particular, Wall Street finance was a mechanism for intermediating higher-yielding riskier loans. This finance provided rocket fuel for both residential and commercial real estate markets -- and the attendant wealth effects. Wall Street Finance also grew into the key source of finance for auto purchases, student loans, credit cards, municipal finance and various business enterprises. Many of these loans were of a risk profile unappealing to traditional bank lending -- and, hence, provided the type of higher yields quite appealing to the speculator community.
And, importantly, as the stature of Wall Street finance grew its impact upon the real economy became embedded deep into the economic structure. Or, stated differently, risky loans came to play a major role in determining spending and investment patterns throughout the "bubble" economy. Wall Street finance became a major direct and indirect generator of household incomes and corporate profits. Moreover, Wall Street finance came to dominate the flow of finance both in and out of the securities markets. Wall Street could create its own liquidity and funnel it into the U.S. and global markets -- and earn unimaginable returns in the process.
It is today impossible to comprehend the full ramifications from the bust in Wall Street Finance. Yet we can be rather certain that for the foreseeable future much less credit and liquidity will be directed to the asset markets. And, at the same time, there will be significantly less credit availability for riskier loans of all varieties -- for the household, business, financial and the government sectors. Few appreciate that these dynamics are extremely problematic for the U.S. bubble economy -- an economic system that had come to a large extent to be governed by asset-based and high-risk lending. These dynamics are at the heart of today's acute financial and economic fragility and the resulting imploding markets.
The leveraged speculating community played such an integral role in the overall credit bubble and, more specifically, to the bubble in Wall Street Finance. They were instrumental in both spurring financial sector credit creation/leveraging, while directing this flood of finance to the asset markets. And the more the leverage and the greater the flow to inflating markets, the higher the returns generated by this expanding pool of speculative finance. And the greater the returns, the more robust the "investment" flows into the hedge fund community -- spurring more leverage and more potent fuel for additional self-reinforcing asset inflation. Well, this historic speculative bubble is now in the process of blowing up. One of the greatest manias ever -- surely the world's greatest episode of "Ponzi Finance" -- is absolutely coming apart. And the wreckage is accumulating in all markets -- everywhere.
Here at home, our maladjusted economic system will only be sustained by somewhere in the neighborhood of $2.0 trillion of new credit. It is simply not going to happen. The $700 billion from Washington would seem like an enormous amount of support. In reality, it is nowhere even close to the amount necessary for systemic stabilization. To the $2.0 trillion or so of new credit required this year (and next) add perhaps as much as several trillion more necessary to accommodate speculative de-leveraging (liquidations forced by huge losses). Importantly, the bust in Wall Street Finance has ensured that insufficient liquidity will be forthcoming to maintain inflated asset prices and sustain the bubble economy -- creating catastrophe for the leveraged speculating community.
The "Freidmanites" thought they understood the (post-crash) policy mistakes that led to the Great Depression. They believed the "Roaring Twenties" was the "Golden Age of Capitalism." The great bust could have been avoided with a simple ($5 billion or so) banking system recapitalization. As we are witnessing today, the issue is not some manageable amount of new "capital" to replenish banking system losses. Instead, the predicament is the massive and unmanageable amount of new credit necessary to, on the one hand, sustain a mal-adjusted bubble economy and, on the other, the trillions more required to accommodate a gigantic speculative de-leveraging. I have a very difficult time seeing a way out of this terrible mess.
On a lighter note, Doug Noland's colleague Rob Peebles is back after a six month plus absence from the Prudent Bear site with this hilarious, well, piece of commentary.
BAILOUT BILL PASSED, SO WHAT HAPPENS NOW?
A total and complete waste of $700 billion. Hyperinflation is way down the road.
Mike "Mish" Shedlock spent a huge amount of time the past two weeks rallying his readers to try a stop the bailout of Wall Street. As we all know the bailout passed through Congress on the second attempt, but it was a valiant effort. So now what?
According to Mish it will be virtually a complete waste of resources. It will only make things worse.
Congress passed a $700 billion bailout package [Friday]. It was a total and complete waste of $700 billion. It further depletes the pool of real funding.
Yes, the Fed has started a monetary printing campaign. Yes, the SEC will suspend mark to market accounting. So what happens now?
Pretending Is Not Reality
What happens now is that pretending does not alter reality. I can pretend all I want that Madame Merriweather's Mud Hut is worth $1 trillion and I can pretend my pet rock is worth the same. The reality (sorry Madame), is that neither is worth the book value I place on them.
Suspension of the mark to market rules will accomplish nothing but further mistrust of banks and bank stocks. Everyone will know banks are lying. No one will know by how much. What we still know is that Citigroup alone holds $1 trillion in off-balance sheet SIVs. Pretending those SIVs are worth $1 trillion will not make it so. Yes, $700 billion is a lot of money. But let's see just how fast it comes and let's see if all of it comes.
The countless $trillions in total bank assets that are not marked to market and will not be purchased by the Treasury, are realistically still going to see credit contraction (on a marked to market basis, and that is what counts).
Foolish Effort To Spur lending
Bernanke and Paulson think that the Fed buying toxic garbage will spur institutions to start lending. It will not. Banks will still be holding more garbage than the Fed can possibly buy. The market will be able to smell that garbage, even if the rules allow banks to pretend that garbage is a rose.
Banks have no reason to lend in a world of overcapacity, rising unemployment, and increasingly sour consumer attitudes. It was disingenuous at best to suggest this would free up lending for main street as it was packaged.
Rescue The Market?
All hopes were that action by Congress would "rescue the market". It cannot and it will not. No jobs are being created by this bill, salaries are not going to rise, outsourcing is not going to stop, and foreclosures are going to rise.
If there was a $700 billion jobs package was passed instead of this monstrosity, especially if Davis-Bacon was scrapped like I wanted, tens of thousands of jobs would have been created and at least the U.S. taxpayer would have gotten something for their money. Note: I am not arguing for $700 billion for jobs per se, I am merely pointing out that we would have at least gotten something out of it.
It was not to be. Stupidity won out as it usually does, but I am holding my head high for the effort that readers of this blog and others put in to kill this boondoggle.
Will Printing Lead To Hyperinflation? Nope.
Many have asked if the actions of the government would lead to hyperinflation. Others mockingly told me that it would. Nope. The answer is the same: Deflation.
There has never been hyperinflation in history with falling home prices. And home prices will continue to fall. Wasting $700 billion will not do the stock market any good either. The bottom is not in. Today's (Friday's) close proved it. There are new lows on the S&P 500, the Nasdaq, and the Dow.
Yes the Fed will print, but the money will sit, just as it did in Japan. Wasting $700 billion will only make things worse. Banks will still hoard cash.
Hyperinflation Dreams Are Way Down The Road
I am not the only one who has come to this conclusion. Please consider this audio with Austrian Economist Frank Shostak on Mises.
Shostak refers to Money AMS in the audio. An complete explanation of Money AMS can be found in Money Supply and Recessions. A more recent update of Money AMS is in TMS: A Truer Money Supply? Unfortunately I cannot update that chart because a falling out with the person who created that chart for me.
Proper Definitions of Inflation and Deflation
Those who believe inflation is measured by the CPI, the PPI, or price increases of any kind desperately need to read (Mish blog entries) Inflation: What the heck is it?, Interview with Paul Kasriel, and Deflation American Style.
The definition of inflation I am using is "A net increase in money supply and credit". Deflation is the opposite "A net decrease in money supply and credit."
Looking at deflation in terms of money supply (money that is actually lent) and credit (marked to market), the proper conclusion is the bailout bill does not change the picture, and that picture remains deflation.
I have said many times the fed can print but it cannot force banks to lend or consumers and businesses to borrow. We are about to find out who is right.
LIQUIDITY IS IN THE EYE OF THE HOLDER
“Illiquid” securities are in fact highly liquid, just not at the prices the owners would like to receive.
Peter Schiff cuts through all the "lack of liquidity" cant and identifies the real issue: People complaining of lack of liquidity are actually complaining the securities they are trying to sell are illiquid at the price they want. In a bear market everyone wishes they had sold at the top, and giant banks are no different here than the small retail investor.
We are being told loudly and repeatedly that the gargantuan mortgage bail-out package is necessary because illiquid mortgage-backed securities are clogging our financial arteries, threatening the economic equivalent of cardiac arrest. The idea of the plan is to transfer these supposedly valuable, but currently unmarketable, assets to the government so that private institutions can freely lend once more. The monumental flaw in this argument is that the mortgage backed securities are in fact highly liquid, just not at the prices the owners would like to receive.
Mortgage bonds are just like houses. They will not sell if the owners stubbornly refuse to drop the price. However, they can find buyers if they acknowledge reality, and lower their expectations accordingly.
The government tells us that if these assets are held to maturity their full value will eventually be realized, and that it is only because of a lack of current liquidity that their value is not reflected in the market. However, as many private transactions have shown us in recent months, these assets will find buyers at the right price. These are not overly exotic assets but relatively straight forward mortgage obligations. The inability to find buyers is not a function of liquidity but simply of price. The government is seeking to "create liquidity" by overpaying.
The government's assumptions about the "held to maturity" value of these mortgages completely understate the likelihood of widespread default. Some of the "illiquid" assets represent tranches of mortgage-backed securities that will be completely wiped out. Even the higher quality tranches will suffer severe losses due to mortgages that will inevitably go bad.
For example, take a $500,000 adjustable rate mortgage on a condo in Las Vegas that has a current value of only $250,000. To assume that this asset can be safely held to maturity is absurd, when in all likelihood the borrower will default shortly after the rate resets, even if the borrower has not yet shown signs of distress. Of course such a mortgage would be completely illiquid if one tried to sell it anywhere near par, but would be extremely liquid if priced to reflect a more realistic value; say 35 cents on the dollar. But if the government pays prices that fairly factors in likely defaults, it will bankrupt the very institutions it is trying to bail out.
Another factor that has not yet been considered is that that the government has already indicated that it will try to avoid foreclosures by reducing the principal and interest rates on the loans it acquires to levels current homeowners can afford. This will immediately eliminate the delusion of the government recouping its "investment" as even if held to maturity the mortgages will never be worth anything close to what the government pays.
Also missing in the discussion is the concept of the time value of money. Even if a substantial percentage of the $700 billion is eventually recovered, it will still represent a huge loss for taxpayers who theoretically have to come up with the cash today to buy the mortgages. Further, the inflationary nature of the bailout ensures a substantial rise in long term interest rates. This will further suppress the present values of the low coupon mortgages the government will be restructuring.
The moral hazard implicit in the government's willingness to rewrite troubled mortgages ensures that the plan will spark a wave of new delinquencies by borrowers looking to cash in on the windfall. Since troubled loans will no longer be foreclosed by lenders but instead sold to the government, the rational choice for many homeowners will be to stop making their mortgage payments and wait for a better deal from the government. This reality will eventually push the cost of this bailout well above $2 trillion.
In addition to the government bailout, distressed lenders are looking to the suspension of "mark to market" accounting rules as a means of salvation. These rules require institutions to value their mortgage assets according to the most recently traded price. However, suspending these rules will not make the losses go away. Rather it will simply allow lenders to pretend that the losses do not exist.
Armed with such fantasies, banks could pretend that their mortgage assets had more value, and that their balance sheets were well capitalized. They would not need to raise more capital in order to fund new loans. But, just as a person with no sensitivity to pain runs the risk of catastrophic injury, such a move would encourage financial institutions to take greater risks which, in the end, will produce more bankruptcies and greater losses.
In fact, the Senate version of the bailout bill, which authorizes a suspension of mark-to-market, also increases the dollar limit on FDIC insured deposits from $100,000 to $250,000 (with no extra money budgeted to fund the increased taxpayer liability). Only in Washington would a bill pass which simultaneous makes banks more likely to fail while increasing taxpayer exposure when they do!
For a more in depth analysis of our financial problems and the inherent dangers they pose for the U.S. economy and U.S. dollar denominated investments, read my new book Crash Proof: How to Profit from the Coming Economic Collapse.
REVENGE OF THE COPYBOOK HEADINGS
The eternal truths laugh last and loudest.
Martin Hutchinson uses Rudyard Kipling's The Gods of the Copybook Headings, an elegiac poem of post-World War I lament, as a launching pad for a discussion of the eternal verities that have been ignored in the last decade and some odd to our peril. Kipling duly noted that the "Gods of the Copybook Headings" had outlasted the siren call of the "Gods of the Market Place." This passage will give one an idea of what Kipling had in mind:
With the Hopes that our World is built on they were utterly out of touch,
They denied that the Moon was Stilton; they denied she was even Dutch;
They denied that Wishes were Horses; they denied that a Pig had Wings;
So we worshipped the Gods of the Market Who promised these beautiful things.
Hutchinson has been writing his column on PrudentBear.com for eight years, and wryly notes that his column's "varying predictions of doom" have suddenly become much more accurate.
Since November 2000, this column has warned of a wide variety of economic and market disasters that have appeared impending. With almost 400 columns, a number have been plain flat-out wrong, as well as the innumerable ones that were more or less repetitive of previous effusions. Nevertheless, in the last few months, this column's varying predictions of doom have had a markedly better track record: as Rudyard Kipling would have put it, the Gods of the Copybook Headings appear to have reawakened and to be taking their revenge for even minor economic transgressions.
Kipling wrote The Gods of the Copybook Headings in 1919, at a time of sadness and disillusionment after losing a son in World War I. The central theme of the poem is that whatever temporary beliefs we may acquire through market fluctuations or fashionable collectivist nostrums, eventually the old eternal truths of the children's copybook return and punish us for our deviation from their instructions:
"Then the Gods of the Market tumbled, and their smooth-tongued wizards withdrew
And the hearts of the meanest were humbled and began to believe it was true
That All is not Gold that Glitters and Two and Two make Four
And the Gods of the Copybook Headings limped up to explain it once more."
Kipling was an instinctive economist. That verse of the poem describes pretty well how the wizards of the tech boom and the housing boom withdrew at the peak of the market, and the Gods of the Copybook Headings took control of the subsequent debacle. Traditional truths about the market that had been thought outdated and irrelevant were revealed to be the factors in underlying control.
Copybook Headings whose Gods have come back to haunt us already include the following:
Don't inflate broad money faster then nominal GDP. This modernized version of the Gold Standard is the Copybook Heading by which monetarists seek to control inflation and suppress asset bubbles. It was followed by Paul Volcker and by Alan Greenspan in his first 7 years in office, then abandoned in early 1995, since when M3 money supply has increased 70% faster than nominal GDP. Its abandonment resulted in series of asset bubbles, the more dangerous of which was that in housing because of the debt involved. Its God appears to have been rather sleepy, allowing 12 years of misbehavior from 1995 to 2007, but is exceptionally powerful and malignant when roused, as we are now discovering.
Initial Public Offering Companies should have a solid earnings track record before venturing into the market. We had fun tickling the sleeping nose of this one in 1998-99, but he eventually awoke. A very noisy God, but only moderately powerful, he caused a substantial stock market crash but failed to suppress market "animal spirits" altogether.
Average house prices should not rise much above 3.2 times average earnings. This God's Copybook Heading had controlled the housing market from World War II until the late 1990s, but we flouted him after 2000. A God who is not often ignored, he has a vindictive tendency, and makes sure we remember not to mock him for at least a generation after he awakens.
Whoever makes a loan has responsibility if it goes wrong afterwards. This Copybook Heading principle of traditional banking was flouted by the securitization market, in which loan originators were able to escape responsibility for poor credit decisions. The result was an orgy of poor housing lending, involving not simply poor credit decisions but outright fraud, connived in by loan originators who collected their fees and passed the fraudulent paper on to Wall Street and international investors. In this disaster, Wall Street was self-deluded, drunk with excessive money supply. The real crooks were the mortgage brokers, mostly a bunch of used-car salesmen who had never been closer to Wall Street than a day trip to the Statue of Liberty. The securitization market will only survive under careful limitations which ensure that, at least to some degree, this God is obeyed.
Don't take risks that you don't understand. Flouted openly in most bubbles, this God was drugged during this one by perverted science, the "Value–at-Risk" risk management technique, which controlled risk just fine provided that the markets involved were not in fact risky. In Wall Street's defense, the proof that VAR was a load of codswallop required fairly sophisticated mathematics and so was available to only a few noisy skeptics like myself and Benoit Mandelbrot, whose previous invention, fractal geometry, was unknown to the intellectually uncurious workaholics of Wall Street.
The maximum safe leverage is 10 to 1 for banks and 15 to 1 for brokers dealing in liquid instruments. Not only was this Copybook Heading flouted, its flouting was made worse by two insidious techniques. First, banks pushed assets off their balance sheet by use of "structured investment vehicles" funded by commercial paper. Second, brokers started buying illiquid assets such as real estate and private equity participations, which had been at most a modest part of their balance sheets traditionally. This God's revenge is traditionally very costly, and is proving so again.
Investments should be recorded in the books at the lower of cost or market value until they are sold. This time around the accounting profession adopted "mark to market" accounting which allowed investments to be "marked up" on rises in value, with mark-up earnings reported and bonuses paid even when the investments had not been sold. Wall Street is now bleating about "mark-to-market" because it requires mark-downs of investments that have fallen in value. The real reason why it should be dropped is its enabling of spurious mark-ups, of which the Street took full advantage. Mark-to-market is highly pro-cyclical and provides counterproductive incentives to fallible and greedy bankers. This Copybook Heading God is rather young and junior. It is not yet clear how severe his revenge will be.
As well as the above Gods whose revenge has already become partly or fully apparent, recent events have flouted further Copybook Headings and will also in due course produce appropriate retribution:
Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people. It is not clear whether Treasury Secretary Andrew Mellon was acting merely as the mouthpiece of the Copybook Heading Gods when he made this pronouncement in December 1929, or whether he then or subsequently became such a God through apotheosis. In any case, Presidents Herbert Hoover and Franklin Roosevelt ignoring this advice in 1929-41 gave us the Great Depression, and ignoring it in the 1990s gave Japan its 13-year downturn. With the $700 billion bailout plan we have ignored it again. We are devoting newly scarce capital to the most unproductive possible use, propping up the price of dead assets. In an era of capital scarcity, the bailout will undoubtedly prolong and deepen the recession. Mellon, a kindly man, would probably not wish this fate upon us, but maybe as a God he has a duty to enforce the Copybook Headings strictly.
Allow capital to flow to its most productive uses. This Heading is always flouted during bubbles, when capital is allocated to innumerable unproductive dot-coms or ugly undesirable McMansions. However it can also be flouted during downturns, when the government rescues failing industries, devoting capital to the dying and unproductive. Examples of this abound, notably in Britain in the 1960s and 1970s and in France in the 1980s and 1990s. In this case there is not just the $700 billion debt bailout, but the $200 billion rescue of Fannie Mae and Freddie Mac, the $50 billion rescue of the automobile industry and the clearly impending bailouts of various states and municipalities to be considered. In downturns, capital is scarce, insufficient to fund all the good investments available. Hence flouting this Copybook Heading during a downturn produces a much nastier revenge by its God, killing off far more new and productive investments than it would in a boom and slowing long-term economic growth to a crawl.
Keep the fiscal deficit to a level that prevents the public debt/GDP ratio from rising. This, originally propounded by Gordon Brown, when UK Chancellor of the Exchequer, is the wimpiest possible version of the Copybook Heading warning against budget deficits. It is true that stricter versions of the Heading can be relaxed if we are using a fiat money, since monetary policy can accommodate moderate deficits more easily than a Gold Standard. However the above is the bare minimum, which the United States is about to flout, both in the short term through $1 trillion deficits from recession and bailouts and in the long term through the actuarial problems in Social Security and Medicare. The revenge of this God is exquisitely cruel. He turns the country into Argentina.
We can speculate why the last decade has seen such a record level of Copybook Heading flouting. Maybe the Baby Boom generation, who have been in charge, were affected so badly by the permissive theories of Dr. Spock and the "flower-power" 1960s that they have an excessive tendency to reject conventional wisdom in the form of the Copybook Headings. In any case, market behavior in the last year is pretty good evidence that the Gods are not happy.
Kipling's poem concludes with a dark warning that mankind is destined to recycle his follies, once the relearned lessons of the day are forgotten:
As it will be in the future, it was at the birth of Man
There are only four things certain since Social Progress began.
That the Dog returns to his Vomit and the Sow returns to her Mire,
And the burnt Fool's bandaged finger goes wabbling back to the Fire;
And that after this is accomplished, and the brave new world begins
When all men are paid for existing and no man must pay for his sins,
As surely as Water will wet us, as surely as Fire will burn,
The Gods of the Copybook Headings with terror and slaughter return!
Hutchinson's column last week, "Creating a Great Depression," is worth reading as well.
JIM ROGERS INTERVIEWED ON COMMODITIES, LATEST WALL STREET SHENANIGANS
There is no question that commodity prices have cooled off, but that is the way the market works.
Jim Rogers was recently interviewed by Indian newspaper NDTV.
Rogers correctly foresaw the coming bull market in commodities in the late 1990s, creating the broad-based Rogers International Commodity Index in 1998. He was also very bearish, again correctly, about the U.S. economy and financial sector well before the severe declines of this year. In August he reiterated that the average American has no idea just how bad this financial crisis is going to get: "The next shock is going to be bigger and bigger, still. The shocks keep getting bigger because we keep propping things up ... [and] bailing everyone out."
And now? He thinks commodities are going through one of their typical cyclical retracements in the context of a still intact long-term bull market. He notes that 50% declines in commodities prices are "normal." For example, Rogers notes, three times in the last nine years, oil prices have gone down by 50%. And gold fell from $200 to $100 from 1974 to 1976 before rocketing over $800. "If it goes down 50% [again]," he says, "I hope I am smart enough to buy a lot more."
Jim Rogers: There is no question that commodity prices have cooled off, but that is the way the market works. You always have consolidation and correction. Three times in the last nine years, oil prices have gone down by 50%, and each time it was not the end of the bull market. If suddenly someone discovers huge oil reserves then the bull market is still on.
NDTV: But how long the bear market in the current commodity space will continue?
In the 1970s, gold went down 50%, but after two years it turned around and went up 850%. So I don't know how long this correction is going to last. If the worldwide economic problem continues for a while then it can last for a longer period.
But everybody is talking about global slowdown, so if there is no demand then how will commodity price rise?
They will have a consolidation but if you are suggesting the world in a perpetual economic decline, then we will never have any bull market.
Regarding the bailout of mortgage giants Freddie Mac and Fannie Mae, you vocally criticized and said that "U.S. is bigger communist than China."
I would call it "pure socialism." It is welfare or socialism for the rich. It is absurd! The U.S. national debt is $5 trillion but within a week the government doubled the national debt. On September 30, the total U.S. federal debt passed the $10 trillion mark, which I and my children will pay off. It is bad for the U.S. economy, dollar and inflation. The government is bailing out the Wall Street, which is not for me but for a few guys at troubled banks.
What if somebody does not bail out troubled banks as the exposure is not just limited to U.S. financials but it is across the world?
We have had banks going bankrupt for so many years. You think the world will come to an end just because banks go bankrupt, it will not. There maybe disruptions for a while but it is not the end of the world.
Will you buy when there is blood on the street?
If the U.S. and other world stock markets did have a selling climate then I would go for it.
But what will you buy in terms of equity asset class?
Well, it depends on what goes down the most. I would probably buy stocks of airlines, water treatment, agriculture, and other recession-proof companies. The way you are going to get rich in the stock market is defined by the companies that come through hard times with good results. Those are the companies when you have next bull market that you make a fortune.
Are you saying that decoupling would work?
When the largest economy in the world gets into trouble then it would also affect anyone associated with it. If you are doing business with the largest U.S. retailer Wal-Mart then you may suffer during this phase of slowdown. But if you are involved in the water treatment business in India or China, then you do not have to worry about. It is because the business has nothing to do with the U.S. If you are involved in agriculture business in Asia then who cares about America.
In India what excites you the most? As an investment story what will convince you to come and perhaps endorse India for the future? Also what worries you in terms of economic policies?
I always tell people that there is no country in the world that has the breadth and depth of culture like India. The Indian government said that inflation is caused because of commodity trade, which I think is quite absurd. India should be the greatest agriculture nation in the world, not the America. If I wanted to buy shares in India then I just could not go to a broker and open an account. India has got some insane regulations which prevent India from an open and free economy.
What will tempt you Jim to come in and buy India story despite all those problems?
If I can find shares that I can trade freely and equally then probably I have to be outside of India. I am very bullish on tourism, agriculture and water treatment sectors. These are spectacular parts of Indian economy that despite the government could have a great future.
You partnered with the legendary George Soros to co-found the Quantum Fund in 1970. Over the next 10 years, the fund gained 4,200%. In the same period, the S&P returned 47%. So what did you do?
I performed like an ordinary investor. I worked very hard and did enormous research to find out sectors that are going to do best. Then I invested a lot of money into those sectors. I used a lot of leverage and it worked.
If you believe that commodity and equities work in opposite directions then will it not make more sense to buy directly into commodities rather than buying commodity stocks?
Over the past many decades commodities and stocks have gone in separate ways. If you can balance your portfolio then one of the best things you can use is commodities. If you are a good stock picker then you are much better off buying commodity stocks than commodities. Natural gas prices may triple but if you find the right natural gas stock, then you can make 10-15 times of your money.
It has been a pleasure to talk to you!
Thanks a lot!
Here are summaries of some other recent interviews, talks, or other public pronouncements by Rogers which we overlooked when they came out.
In this Bloomberg TV interview with Rogers in mid-September when it came out. He comments on the then-recent bailouts of Fannie and Freddie, saying "I don't know why (ex-Fannie Mae CEO) Franklin Raines is not in jail."
On oil, he said it could fall 50%, to $75, but "the bull market will not end until somebody finds a lot of oil, or unless we have worldwide economic collapse, perpetual economic collapse." Rogers also, modestly, asserted that he was "the world's worst market timer, the world's worst short-term trader," when the interviewer tried to pin him down on a shorter term call on oil. He concluded on the subject: "I will tell you I've not sold any oil. Even if it goes to 75, I don't plan to sell any oil. I plan to continue to invest in things that I think are cheap, including commodities and hopefully selling short things that I think are too expensive."
Rogers concluded by saying he was long airlines (presumably non-U.S.) and short long-term Treasuries.
In early September, Rogers pronouced himself very bullish on Taiwan: "Taiwan has the world's third-largest stash of foreign exchange reserves... and holds some of the world's most competitive technology companies. Not to mention a 25% household savings rate. Taiwan is also perfectly placed to profit from China's rise to world superpower status.
"The Taiwan stock market is the worst performing stock market in Asia over the last 20 years. (He must mean Asia ex-Japan.) It's down 40% from 1990 levels."A Taiwan market ETF (EWT) is the easiest way to gain exposure there.
A longer talk on Rogers's bull case for commodities is here. He claims he never sold any of his China stocks here.
Finally, in this very interesting interview in August, Rogers discusses the decline and fall of world financial superpowers, Ben Bernanke's role in greasing the skids of the decline, exchange controls, and related subjects.
RUSSIAN STOCKS: FROM BOOM TO BUST
So much for “decoupling”: The emerging market “airbag” fails to open.
The people at Elliott Wave International accurately made the call that the Russian stock market was topping last December. Good timing. Since the end of last year, the Market Vector Russia ETF Trust (RSX) labored its way about 15% higher into May and is now down about 68% (and about 72% from its absolute peak). Russian's huge foreign currency reserves and alleged independence from the rest of the world proved to be of no help in preventing or stemming the fall. Surely the Russian finance minister tempted the gods when he boasted in January that the country would "play the role of an airbag" and serve as "a haven of stability."
In the last month, Russia (a.k.a. "the Lungs of Europe") has come down with an acute case of financial pneumonia. Every effort to clear the airways -- from NINE shut downs of the Russian Trading System Index (RTSI) to $150 billion in cash infusions -- has been for naught. Moscow's main bourse continues to choke, culminating in the code blue event of "Black Monday" (October 6).
The RTSI plummeted 19.1%, sending the market to a three-year low in its steepest one-day drop EVER. "The mood is kind of disbelief, " observed one popular news site. "Traders are just sitting there staring at the screens and going 'wow'." (AP)
Not that we blame them. After all, at the start of 2008, Russia was widely hailed as the picture of lasting health, an emerging superpower whose ability to "decouple" from Wall Street secured it "immunity" from the economic contagion spreading across the West.
In a memorable speech at the World Economic Forum in late January, Russia's finance minister boasted of his nation's ability to "buffer against" a U.S. downturn. In his own words: Russia will "play the role of an airbag. I believe [we] will soon be the focus of attention as a haven of stability."
It goes without saying, said "airbag" never opened. Its failure to do so, however, was hardly a surprise to Elliott Wave International's long-time subscribers. ...
While the mainstream experts saw Russia being insulated from the global rout, our analysts saw the nation being included in it. In the collision course with bear market forces, we warned: Russia would not be there to cushion the blow.
Almost a year ago, in the December 2007 Global Market Perspective, EWI's own Alan Hall presented a special, two-part study on Russia that suggested a major stock market top was imminent. Alan presented the following price chart of the RTSI since its inception (Some labels have been removed for this publication) and wrote:
"Our Elliott Wave count shows a clear five-wave advance that began in 1999 is near completion. The index should soon begin its biggest bear market since the pattern began. The minimum probable drop -- a move into the area of the fourth wave of 2004 -- would more than halve the value of the index."
The 67% plunge in shares since then stands as one of the most powerful testaments to the accuracy of Elliott Wave analysis.
From the United States to the B-R-I-C economies (Brazil, Russia, India, and China) -- this is, and always has been, a GLOBAL story.
REAL PRICE OF GOLD SOARS
Deflation is here and now, the only question now is how long it lasts.
Mike "Mish" Shedlock notes that while gold is essentially holding its own versus cash it is soaring compared to everything else -- because everything else is tanking. The bottom line, he concludes, is that gold is money, we are in a deflation, and prices of things falling versus money falling is consisent with deflation.
Technically, deflation is a contraction in money and credit (inflation is the opposite, an expansion). It is not falling prices (increasing in an inflation) per se as is almost universally reported. Nevertheless, prices falling virtually across the board is of course what one would expect to happen during a systemic deflation. It is happening. The question now, is for how long?
Gold in "Real" terms is soaring. "Real" in this case means how much an ounce of gold will buy. Let us compare gold to a commodities, to silver and to the stock market, starting with a basket of commodities as measured by $CRB commodities index. Charts are as of 2008-10-06.
The world economy is rapidly slowing. There is a recession in the U.S., UK, Australia, Japan, Spain, Ireland, New Zealand, France, and there is manufacturing contraction in China. With that backdrop, one should expect the price of commodities to drop. And drop they have as shown by the above chart.
For the time being, forget about China. There is simply no way growth in China can make up for falling demand virtually everywhere else in the world. U.S. and the Western World is the dog, China remains the tail. That may change in the future, but it is important to concentrate on the present.
I expect the global slowdown to be far bigger than most expect, potentially wiping out all commodity price gains back to the beginning of 2004 if not further. A drop in the $CRB to the 200 EMA would do just that.
Now let us see how gold is holding up vs. commodities. Gold buys a bigger basket of commodities now than any other point on the chart.
Fundamentally, silver is more of an industrial commodity than it is a currency. It is not holding up as well as gold in recent selloffs. [See chart.] There is a very real possibility that silver falls back to the 2004 high around $8. Those who pay attention to moving averages will note that $8 happens to be the 200 EMA as well.
In contrast, gold has almost no industrial use worth mentioning. The demand for gold is the same as it has been throughout history, as money. With that in mind, let's compare gold to silver. One of the ongoing debates was how well silver would hold up in deflation relative to gold. I think we now have our answer, and it does not look pretty. [See chart.]
In the wake of the dot-com bubble, banks were in bad shape because they made poor lending decisions to busted companies and also to countries like Argentina. To reflate banks, Greenspan slashed rates to 1% fueling a global liquidity boom that lasted 5 years.
The housing boom ended in 2005, but the party in commercial real estate, commodities, and various carry trades continued on for two full years when the pool of greater fools finally ran out. Since August of 2007 the world has been in a massive deleveraging mode.
The S&P 500 made a marginal new top in 2007 [see chart], but the reality is the secular bear market that started in 2000 is still ongoing. In real terms, (either compared to gold or the CPI) the S&P 500 came nowhere close to making a new high. ...
Greenspan did not defeat deflation in 2003 as is widely believed. Instead, he fueled the biggest credit boom in history, sowing seeds of the biggest deflationary bust since the great depression.
It took a while but the "D-Word" is back in the news after a long hiatus. Bloomberg is reporting Deflation Threat Returns as Asset Markets Decline:
As Federal Reserve Chairman Ben S. Bernanke and his global colleagues fight the worst financial crisis since the 1930s, one danger is looming larger by the day: deflation.
The deflation scenario might go like this: Banks worldwide, stung by $588 billion in writedowns related to toxic assets -- especially mortgage-related securities -- will further reduce the flow of credit, strangling growth. That will push house prices lower, forcing additional losses and making banks even more reluctant to lend. As the credit crisis worsens, businesses will find it almost impossible to raise prices.
Prices are already falling in parts of the world economy. Home values dropped more than 10 percent in the U.K. and in the U.S. in the past year. Oil, copper and corn drove commodities toward their biggest weekly decline since at least 1956 on October 3, with the Reuters/Jefferies CRB Index of 19 raw materials tumbling 10.4%. The Baltic Dry Index, a measure of commodity shipping costs, has dropped 75% since May.
Prices manufacturers paid for materials last month plunged the most since at least 1948, with the Institute for Supply Management's index dropping 23.5 points to 53.5 points.
Deflation may be back in the news, but the context is still incorrect. Falling prices are only a symptom of deflation, and not even a mandatory one. Deflation properly defined is a net reduction in money supply and credit, so let us take a look at at base money supply, courtesy of the St. Louis Fed.
The above chart shows the Fed went on a recent printing spree. However, that printing spree is dwarfed by the decline in the value of credit marked to market on the books of banks and brokerages. Unfortunately I cannot prove a decline in marked to market credit because the SEC has suspended mark to market rules.
However, one can judge by actions, and the Fed in particular, and global central banks in general are in easily verifiable panic mode over the ongoing credit crunch.
Nearly Everything Consistent With Deflation
Commodities are sinking, the dollar is strengthening, the stock market is getting crucified, treasuries are rallying, jobs have contracted for 9 straight months with no end in sight, banks do not trust each other, consumer spending is declining, foreclosures are soaring, the TED Spread (3 month Treasury vs. 3 month LIBOR) is at an all time high, and the Fed Funds Rate fell at the fastest rate in history.
That list does not prove deflation, but it is consistent with what one would expect in deflation.
Given that gold is money, and money should do well in deflation, one would expect the purchasing power of gold to rise. The above charts show exactly that. Gold, especially in real terms is soaring.
So why have the miners gotten pounded? Hindsight may be 20-20 (or not) but here are a few possible explanations.
Mining stocks are leveraged compared to gold and a massive unwinding of that leverage is taking place, especially by hedge funds. There are now ongoing funding questions for some of the miners and explorers. There has been indiscriminate selling of virtually everything.
For more on how treasuries and gold should act in deflation, please see Treasuries and Gold Rise as Global Credit Freeze Prompts More Bailouts.
Those believing in stagflation, hyperinflation, or some sort of 70's rerun can now kiss those theories goodbye. Deflation is here and now, the only question now is how long it lasts.
Shedlock as usual had so many good postings on his blog this week that it is hard to know which ones to recommend most highly. Here are a couple:
KEVIN KERR ON COPPER AND CORN
We last posted a Kevin Kerr-related piece in June. It was then near the height of the oil price runup, and he was predicting that food prices were bound to go much much higher as they reflected the cost of the embedded energy inputs of the U.S. food production process.
Times can change quickly. Oil, grains, and commodities in general have fallen by over 1/3 since their peak this year. So what is Kerr's -- a consumate trader's -- perspective now? This interview amounts to a stream-of-conciousness broad view of the commodities markets, with a focus on copper and corn. Like many, e.g., Jim Rogers, he thinks we seeing a sharp correction within an overall long-term bull market. He believes silver and base metals will "recover faster than gold" -- consistent with a quick end to the current deflation, although Kerr does not appear to think in such abstract terms. The key driver for all the commodities markets is energy, Kerr maintains.
Dave Nadig, assistant editor, HardAssetsInvestor.com: Kevin Kerr is one of the most recognized traders in U.S. commodities. He is the Editor of the Global Commodities Alert, available at www.kerralert.com, and he is a frequent television commentator on commodities trading. Kevin is going to join us each week to take a quick survey of the commodity investing landscape from a trader's perspective. Welcome, Kevin.
Kevin Kerr, KerrAlert.com: Well, good to be here, thank you.
Nadig: So Kevin, I have to tell you: I was reading the papers and checking my wire, and what the heck is going on with copper? As far as I can figure out, this is about the most dismal time to be in base metals in recent memory.
Kerr: Yeah, we have really seen a big pullback in all the base metals. All the things that have surged over the last few years have really pulled back with this global slowdown, and I think it is unprecedented in this pullback. So we have to really take a deep breath and try to figure out where we go from here.
But how real is it? Certainly we have seen a lot of headlines and a lot of analysts talking about the end market demand just going away, like China never happened and nobody is ever going to build a house again or put in any plumbing. How real is the demand and how much of this is really just market panic?
No, I totally disagree with that analogy. I think that the demand is still there. What we are seeing is a liquidation of a lot of the assets of these funds that have climbed into commodities. They have quickly had to withdraw their cash and will probably come back just as quickly. So I really would not get too bearish on a lot of the fundamental commodities.
Oil, the base metals, the grains ... a lot of these commodities we will probably see recover fairly quickly. I really just do not buy into the whole idea that this was a bubble; that this is the end. I think it is actually just a fraction that was probably overdue and there are actually some good buying opportunities now.
So if this is funds [causing the downturn], I assume you are really talking about hedge fund players more than anything here, right?
We are, yeah, of course. A lot of these funds have been pressured to take their cash off the table, rein in the spending, and kind of reassess. When they reassess I think they will see that the value of a lot of the commodities that they bought is still there and probably even cheaper now. So we probably will see that money come back in within the next 6 to 12 months, no doubt about that.
So let's spin a tale: I am a hedge fund manager, I have been playing copper really heavily. Maybe I rode it up perfectly until the peaks earlier this year, and now I am capitulating and I am pushing these assets back out into the market. Would we expect to see that really show up in things like the LME [London Metals Exchange] stocks levels, or is this just going to be the kind of thing that we see mostly in the futures markets?
I think in the physical market you will not see it as much. I think you will definitely see it in the futures markets. You are seeing the pressure already across the board in aluminum and copper and everything, and you will continue to see that until those margins are covered. The bottom line is a lot of these buyers will come back in when those base metals bottom out. I think we are getting close to that. I think it may have further to go. The fear of an industrial slowdown is affecting everything from silver to copper and everything in between. But at some point you will see value buying come back in. Like I say, it is probably about six months out.
You opened the door here; you mentioned silver. So if we move away from some of these base metals towards gold, in this kind of panic, should we expect gold to just keep piling on or do you see that as being played out too?
Yeah, I do actually. Gold is really having a strong time right now. It has been very volatile. Basically gold is now an inflation play, and silver has become an industrial play. We have to be really careful as investors to get too overanxious about gold. Longer term I think gold will do just fine, but I think as the dollar strengthens we will see gold weaken for probably the next couple years, and so this is not an area I would be involved in. I would see silver or the base metals probably recovering faster than gold. But right now, it looks like the gold bulls have the market.
That is a pretty bold call that gold is perhaps headed for a relative decline over the next couple years. When I hear that, and I am not world's smartest gold bug, to me that makes it sound like well, OK, if gold is going to be going down then that means other stuff is going up, right? That implies that we see increased investment in the stock market, all the things that people invest in gold to get the counter correlation for would be going the other way.
That would be the inclination. Nothing is at all relative to how it used to be. We used to say if the dollar was going higher, gold would go lower. We had never compared sugar to crude, but now we have to do that. So the markets have really changed. I do not want to discount gold too much. On the other hand, I will say that gold has had an incredible run and is probably correcting now off its high.
OK, that makes sense. What is your take on the near-term volatility issue? We have talked about some of these funds getting out of copper and perhaps just getting out of the commodities game, getting out of anything that touches the CRB [Index] for a while while they try to figure out how many of their assets are actually walking out the door versus whether or not they are going to be pulling any new assets. Do you think that we are heading for a time of perhaps lower volatility as those players actually exit the market?
No, I think we are heading for a time of higher volatility and actually the CRB index and these markets will do very well. Higher volatility of course for options traders is going be very successful. It is really not a time for the average investor to take higher risk. It is really a time to be more conservative but to look for opportunity when it presents itself.
So you mentioned the difference between, say, an industrial investor who has been watching the commodities boom versus perhaps a sophisticated options trader who might have some real interesting opportunities with this kind of volatility. But if I am just an average industrial investor and my exposure to commodities has been primarily through exchange-traded funds, what am I going to be looking for here? What do we see these indexes doing as we go through this period of shifting the players?
Well, I think there is going to be a real consolidation. You have a lot of investors who probably were unfamiliar with these markets, not comfortable with the volatility, who have been in these ETFs and who now have withdrawn their money. The bottom line is, we are going to see some volatility going forward in those indexes. Having said that, there is a real value to these indexes and to the commodities that underlie them, so I think you will see those investors come back in gradually this time, not as aggressively but gradually. There will be value there for the rest who trade these markets
Let's just stick with the base metals stuff for another minute or two. If we think that these base metals are losing some of their speculative players, at least for a while, and the price is going to return to some more basic supply-demand kind of numbers, to me that suggests that the impact of energy becomes even more important. We know for a fact that, for example, in China, the energy situation has really impacted the aluminum market there because aluminum is such an energy-intensive commodity to refine and to get out into the industrial uses. With the apparent continued decline in energy prices from where they were just a short time ago, does that imply that aluminum will stay down as well?
Well, bottom line is energy is the key factor in all of the commodities prices, whether it is agricultural, metals, etc. No matter what, it has impacted every commodity that is out there. If we do not get energy right, then all of these commodities are going much higher. So I think right now we have a little respite; we have a respite in the economy where we can say OK, now we have a chance, the last chance quite frankly, to get energy right, and if we do then maybe many of these commodities will reduce in price.
Unfortunately I do not believe that is the case, I think we will get energy wrong and these commodity prices will continue higher. Gold mining, silver mining, aluminum manufacturing, everything is dependent on energy, so if you do not get that right, if we do not get it cheaper worldwide, then we are going to see higher commodity prices within the next decade, there is no doubt.
Let's talk about the impact on the agricultural side because certainly if we are looking at things like the U.S. corn market, energy has an interesting bilateral arrangement with corn because corn is not only heavily reliant on energy just like every agricultural commodity -- just shipping it, moving fertilizer around, the energy it takes to actually farm the stuff -- but it is also an energy input now through ethanol. We have seen some analysts talking about a long-term slowdown in ethanol demand. What do you think?
Well, let's break it down. First of all, agricultural is highly dependent on energy. Most of the farm equipment runs on diesel fuel, and farmers cannot run their equipment on anything else. The bottom line is, with ethanol and corn-based ethanol, it has been a big boom for farmers, but that is coming to the end of the line. McCain and Obama, both Administrations have said, no matter who gets elected they are against corn-based ethanol. I think that gravy train in the grain markets for corn is coming to an end. Now corn at $6, $7, $8 a bushel is much different than at $4 and $5 a bushel where we are now. Farmers who are getting paid in advance for their corn crop, I think those days are over, and also we are already seeing ethanol plants fold all over the country. So my belief is that we will move into more of a biofuel-based country with additional alternative energy, whether it is solar, nuclear or whatever. But I just believe that corn-based ethanol play is probably coming to an end.
I have a hard time putting my head around that because we know that about a third of the U.S. crop is going to ethanol. We know that the basic mix is probably not going to change. Nobody is introducing legislation to make the default mix 2% ethanol instead of 10% ethanol, and there are still some states rolling out their full ethanol infrastructure. While I understand we may not be heading toward a world where every car is running E85 mixtures that are more ethanol than gas, how can we say that it is over? Do we really think that there is a backlash coming to the extent where there is literally less ethanol being produced every year, or is this just the end of the growth curve?
I will not argue with you, but I will say how many states actually rely on E85? I grew up in Minnesota. It is one of the few states that has E85 gas stations in it, and the people that have those gas stations in their town, how many of them actually use it? There are very few, so we have never really seen E85 actually take hold and pick up, and even with the ethanol plants that are supposedly going to be coming along, they have been privatized now and the corn costs have become so high that I believe it is just not sustainable. It is not that it is not viable, that it could not be usable. At these prices it is not functional for any part of the country. You can not transport ethanol very easily, so for nationwide oil use or energy use it i’s not very practical.
So would you imagine that as we head into -- we are way ahead of actually seeing these numbers -- but as we start looking towards next year's planting numbers, do you think we are going to see as big a turnaround and see fewer acres of corn planted, more soy beans planted, more wheat planted? Do you think we are really headed for reversal of that corn planting surge we saw the last couple years?
No, I do not want to get ahead of myself, because the subsidies are still there as you pointed out, and you make a very good point. The subsidies have not been removed yet, so of course farmers are going to plant what they are going to get paid for, and right now subsidies say plant corn. What I am worried about are the younger farmers who are planting corn on corn, who are not planting enough beans, who are not planting enough cotton, who are trying to plant corn in the Southern states, it is just not a very prudent thing. But I completely agree with you, as long as the subsidies stay in place, we will see more corn planted. Whether it comes to harvest is another question, but I think the ultimate beneficiary for traders will be the soy bean market, because I think we will see less bean acres planted.
Well maybe we can hit that another time. I think we have run out of our time for today. Kevin, I wanted to thank you for joining us here today.
CLOSED-END FUNDS DIVE IN DOWN MARKETS
Closed-end funds have become a virtual anachronism with the advent of ETFs. Unlike the far more popular open-ended mutual funds and ETFs, CEFs are closed to new capital once their offering is completed (save for an occasional secondary offering). Post-IPO their shares trade freely like shares of stock; an investor liquidates his or her position by selling the fund shares on the open market rather than directly redeeming them (or indirectly as with an ETF). With the number of closed-end fund shares fixed, there is no riskless arbitrage mechanism to keep pricing in line with net asset values, and CEF share prices can sell at either a premium or -- more usually -- a discount to NAV.
Buying a CEF on its IPO is a virtually guaranteed sucker's game. Once the syndicate managing the offering takes out its fees, the investors are left with shares whose value can be calculated with great certainty to be worth less than the offering price paid. It is the equivalent of telling your broker to buy 100 shares of IBM and paying him a commission of 7% of the value of the transaction. Inevitably the share price converges to the fund's net asset value, and then falls to a discount. Besides broker hucksterism, the main reason people buy CEF offerings is that the fund is catering to a recently hot area of the market.
However, even if born in sin, closed-end funds can offer opportunities during the post-IPO phase of their lifecycle. If the discount to net asset value gets large enough, for example, you can bet on the discount narrowing. Of course the risk is that over the period the discount narrows the NAV itself is falling. So you might look for funds run by good managers who do not charge an exorbitant management fee where the portfolio itself is generally comprised of quality cheap securities -- the same criteria you would seek when buying a non-index open-ended fund or ETF.
CEF discounts to NAV tend to run in cycles. Usually, but not always, the discounts widen during periods of pessimism and narrow during times of optimism. Currently the discounts are running high. As shown in this chart the median CEF discount to NAV is over 12%, implying over half are selling at greater than 12% discounts. Time to buy? A commenter to this article points to a couple of CEFs which sell at 15% discounts and are scheduled to terminate in 15 months, which means they will liquidate at NAV at that time. Meanwhile their expected yield from dividends and from selling covered call options is 10%, so the market would have to fall another 25% from here for you to lose money. Seems unlikely, even to chronic pessimists like us, but it certainly cannot be ruled out.
Here Roger Nusbaum, who is mostly an ETF man but who dabbles in CEFs, spends a lot of time warning readers that just because the discounts are big does not mean they cannot get bigger. This is not saying much, but these are extraordinary times.
A byproduct of the financial crisis, as has been the case in past crises, is that closed-end funds come unglued. This has happened before, is happening now and, more importantly, will happen again.
The reason for this is the structure of the product. They have a fixed number of shares (save for the occasional secondary offering) and so the market price can deviate from the net asset value of the fund. This creates a discount or premium to the net asset value.
The strategy of buying a closed-end fund that has a wider discount than normal and selling it when the discount narrows or even swings to a premium is somewhat popular and valid, although it is not easy.
Then there are times, like now, where things move violently out of sorts. Below are charts of the discount history of three not-so-randomly chosen closed-end funds. (The indicated charts were not provided. But closed end fund discounts to NAV have gone way up lately. See, e.g., the chart linked to above.) They all show a similar cliff dive very recently. They are not so randomly chosen, because earlier this week, Jeff Saut recommended them to clients at Raymond James.
The funds are BlackRock Strategic Dividend (BDT), BlackRock Enhanced Dividend Achievers(BDJ) and Eaton Vance Tax-Advantaged Global Dividend Income (ETG). According to Saut, all three have blue-chip portfolios and they pay generous dividends.
Many closed-end funds have blue-chip portfolios and pay generous dividends. The point is not to pick on Saut or the funds he chose but instead to create a better understanding of how the product works. During times of unusual uncertainty or panic, it makes sense to expect closed-end funds to react very negatively.
A big reason for this is that they are an easy source of funds when the market is going down, and the psychology of fear in a downturn often causes an over-reaction on the part of the market. As a result, the market prices lose value faster than the NAV.
In the last couple of months, I have had quite a few emails and comments on my blog asking why some funds are down a lot more than others. In all of these questions, there was a lack of differentiation between closed-end funds and exchange-traded funds. ETFs do not have an issue with prolonged deviations between market price and net asset value.
When demand for an ETF increases, more shares are created, and when demand decreases, shares can be taken back in. In addition to the mechanics of ETFs, there are traders that arbitrage away small discounts and premiums when they occur. None of this pertains to closed-end funds.
This does not make closed-end funds a bad product. When the markets start to recover and act normally, it is a good bet that the discount on many funds will return to normal levels, which means at some point, CEFs become a good trade for more aggressive investors. The risk in going with Saut's picks now is not the management of the funds but whether the crisis is over.
Equity markets are down 32% so far this year and just about every fixed-income market is under some form of distress. From here, an additional 20% drop is unlikely, but if that is what happens, I would expect the market price of many closed-end equity funds to do worse.
Having the correct expectations is crucial to not making panicked decisions.
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