Wealth International, Limited (trustprofessionals.com) : Where There’s W.I.L., There’s A Way

W.I.L. Finance Digest :: July 2009, Part 2

This Week’s Entries :


Buy and hold is no more likely to be a good choice for the next 5 years than it was for the last 20.

The “buy and hold” mantra cum investment advice ship has been leaking for some time and has been entirely blown out of the water this past year. Various researchers have shown that “over the long term” stocks hardly do better than bonds despite the much higher volatility. Research cited below claims that even CDs beat out stocks; however, dividends are omitted from the calculation, thus the claim is not correct. Nevertheless, the experience in Japan the past 20 years – we are approaching the 20-year anniversary of the 1989 stock and property market peak – and the U.S. over the past 10 – we will soon hit the 10th anniversary of the dot-com mania peak – clearly throws doubt onto the buy and hold idea.

One can see some germ on integrity behind the buy and hold advice, and that is that investors do even worse when they try to time their entry and exit points. Buying at the top and then selling at the bottom is going to do even worse than just holding on through thick and thin. But are those two extremes the only alternatives?

“Mish” points out that selling when the Treasuries yield curve inverts, i.e., T-bill rates rise above those of T-bonds, and staying out until the NBER announces the official end of the recession would have avoided most of the damage from the two major stock market downdrafts this decade. “One would have exited the stock market in Summer of 2006 and would still be out,” he notes. Mish does not show how well the strategy worked, e.g., 1982-1999, when buy and hold would have worked well despite a couple of cyclical bear markets.

And why do investment advisors insist on regurgitating the buy and hold advice, in the face of mounting counterevidence? “I do not get paid anything if my clients are sitting in cash,” replied one advisor. A joke that used to make the rounds was that your stockbroker was like a shark; he had to keep moving or he would sink. The idea was that it was in his interest to keep your account churning, but not necessarily yours. In this day of miniscule commissions and wrap/asset management fees, we see the joke is still on us even as the players and script have changed.

In spite of what you hear from main stream media and self-serving advice from Wall Street, an investment philosophy of long term buy and hold is not what it is cracked up to be.

Unfortunately, many boomers headed into retirement are finding that out now, at the worst possible time. Moreover, looking ahead, I doubt the next decade is not going to be much better than the last.

Please consider the following analysis from my friend “TC”:
Recently a CalPERS spokesman was on CNBC talking about how they are “managing” through the market downturn and how over the long haul they feel confident they will hit their 8% annual target. Also consider The house that Jack built, a MarketWatch article in which [Vanguard Group founder Jack Bogle] reiterated his “buy and hold” investment recommendation.

Meanwhile in the same period my parents reiterated their successful and simple retirement strategy – CD laddering. This caused me to set out and look into greater detail about the market’s historical return, analyze buy and hold and see if an 8% annual market return target is even achievable.

My findings about the market from start to finish were of no surprise. The S&P 500 is down 32% over the past 12 months and down 31% over the past 10 years (-3.6%/year). However, it is the “long haul” where I have been promised and 8% annual return – and sure enough the returns did improve. The S&P 500 is up 100% (+4.7%/year) over the past 15 years, up 500% (+7.4%/year) over the past 25 years and up a staggering 5,313% (+6.9%/year) since inception in 1950.

Although the annual ROI amounts fell short of the 8% target, it seemed reasonable that CalPERS in its infinite “wisdom” could outperform near 60 year market return by 1.1 annual percentage points.

However, the problem with looking at these returns is that they bare no semblance to reality. CalPERS or an individual does not investment all their money on January 1, 1950 and then buy and hold. Rather individuals make regular contributions through their working years and dollar cost average into the market.

And according to CNBC’s clueless happy talker Dennis Kneale this is how individual investors can assure themselves they will not lose and will make a killing in the market.

Due to different holding periods, the next references will all be related to Internal Rate of Return (IRR).

True to Dennis’s hope over the past 12 months a strategy of dollar cost averaging into the market improves an individuals’ IRR to -8.7% (compared with -32.4%). However, for the next 6 time periods, dollar cost averaging into the market actually hampered performance. Additionally, one has to extend the time period to at least 20 years in order to even show a positive IRR!

For example the 3 year time period resulted in -17.1%/year (compared with -10.6%/year) and a 15 year period resulted in -0.6%/year (compared with +4.7%/year). Fortunately, when you extend out the window to 38 years or more, dollar cost averaging once again works in your favor. But how many investors have been systematically investing this long?

Keeping my parents in mind, you are probably wondering how someone did by simply investing in 6 month CDs. The answer is for any holding period of less than 25 years, a stock market investor who made regular and equal contributions has actually underperformed a CD investor! Yes, you read that right for time periods of 1-20 years a CD investor outperformed the stock market by 1.6 to 20.1 annual percentage points.

Additionally, if one extends the time window to 50 years (clearly “long term”) CDs again have outperformed the stock market by 0.3 annual percentage points. Even when one extends out the time period to the full 59+ years (the start of the S&P 500 index); the stock market has outperformed short-term CDs by a mere 0.2 annual percentage points – not much of an equity premium.

However, the problem with dollar cost averaging into the market is that over the long term is that uniform dollar cost averaging bares little semblance to reality. Individuals typically invest more each year as the value of their dollars fall due to inflation. In other words if they invested $10,000 annual today – they surely did not also invest $10,000 in 1980, rather they invested $4,000 (an inflation equivalent). To account for this, contribution limits on retirement accounts increase annually.

I reran the numbers using the annual 401k contribution limits for the weekly investment and the results surprised me.

Imagine you are 55 years old, investing for the past 25 years and looking to retire. Assuming you invested $250,000 (roughly the 401k maximum over the time period) you now have about $725,000 – not too bad right? Meanwhile “my parents” experienced none of the volatility and have just over $800,000. Which would you choose?

Now imagine you are in your early 40s and investing for the past 15 years. Assuming you invested $175,000 (roughly the 401k maximum over the time period) you now have less than $150,000 – a loss of nearly 18% over a 15 year horizon. Meanwhile, “my parents” experienced none of the volatility and have over $300,000 – nearly an 80% gain. It is going to be near impossible for today’s early 40s investor to overcome this 116% divergence. Even if the stock market doubles tomorrow “my parents” are still ahead of the average market investor.

Buy And Hold Vs. CD Laddering

To help show this disparity of an IRR of -1.3%/year vs. +3.9%/year over 15 years I included a chart of return per $10,000 invested. Looking at the above chart one should quickly realize they either need to be active investors or stick to simple, unsophisticated CD investing.
TC is ignoring dividends, and stock selection. Then again stock selection would imply some activity as sectors fall in and out of favor.

One simple, active strategy that would have avoided the stock market holocaust in both the recent recessions would be to get out of the market when the yield curve inverts and stay out until the NBER announces the recession has ended. ...

Using the above two charts one would have exited the stock Market in Spring of 2000 and reentered in November of 2001. One would have exited the stock market in Summer of 2006 and would still be out.

One could have improved returns by buying long dated treasuries after exiting the stock market. Of course one can improve upon the CD strategy by buying 6 months treasuries, switching to 10 year treasuries when the yield curve inverted and back after into 6 month treasuries when the yield curve gets sufficiently steep.

Regardless of what strategy one uses, it is a horrible idea to hold stocks throughout recessions.

Why Is Bad Advice So Common?

Clearly, stay the course is bad advice. So why is it so common? A personal anecdote might help explain things: In January of this year, an investment advisor from Wachovia Securities called me up and stated “Mish, I am sitting on millions because I see nothing I like.” I told the person I did not like much either and that Sitka Pacific was heavily in cash and or hedged. His response was “Well, I do not get paid anything if my clients are sitting in cash.”

I called up a rep at Merrill Lynch and he said the same thing, that reps for Merrill Lynch do not get paid if their clients are sitting in cash.

Massive Conflict of Interest

Notice the massive conflict of interest possibilities. Reps for various broker dealers have a vested interest in keeping clients 100% invested 100% of the time, even if they know it is wrong. And so it is every recession, bad advice permeates the airwaves and internet “Stay The Course.”

A Look Ahead

Clearly stocks are a better buy now than in 2007 or 2008. But that does not mean stocks are cheap. Indeed, by any realistic measure of earnings, stocks are decidedly not cheap. Then again, 6-month treasury yields are yielding a paltry 0.31%.

Can equities easily beat that? Yes they might, but that does not mean they will! Fundamentally, the S&P 500 can easily fall to 500 or below, a massive crash from this point. Alternatively, stocks might languish for years.

Please consider a chart of the Nikkei.

The Japanese Stock Market is about 25% of what it was close to 20 years ago! Yes, I know, the U.S. is not Japan, that deflation cannot happen here, etc., etc. Of course deflation did happen here, so the question now is how long it lasts. Even if it does not last long, there are no guarantees the stock market stages a significant recovery.

Buy and hold is no more likely to be a good choice for the next 5 years than it was for the last 20.


When Bernard Madoff admitted that his investment performance and the fund itself were “all just one big lie,” $65 billion worth of imagined assets evaporated. What if some key member of the U.S. government admitted the same thing about the ability of the U.S. federal government to pay its debt and keep its other financial commitments? Nobody knows, but it is a fair bet that the notional value of a lot of financial assets would decrease, perhaps to zero.

Yet, in their more sober moments most people will admit that government promises are so much hot air. Our situation is akin to the situation in which Wile E. Coyote found himself so often when trying to catch the ever elusive Road Runner: He would walk off a cliff into thin air, but as long as he was blissfully unaware of his status it would be as if he were still on solid ground. The laws of physics were superceded. Only when he became aware of the lack of earth under his feet – usually because the Road Runner drew the Coyote’s attention to the fact – did he go plunging to his doom. In cartoons protagonists routinely recover from such catastrophes virtually instantaneously. But when the lack of substance propping up the Ponzi Scheme that is government is revealed we suspect asset prices will plunge as if off a cliff, but the fall will be real-life fatal. The cartoon analogy will cease to hold.

Stewart Dougherty provides some details about the big lie.

On December 9, 2008, $65 billion of investor money was at peace. On the fear-greed seesaw that is said to characterize investor emotion, fear was down on the ground, while greed was high in the sky, having all the fun. Greed was earning a steady 1% per month, making fear look like an over-cautious fool.

On December 10, 2008, six simple syllables transformed that greed into lead, sending it crashing to earth while launching fear to the moon. The syllables were these: “It’s all just one big lie,” and they were spoken by Bernard Madoff. It was an admission that his investment fund was nothing but an illusion and a fraud. These syllables represented a savage truth that would wipe out the savings of thousands, and toll the bell for the rest of the world’s investing public.

Those six syllables possessed powers far beyond their size. They forced $65,000,000,000 to vanish back into the thin air from which they had materialized. Thin air has been busy these days, as you will see.

The fact that a mere six syllables could cause a multi-year, $65,000,000,000 fraud to implode is testament to the truth’s simplicity and power. The truth represents intellectual gravity, and sooner or later, all things fall into its arms, whether they want to or not. The truth does not need phalanxes of lobbyists, czars, public relations personnel, pundits, pontificators, propagandists, pollsters, or politicians to express itself. Rather, it represents magnetic north, toward which the human consciousness is naturally inclined. In the beginning of the revelation of a truth, only those with courage can see it; in the end, it is clear to everyone.

[Editorial note: In this article, we will express numbers in digits. The government, financial “services” industry, and television talking heads, to name a few, are currently bombarding society with the terms “billions” and “trillions.” The constant repetition of these terms has given people a false sense of familiarity with them, and made them appear “normal” and “everyday.” These colossal sums are anything but normal and everyday. They are monsters that are tearing apart our fiscal, financial and monetary systems. Those who casually throw around a trillion here and trillion there, such as the steady parade of CNBC commentators, try to act as if they understand the magnitude and implications of these sums, but they do not, because the sums are incomprehensible and their systemic consequences are totally unknowable and unpredictable. This is patently obvious given the extreme financial crisis afflicting our nation and the world. Also, only “two” of something, such as trillions, does not seem like very much to most, whereas the written expression of that same number, in this case $2,000,000,000,000, does.]

Compared to current fiscal, monetary, economic and financial reality in the United States, Madoff’s losses were modest, even quaint.

The United States’ fiscal year 2009 federal loss (euphemized for the masses by the term “deficit,” which sounds technical, econometric, and not nearly as bad as what it really is, a loss) will exceed $2,000,000,000,000, more than 30 times Madoff’s $65,000,000,000 loss. Keep in mind that it took Madoff a professional lifetime to lose that money. The United States will lose $2,000,000,000,000 in just one year, and according to official budget projections will continue losing hundreds of billions more, annually, for decades to come. (More on this in a minute.)

The cost of the government’s financial-crisis-related bailouts and guarantees currently exceeds $13,500,000,000,000, which is 200 times larger than the Madoff scandal. And the nation’s unfunded contingent liabilities, for programs such as Social Security, Medicare, Medicaid, government pensions and the like stand at $75,000,000,000,000, 1,150 times larger than Madoff’s fraud. They should let Madoff out of jail and put him in charge of the Treasury. Maybe America could get some relief.

Of course, these numbers make laughable the government’s righteous indignation and shocked disbelief that a “Ponzi scheme!” as “large” as Madoff’s could have operated in the United States. The government’s response is a textbook example of the intelligence industry’s attention-diverting technique known as misdirection.

In June, 2009, the Congressional Budget Office (CBO), a government entity, issued its “Long Term Budget Outlook” for the period 2010 through 2080. The executive summary begins with these words: “Under current law, the federal budget is on an unsustainable path – meaning that federal debt will continue to grow much faster than the economy over the long run.”

While that statement might seem stark, it is the verbal equivalent of morphine compared with the actual numbers in the CBO’s long-term budget projection, which are nothing short of terrifying.

According to the CBO, over the next 70 fiscal years, the federal government will NEVER have a surplus. Rather, the United States will continue to suffer massive, escalating, multi-hundred billion dollar losses (“deficits”) each and every year for the next SEVEN DECADES, which is when the budget projection stops. Under both CBO budget scenarios (catastrophic and worse-than-catastrophic), losses in fiscal year 2080 will be the largest of the entire 70 year series, meaning that the budget crisis will continue well beyond 2080. In the best case, the 2080 loss will be 17.8% of Gross Domestic Product (GDP); in the worst case, it will be 42.8% of GDP. To put this in context, the 2009 federal budget loss is projected to be 11.9%, in this, the worst financial crisis in American history. So 2080 will be 50% to 300% worse than now. Who the CBO thinks will fund these trillions of dollars’ worth of forever losses, it does not say. Apparently, America is headed back to the Stone Age, thanks to our profligate politicians and corrupt financial elite.

The United States has already reached the point where it is arithmetically impossible for it to pay its debts or keep its promises, unless it devalues its currency to the point where it impoverishes its citizens and creates international financial chaos. And even devaluation as a means of ending the country’s budget nightmare will be difficult, given that so many government programs have cost-of-living escalators, making inflation a “No Exit” horror story. This is not subjective opinion, but rather objective, arithmetic fact, now supported even by government agencies themselves, such as the CBO. As John Williams of shadowstats.com has observed, even if personal incomes were taxed at 100%, the United States still could not pay its bills.

Astonishingly, given this fiscal context, the government now proposes to effectively nationalize the nation’s health-care industry, with projected additional losses of $1,000,000,000,000, a number we can be 100% certain will prove to have been grossly understated. Additionally, it has created $13,500,000,000,000+, so far, to bail out Wall Street, at the direct expense of America’s citizens, adding to the nation’s debt misery and hopelessness.

All the while, government has looked on with apparent admiration, envy and awe as Goldman Sachs announced that despite America’s financial catastrophe and despite the fact that it gorged earlier this year at the feed trough of taxpayer bailout money, it will reward its staff with record bonuses in 2009, totaling some $20,000,000,000. It is taking the taxes paid by everyday people such as nurses, teachers, auto workers and fast food clerks, and stuffing its pockets with it. Of course, that is just the tip of the iceberg. The rest of Wall Street will lavish itself with taxpayer-funded bonuses, too.

Even more astonishingly, on June 26, 2009, in the midst of America’s employment and economic meltdown, Congress approved $108,000,000,000 in loan-guarantee funding for the International Monetary Fund (IMF), so the IMF can provide financial assistance to “poorer nations.” No citizens on earth are as indebted as Americans, given the nation’s $11,500,000,000,000 federal debt, and more than $85,000,000,000,000 of combined federal debt and unfunded contingent liabilities. So how the world’s most indebted nation proposes to provide assistance to “poorer” nations is a fiscal mystery, the solution to which is apparently known only to the spendthrifts in Washington. Unless, of course, the money were slated to return to the United States as “foreign aid,” but that is not the plan. What arrogance, callousness and conceit on the part of our government, to strap this added tax burden onto the backs of American citizens, who are already the most debt-enslaved people in the world.

The IMF funding is in ADDITION to the government’s June 26, 2009, $106,000,000,000 supplemental war appropriations bill, which was supposedly meant to pay for continuing military operations in Iraq and Afghanistan, but which includes U.S. taxpayer gifts of $660,000,000 for Gaza, $555,000,000 for Israel, $310,000,000 for Egypt, $300,000,000 for Jordan, $420,000,000 for Mexico, and $889,000,000 for the United Nations, for so-called “peacekeeping” missions. War is peace. Orwell must be laughing himself sick, six feet under.

Congress is in such massive denial about the fiscal and financial crisis it has already created that its spending orgy continues without restraint. In fact, the out-of-control spending is now so outrageous that one can seriously argue that Congress, the Treasury and the Federal Reserve (Fed) are deliberately trying to destroy the United States. Bob Chapman, a brilliant analyst and publisher of one of best newsletters in the world, has long argued that what is happening is part of a systematic plan to bring this country to its knees so a one-world government-for-profit, owned and operated by global power brokers can be implemented. His ideas deserve deep and thoughtful consideration, because his track record thus far has been nearly perfect.

The fact is that the United States is suffocating in what has become an airless House of Lies. Social Security is a promise that cannot be kept with anything even remotely resembling America’s current “money,” and is therefore a lie. Medicare and Medicaid are promises that cannot be kept, and are also lies. SSI benefits cannot be paid into the future, and are lies. The federal debt cannot be paid, and is a lie. Government pensions cannot be paid, and are lies. The prescription drug program is unaffordable, and is a lie. Food stamps and other forms of welfare are unaffordable, and are lies. And the list goes on and on.

Arnold Toynbee wrote, “An autopsy of history would show that all great nations commit suicide.” This is exactly what we are witnessing today in the United States: fiscal and economic suicide. As America’s “leadership” injects financial poison into the country’s veins, the citizens stand by and watch, having not a clue about what to do to stop the destruction. Today’s unavoidable reality is that tens of millions of American citizens are going to die financially before they die physically, thanks to government losses and crony payoffs that enrich and empower a small, shameless, greed-stricken minority at the expense of the entire nation. This latter point is amply demonstrated by Washington’s race to Wall Street’s defense via the recent bailouts, where trillions of taxpayer dollars were handed over to centimillionaires for nothing, while for the past 20 years, it stood by and did nothing as the lives of millions of American workers were turned upside down when they lost jobs that migrated overseas thanks to state-sponsored globalization, another moronic and disastrous market intervention.

Despite the CBO’s calm outline of the next seven decades’ worth of ceaseless, staggering American operating losses and surging debt, we are fast approaching endgame. One of the greatest prize fights in all of history is about to begin. In one corner of the ring will be a scrawny, sick-looking contender called The Lie, coached by Washington, D.C., and Wall Street. In the other corner will be a 250-pound, aerobically perfect, experienced fighter called The Truth, coached by the collective wisdom, experience and technique of Time. Once the fight starts, it will be over in a second. The same way Madoff’s fund was knocked out with one punch, once he put his Lie into the ring with The Truth.

Speaking once again of Madoff, as a citizen, you must ask yourself this: What if an official at the Fed or Treasury woke up one morning, seized by his or her conscience? What if this official could not continue to lie about America’s finances?

What if, in a moment of personal honesty and catharsis, that official repeated in public, say, at a Congressional hearing, those six simple syllables spoken by Madoff? What if someone in authority admitted that, “It’s all just one big lie”?

What would happen to the bond market? The stock market? The financial system? Your local bank? The Federal Reserve Note? It seems logical that all of these would all suffer, probably mightily. And the prices of gold and silver? Would they not go up, potentially by an order of magnitude, as millions scrambled for financial sanctuary?

The financial laws of gravity are exactly that: laws. The narcotics of hope and denial cannot repeal them, just as they cannot make a butterfly turn into a 747, convert lead into gold, make America’s debt disappear, or transform Fed Chairman Ben Bernanke into a mangod who can make the consequences of gross fiscal and economic dereliction go away, just because he says so.

The financial laws of gravity say that it is impossible to indebt a society into prosperity, or money-print everyone rich. In fact, reality says the exact opposite: Endless debt and money creation impoverish and enslave a people, while enriching to a grotesque degree a relatively few opportunistic, immoral, greedy, insider manipulators, just as we have seen and continue to see.

If government were genuinely trying to fix this mess, then perhaps we could have some hope, even though we are already beyond the fiscal point of no return. But recent actions, such as the June, 2009, $108,000,000,000 ($108 BILLION) added funding for the IMF, and the proposed nationalization of health care, to cite just two relatively minor examples, demonstrate that Washington is, at best, incapable of recognizing the seriousness of the country’s circumstances, or, at worst, is spending us into oblivion on purpose. (Collectively, could they really be this reckless, stupid and destructive? Is that conceivable? Or is something far more evil and diabolical at work?) Pinning one’s hopes to “change” is an act of insanity given the situation. The only change in America is the total lack of it.

There is a solution: It is called the truth. The United States government must irrevocably admit that its wanton, escalating experiment with socialism, which is now veering into something even more sinister, called corporatism, which is another word for fascism, has failed catastrophically, just as it has failed every other time throughout history that it has been attempted. And the people must be told that this nation can return to greatness only if they and their government will re-embrace the virtues that made it great in the first place: honesty, responsibility, restraint, ingenuity, hard work, self-reliance, morality, character, dignity, honor, duty, sacrifice, patriotism and an abiding belief in something greater than ourselves.

Each reader can make his or her own decision as to whether America and its “leadership” will have the strength to face the truth, or not. If they do not, then we will soon enter a period of personal and financial survivalism. If you believe that the nation will not face reality, then you must immediately begin to put your affairs in order. Those who think ahead will be able to survive the whirlwind that denial will unleash. But those who stand before such a tornado, unprepared, have poor and more likely tragic prospects. The odds that you, the reader of this article, will find a way to prevail are good. But unfortunately for your fellow citizens, you are in a small minority. You are distinguished by courage, thoughtfulness, an ability to face facts, resourcefulness, and a genuine concern not just for yourself, but for all who are dear to you. Those virtues were required to get you to this point in this difficult article. Those same virtues will save you as the flag of the future unfurls.


Chuck Cohen, “one of the smartest investors” Rick Ackerman knows, commences his intended regular contributions to Ackerman’s site with a 3-part series on gold as insurance and an investment. The promise is the the ultimate focus will be on opportunities in junior gold stocks. The first part muses on why most investors are unsuccessful: “history reveals that most investors were wrongly positioned for change.” Parts 2 and 3 start to build a bullish case for gold.

When choosing a home, a car or even a vacation, most of us will research and reflect for weeks. We will gather material, discuss it with our friends and family, and eventually come to an informed decision. But when it comes to our finances we can be strangely nonchalant and careless. Instead of applying the same thorough diligence to investments, we tend either to passively follow the opinions of the mainstream media or hand over our money to a mutual fund manager whose outlook may be just like the media’s. During a major bull market, such as the one we had from 1982 to 2000, this might not be a concern. A rising tide carries out all boats. But at a major turning point it becomes very costly, not just because our stocks might go down sharply, but also because we are not set to take advantage of the next great opportunity.

Looking back from our current perch we now know that few of the public media voices foresaw or warned of the dangers that were about to hammer the financial markets. Since most remain resolutely upbeat today, it is probable that they will not anticipate any unexpected new jolts. In spite of the spectacular stock boom of the 1990s and the housing mania of the 2000s, our once great nation is now in dire shape. I believe that the next shock will slam into an already weakened and fragile structure, and the damage will be incalculable to those who are not prepared for it.

This is my first article for Rick [Ackerman]. My hope is that over time we might see why we tend to make bad decisions, both in selection and in timing, and how, by changing this understanding, we can become wise investors and traders. Getting back to the individual investors.

Late to the Party, and Late to Leave

Stock market history reveals that most investors were wrongly positioned for change. In late 1929 the market appeared invulnerable. Euphoria was everywhere. But then came the collapse and with it the Great Depression. Once again, right after the Second World War, the prevalent expectation was a recession or even another depression. The common wisdom was to play it safe by staying in bonds – just as stocks were about to launch upward for almost 20 years.

After almost 16 years of a terrible stock market, in 1982 the prevalent stock market advice was that it would never go anywhere. At the bottom, for almost two years, the average bullish sentiment hovered around 15%. But as it usually does, the market did its own thing, broke through the seemingly impenetrable 1000 barrier, eventually topping at 11000 within 18 years. By then, there were those who did not know a balance sheet from the Daily Racing Form who were dishing out stock market tips. Do you remember reading the market advice of Jose Canseco and Shaquille O’Neal?

Being Correctly Positioned

Today, we have access to an almost unlimited supply of information and charts, and yet most investors still tend to come to the wrong decisions, especially when it comes to timing. I believe there are definite reasons why this happens and why we are slow to adjust to impending changes. The key to doing well in stocks is to be positioned in the correct up cycle and to be out of one that is heading down. One proven maxim regarding the stock market is that you are usually better off owning the worst stocks in the best group than the best stocks in a bad group.

The veteran stock market observer, Richard Russell has repeatedly pointed out, “The stock market will do whatever it can to take away your money.” Over time, few really succeed. The stock market is stacked against you and your emotional makeup, and just when you think you have it mastered, it will rob you. And you thought it was just the casinos and the racetracks that do this.

Why Does Gold Get No Respect?

Even after the recent rally, the stock market is still down about 35% since 2000, while the price of gold has risen almost 400%. It seems logical, at least to me, to expect investors to have become a little intrigued towards gold. But strangely, that has not been the case. Inexplicably, the long-term view towards stocks remains remarkably upbeat, as though the alarming problems of the past two years have vanished. Just look up the very recent Barron’s “Big Money Poll,” or read the comments of the same economists who never foresaw even a recession coming down the pike.

Conversely, few people have yet to acquire gold in any form–bars, coins or mining shares. Gold in most people’s eyes is considered overpriced, dangerously volatile and perhaps even in a bubble – in short, too risky and too late to get into. To try to prove that gold is still a poor, unwanted orphan, I am inaugurating a series of articles on gold in Rick [Ackerman]’s Picks by posing a few questions, below. If you consider yourself a contrarian, you are especially likely to view gold as hidden from view and therefore very bullish. Speaking personally, and given the history of financial markets, I expect gold to rise until it culminates in the most spectacular run in the history of markets.

Any Bulls Here?

Friends and Family: How many people do you know personally who own gold or gold mining shares? Have any of them called you to buy gold as they most likely had, to buy tech stocks in the late 1990s? Also, how many of them do you know that did not buy or refinance a home?

Financial Advisors and Institutions: Why do so few people or institutions own or even recommend gold in any form? If you have a broker or adviser, you probably know what I mean. If you mentioned gold to your broker, what was his reaction? Was it supportive or negative? Also, if you own a mutual fund check out how much of their assets are invested in gold shares.

The Financial Media: Most investors form their opinions from the coverage and advice given in the financial media. But why is it that so few of the regulars on CNBC or Bloomberg talk favorably about gold? In fact, when is the last time you heard Jim Sinclair or Jim Puplava, two of the staunchest and most articulate gold advocates, interviewed on CNBC?

European and U.S. Governments: This includes our illustrious congressmen and senators. Why is the West so opposed to the role of gold? Why do they always seem to wish only to sell it? Ironically, the actual recent bottom in gold in 1999 was nailed almost to the penny by the current Prime Minister of Great Britain, but then Exchequer, Gordon Brown. Through his shrewd sale Great Britain summarily liquidated its entire gold reserves. What is amazing is that even very recently, Mr. Brown, unrepentantly, is still pressuring the IMF to sell its gold.

At the same time, why are the fastest growing nations, all to the east – Russia, China, India and the Middle East oil nations, all very favorable towards gold? Consider this: If the anti-gold, Western nations are faltering and selling their gold while the pro-gold countries are accumulating reserves and buying gold, what should be the logical future effect on its price?

The Cash-for-Gold Phenomenon: After 8 years of a rising gold price, is it not reasonable that the media would be saturated with appeals to get in the action. After all, that is what happened during the tech mania in the late 1990s, and then later during the housing bubble. I can recall seeing whole real estate sections in the newspapers. But when the word “gold” is heard, it is usually an appeal to sell your unwanted gold for “cash” or paper. Have you noticed how many “We buy gold!” signs you see. This is very strange.

Those Pesky “Gold Bugs”: Why are gold enthusiasts called “bugs”? Have you ever heard of a dot-com bug, or a bailout bug?

John Paulson, arguably the world’s most successful investor (sorry Warren): After betting large against the banking sector and winning really big (up almost 600% in 2008), why has he now placed over 50% of his funds in gold and gold mining shares? Is it likely he will suddenly be totally wrong?

Gold Treated Differently

I hope you can see that attitudes toward gold are strangely different from those that govern more traditional investments. Since one of the attributes of the metal is that it serves as a guard dog against the unrestrained creation of credit, gold will remain an implacable enemy of the financial community and politicians. Soon, in future columns, I will try to get into this unspoken war and elaborate on some of the above topics in greater detail. To contact Chuck, click here. If you would like to have Rick’s Picks commentary delivered free each day to your e-mail box, click here.)

Gold As Insurance

No One-Size-Fits-All Strategy

In spite of the sharp drop in shares over the past 9 years or so, most investors remain firmly committed to common stocks. Mutual fund statistics show that very few holders have pulled their money out of their funds. And the recent “Big Money Poll” in Barron’s shows that the big guys are even surer than they were even at the very top. It is clear that investors have been stirred, but far from shaken, by the decade’s decline and by our faltering economy.

And gold? To many investors and even professionals, buying gold is like traveling to Myanmar or northern Pakistan: Few dare to venture there. The truth is, that to our Ivy League and Keynesian educated financial community, gold is viewed as a superstitious relic.

I do not seek to persuade you to sell everything you own, put it all into gold and gold shares, and then buy guns and ammo before retreating to a barricaded cabin in the Ozarks. Instead, I hope to try to make you understand that gold investments come in different sizes and shapes, with varying degrees of risk and reward. It is not an all or nothing choice. The better you understand gold, its attributes and how it fits into your financial planning, the more you should feel more comfortable with it. You might then want to take bolder steps that can protect you more fully against the enormous unknowns facing us.

I believe that in spite of a huge move since 2001, gold is still very early in a generational bull market. Bob Hoye, one of the most astute market analyst around, believes it will last for 15-20 years. That gives us 7 to 12 more years to ride it. Remember, the recent bull market in stocks lasted almost 18 years. The gold fundamentals continue to get more and more compelling, and technically gold is rapidly approaching an amazing liftoff stage.

But back to the three approaches towards gold. I have put them into an ascending order of risk and reward: 1) gold as insurance; 2) gold as a core investment, and 3) gold as a speculative vehicle. Today we will discuss the first approach.

Protecting Against the Unknown

What is the purpose of insurance? Of course, it is to protect you against the unknown and the unexpected. You cannot risk not having it in your life, even if you never have to use it. One disastrous episode, even if you had nothing to do with it, could totally change your life.

If you own a house, you undoubtedly carry property, theft and fire insurance. In spite of the onerous costs, you must have life and health insurance. You cannot legally drive a car without adequate property and liability coverage. But strangely, when in comes to finances, most people handle things differently. [Emphasis added.] They tend to be careless without giving any serious thought as to how or where they should put their money. Remember the dot-com era? I do not know a single person who does not have his tale of woe from it. And to prove that this was not an accident, many then threw the leftovers, plus what the banks and mortgage companies shoveled their way, into the great American housing disaster.

We from W.I.L. must, of course, interject here that the same logic applies to diversifying your asset holding jurisdictionary as applies to owning some gold. And in the case of investing in gold late is better than never, while with moving your capital offshore late may end up being the same as never. When the gate closes you are trapped.

But when it comes to gold, after nearly 9 consecutive years of higher prices, a great majority of Americans do not have one cent in a gold-related investment. And even after watching the government inject trillions of governmental monopoly money, most Americans continue to shun it. Incomprehensibly, most Americans still put their trust in stocks and real estate. And the financial media think that “gold bugs” are weird.

Getting Started

Here is what I am getting at. If you are one of those who feel as though gold is too mysterious or too risky to get involved with, then I want to present the first step to getting comfortable with it. Approach gold just as you would with the different types of insurance you carry. You can get more deeply involved later. Your mindset has to be that if things do not get much worse, gold may not do much. Although, considering its performance over the past 9 years, even through some good times and rising and falling consumer prices, it should continue to do well.

But, if things hit the proverbial fan, gold, like a comprehensive car or property policy, will bail you out, or at least greatly help you in your time of need. Do you not think that those who really got rocked after 2000 wish they had bought some gold insurance instead of gambling it in those supposedly safe places?

Without going into great detail, there are several ways to buy the insurance. I do not want to pose as an expert in these areas, but they are simple to buy: coins or some other small amounts in bars, or through the various ETFs or gold funds. Personally, I would start with coins purchased through one of the reputable online dealers, or if you have a coin store nearby that others can recommend, that would be okay. Given my expectations for the future, I am not comfortable with owning gold through a paper deed, especially if there is no formal audit procedure to verify your share. This may ultimately prove to be an important concern. We can get delve into this at another time, or you can email me and I will get you a good source of information.

The followup article to this, “Why Gold Should Anchor a Portfolio” is included in the next Digest.


If only financial advisers could make money by recommending gold. ...

Tim Iacono on the Seeking Alpha website took a look at a recent article in the Wall Street Journal section of the Wall Street Journal and deemed it “groundbreaking.”

His standards are pretty low for mainstream media sources. Iacono found the article to be intelligently written, with a few forgivable gaps, and it made the quoted financial advisors, who would normally be among the Journal’s readers, look like “just about the dumbest guys in the room.” Overstated, we would say, but considering the source we see Iacono’s point.

Why would financial advisors play down gold as an investment. Similar to the advisor quoted in the Mish piece above regarding investing in cash, they do not make any management fees when clients buy bullion and lock it away.

This story about investing in gold (hat tip NG) that appeared on the front page of the Wall Street Journal’s Personal Journal section is ground-breaking in many ways, the most important of which is that it paints today’s financial advisers as being just about the dumbest guys in the room. ...

Why is this ground-breaking?

First, it is in the Personal Journal section, not the Money & Investing section and, while they have had similar stories like this over the years, I cannot remember one that dominated a section of the newspaper like this one does.

Anyone who picks up today’s [July 9] paper cannot help but see this story in which author Larry Light talks glowingly about the yellow metal. Although he comes up short in a few areas, probably due to not having covered this topic in such detail before, his heart seems to be in the right place, his views clearly unaffected by how money makes its way into his wallet.

To wit:
Catching The Gold Bug

Worried about a harrowing, inflation-ridden future, Scott Van Steyn has found the answer in a batch of glittering one-ounce gold coins. In fact, they make up a large chunk of the physicia’qs assets.

“There’s 2,000 years of history to show that gold is the best thing to own during bad inflation,” says Dr. Van Steyn, a 45-year-old orthopedic surgeon in Columbus, Ohio. “People used to laugh at me for buying gold. They don’t anymore.”

More and more investors are acquiring physical gold, or bullion, in the form of small bars the size of iPhones or coins like American Eagles and South African Krugerrands. Individuals’ bullion purchases almost doubled last year, amid apocalyptic panic over the financial system, to 862 metric tons.

Lately, that panic-driven demand has given way to a more subdued, yet still potent, fear that stocks will suffer as the recession grinds on for a long time, so gold makes sense. At the same time, there is a rising anxiety about inflation among people like Dr. Van Steyn, resulting from the Obama administration’s massive stimulus spending.

“When you are in uncharted economic waters, people buy gold,” says Shawn Price, manager of the Touchstone Large Cap Growth fund, which holds several hundred ounces of the stuff.
While Mr. Van Steyn’s views are indicative of the changing mood of retail investors who, after the bursting of two or more gigantic asset bubbles over the last 10 years still have money left to invest, the comment by Mr. Price is somewhat puzzling.

The total of “several hundred ounces” of gold is not a lot of gold for a mutual fund, especially one that has over $400 million in assets, according to this entry at Yahoo! Finance. By my calculation, that $250,000 or so allocation to gold is not only less than one percent, it is less than 1/10 of one percent.

Certainly a quick calculation would have been in order here, though you cannot really argue with what Mr. Price says.

The report goes on to talk about flagging jewelry sales, decreased mining output, along with the surge in investment demand over the last year or so and then turns to the “experts” on personal wealth management – financial advisers.

That is, the people who have been wrong about gold for almost 10 years now and have been steadily losing money for their clients while continuing to earn fees for their effort.
Many mainstream financial advisers, however, are leery about owning gold in its physical form. “If we get total chaos, are you going to chip off a piece of your gold to buy milk at the store?” says Michael Goodman, president of Wealthstream Advisors in New York.

And while they often recommend putting 10% of your portfolio into commodities such as gold for the long term, a number of advisers think that no gold should be included, physical or held in other vehicles such as exchange-traded funds. The thinking is that gold performs best during times of unrest, and not so well at other times.
The fact that a “financial adviser” cannot make any money from clients if they recommended the client go out and buy some gold coins and put them in safe deposit box pretty much precludes this as a common recommendation.

This is an important point here, one that the author should have broached in some way.

As for “chipping off a piece of your gold to buy milk at the store,” there is an easy solution to that one – it is called “junk silver.” In a worst case scenario, pre-1969 silver coins that people of all walks of life have long since removed from circulation because its metal content is roughly 10 times its face value will do just fine to buy milk in any Armageddon-type outcome.

Then there are the performance claims from the financial advisers.
Over the past four decades, gold has been one-third more volatile than the Standard & Poor’s 500-stock index, and yet has delivered a lower return: an annualized 8.4%, versus 9.1% for the S&P index, says Steve Condon, director of investor advisory services at Truepoint Capital in Cincinnati.
I do not know where Mr. Condon gets his data, but if I go back 40 years, I find gold at about $40 an ounce versus $917 today – an annual gain of 11%. As for the S&P 500, its average 1969 value is right around 100, which, when compared to today’s 885 level produces an annual gain of about 7.5%.

Let’s be objective here. Holding gold bullion would entail storage costs, while the S&P does have and has always had a dividend yield – our guess would be an average of over 3% during the past 40 years. This would make the total returns roughly equivalent for gold and S&P over the past 40 years. Advisor Steve Condon’s numbers still look spurious.

At least the investment performance was not based on the 1980 peak when, for a few days in January of that year, gold spiked some 30%.

Ooops, that was a bit premature. ...

Here comes the 1980 comparison and the “poor inflation hedge” mantra that every financial adviser must have committed to memory by now.
As an inflation hedge, gold’s record is not perfect either. After reaching a record high of $850 per ounce in January 1980, gold’s price fell almost 44% in two months. It did not reach $850 again until January 2008, meaning it was flat while inflation rose 175%, Mr. Condon calculates. Indeed, today’s gold price is far below its 1980 apex when inflation is factored in: That $850 is worth $2,206 in today’s dollars.
I will be the first one to tell you that gold was a terrible investment from 1980 to around 2000. But, that does not mean that it will always be a terrible investment.

Aside from gold stocks, gold bullion has been about the best investment of this decade, a fact that still seems to be beyond the grasp of most financial advisers.

A couple more man-on-the-street stories follow, all of which make much more sense than what the investment “professionals” have to say, and then we come to Mr. Richard Dempsey who just told the world he has gold coins at his home in New Jersey.
Gold’s tangible quality is reassuring to its owners. Gold owner Richard Dempsey, 63, a vice-president at Bank of New York Mellon, keeps some of his 60 gold coins in a safe at his Point Pleasant, N.J., home and some in a safe-deposit box. “I like to know it’s there,” he says.
Anyone who owns precious metals in physical form should know that there is very little upside to telling people that you have tens of thousands of dollars worth of valuables in your house. It is not clear who is dumber here – the interview subject or the author.

The topic of gold versus gold mining stocks is then discussed, Mr. Light doing a fine job of distinguishing between the two.
Gold-mining stocks often do not correlate well with ETFs dedicated to physical gold, and sometimes lag the price of gold. SPDR Gold Shares, which holds gold, returned 4.9% last year and 5.4% in 2009. Meanwhile, Market Vectors Gold Miners, owner of mining stocks, lost 26% in 2008 and is up 11.6% this year. One problem is that miner stocks track the broader stock market, and gold prices do not. Another is that the miners have capital costs and can waste money on fruitless digs.

The truest gold buffs, though, want nothing to do with ETFs or mining stocks. Mr. Martenson, who runs an investing Web site, dismisses them as creatures beholden to untrustworthy managements and financiers. “I’ve lost faith in how Wall Street does business,” says Mr. Martenson, who keeps more than half his portfolio in bullion.
Earlier in the story it is learned that Mr. Martenson is a scientist who favors gold over other forms of money, a view with which it is easy to agree.

It is funny how those who have not had formal training in the ways of modern finance (like myself) can so easily come to conclusions about gold that are so different than those who have had formal training.

Maybe funny is not the right word there. ...

A bit more discussion about futures markets, insuring gold stored at home, coin premiums, tax issues, and a breakdown of global demand round out the discussion in what is really a pretty good, highly favorable article about gold as an investment.

Lastly, this comment from a financial adviser (comment #2 at the WSJ online) just serves to reinforce how dopey these people are sounding after losing money for their clients over the last 10 years.
Garry Stoklas wrote:

While I agree that gold has never been worth zero and it has been used for thousands of years as a medium of exchange, It is not worth any more than what you can trade it for. If you have gold and want food, the gold is only worth something if the person with food is willing to trade what they have for your gold. As noted in the article, gold is worth a very small percentage above the 1980 high and worth considerably less when you take inflation into account. I am a financial advisor. I get client who regularly ask my advice on owning gold. The majority of those interested in buying gold are concerned that we will have a total or near total collapse of our financial system. What I tell them is that if it makes them feel better prepared, go ahead and buy some. But if they truly believe in a near or total collapse, they would be better off having food, water, fuel, guns and ammunition stored. Gold is only worth what someone is willing to trade you for it and you certainly cannot eat it.
If only financial advisers could make money by recommending gold. ...


Investors who followed Barron’s stockpicking advice this year should be happy campers, based on our latest score card.

Over the past year and a couple of months we have posted a steady diet of pieces from Barron’s. (Unfortunately for us, the printed/online newspaper has chosen to withdraw most of their offerings from public/nonsubscriber view, so they will be featured far less going forward.) Well written and intelligent investing articles – or “insightful and provocative,” to use their words – are one thing; useful in helping one’s portfolio returns is another. Just how well have the profiled companies, that is those featured in articles where one or two are given a fairly thorough going over, done?

The answer is pretty darn well this year, as the Barron’s “picks” have handily outperformed their relevant benchmarks (scorecard here), following a rough 2008 (scorecard here) where their covered companies dropped every bit as much as the plummeting benchmarks. So definitely read Barron’s for the investing education. Just argment the analysis, especially your valuation assessment, before plunging in.

After a tough 2008, Barron’s smartly beat the market with our stock selections this year. The 57 companies we profiled positively in the first six months of 2009 were up an average of 20.4% through the end of June, double the 10.2% gain in the relevant market indexes, based on calculations from the Friday before publication.

Our bullish selections from 2008 – 107 stocks in all – have not fared so well. They are down an average of 26.1% through June 30, behind the 23.8% drop in the benchmarks. A list of the bullish and bearish picks from 2009 is shown in tables nearby. A list of the 2008 picks is available free of charge on our Website.

Barron’s has kept a scorecard since 2004, when we calculated the performance of our stock selections from 2003. We grade ourselves twice a year, assessing the prior year’s picks in January and our first-half selections in July.

Our 14 bearish stock picks from 2009 also did well. The average selection was down 3.4% through June 30, versus a 6.4% gain for the benchmarks. The bearish group from 2008, involving 20 stocks, was off 33.8% through June, more than the 26.8% decline in the benchmarks.

Instead of comparing all our stock picks with the Standard & Poor’s 500 index, the most popular benchmark for large-capitalization stocks, we measure midsize companies against the S&P MidCap 400 and small ones against the Russell 2000 index. We use the S&P 500 for big-cap and foreign stocks.

The S&P 500 rose just 1.8% in the first six months of 2009. It plummeted 25% from Jan. 2 through March 9, and rallied 36% from the March low through June. We calculate the gain or loss in each of our picks from the stock’s closing price on the Friday before publication, and measure it against the performance of the relative benchmark from the same starting date. Each stock, regardless of size, gets an equal weighting in the tally. We do not factor in dividends.

Barron’s is not an investment newsletter. We aim to write insightful and provocative articles on a range of investment and business topics. But we are well aware that many readers turn to us for investment ideas, and we think it is important to assess periodically how we are doing, even if the results do not always shine. In the tables we have ranked our 2009 stock picks from best to worst, and included the performance through June 30 of the relevant market benchmarks. In this ranking we include only stocks featured in stories in which one or two companies were profiled. We do not include industry articles that feature many stocks or reflect the stock picks and pans of our many columnists. They keep their own scorecards and share the results with readers.

The leading performer among our bullish picks this year is Bank of America which is up 4-fold. At the market low in early March, we offered an upbeat view of the banking giant, in which its much-criticized CEO, Ken Lewis, said Bank of America was not about to be nationalized or go the way of Citigroup; Citi is massively diluting common shareholders through an exchange offer involving more than $50 billion of preferred stock. Since then, Wall Street has come around to the view that Bank of America has sufficient earnings power to offset loan losses and could come out of the current downturn in good shape. The stock ran up to 13 on June 30 from 3 in March, and now trades for 12.

In February, we wrote that Ford Motor could emerge a winner amid the crisis enveloping the auto industry, which could include the failure of rivals General Motors and Chrysler. Ford more than tripled through June, but it has given back some gains since then.

We also were right that Dell would not succumb to weak corporate-technology spending and the threat from rival Apple (AAPL). At the time of our March story on Dell, its depressed shares looked attractive partly because the company’s cash was equal to approximately half its market value.

Around the same time, we argued Avon Products looked cheap at 10 times earnings, a valuation reflecting concerns about its exposure to the developing world. Those fears have subsided now that many emerging economies are recovering more quickly than those in the developed world.

We also wrote a bullish cover story in March on Goldman Sachs and Morgan Stanley, in which we stated the pair stood to benefit from the shakeout on Wall Street and were well capitalized. Goldman rose about 50% from the publication date through the end of June, though Morgan Stanley is up just 12%.

Goldman had a strong first quarter and may report excellent second-quarter results because of big rallies in the stock- and corporate-bond markets. Morgan Stanley’s first-quarter results were disappointing as the firm took conservatively sized trading positions.

There were no major losers among our bullish choices. The worst performer was Mentor Graphics , a software turnaround candidate whose revival has not yet taken shape. Its financial guidance for the current quarter, announced in May, was disappointing, and the stock dropped about 19% subsequent to our article. Mentor President Greg Hinckley has been buying stock around current levels.

KeyCorp has been a disappointment in the improving banking sector because of larger-than-expected loan losses, which have prompted a dilutive move to boost equity capital. At around 5, KeyCorp. trades for a fraction of its stated book value. Hess is an independent energy company with profits highly sensitive to oil prices; it has been stung by lower crude prices.

Among our bearish selections, gold explorer Tanzanian Royalty has dropped more than 25% since our April article. We argued Tanzanian’s market value of $370 million looked steep in view of the company’s lack of revenue, earnings or proven gold reserves. We were also bearish on energy-drink maker Hansen Natural in May, noting its stock looked rich at almost 20 times estimated 2009 earnings, while Campbell Soup looked good at 12 times earnings. Hansen is down 27% since then amid concerns the weak economy is dampening demand for its caffeine-laden Monster energy drink. Campbell is up 10% since the story.

Vulcan Materials and Martin Marietta Materials were the subjects of a skeptical piece in January, in which we argued that these makers of crushed rock and other construction “aggregates” used in road-building were riding too high, based on inflated hopes about the benefits they would derive from increased infrastructure spending. Vulcan, then trading for 30 times earnings, has fallen more than 25%.

Insurer Unum is up 50% since our bearish call in March, when we said it appeared to be under-reserved for losses on disability-insurance policies. Many depressed financial stocks are up sharply this year.

With stocks in retreat after their spring rally, and major indexes trading at late-1990s levels, we continue to look for undervalued companies and sectors, as well as shares that look overpriced. When we find them, we will write about them. And after that, we will let you know how they – and we – have done.


The Greenspan Fed befriended a community well known for its sense of altruism and public service, the Wall Street speculators, as a strategy to further its policy objectives. This turned out to be a case of the proverbial riding the tiger. The Germans who thought they could “control Hitler” come to mind. With the Fed able and willing to manage and direct speculator profits and with the promise of insuring marketplace liquidity via the “Greenspan put,” leveraged speculation expanded to the point of engulfing the whole economy. With the profits came the ability to fund political influence; now the leaders of the leveraged speculator special interest group are among the members of the Obama administration inner sanctum.

Excessive government-sanctioned speculation has been belatedly recognized as having contributed to the economic problems we now face, and greater regulation is threatened. Doug Noland expects the restraint to be mild, as policy makers yet hope the speculators will help them bail out the mess the speculators had a major role in helping create. We are not holding our breath on that one.

Meanwhile, the Chinese credit system has entered into what Noland labels the “terminal phase” of credit excess. Chinese authorities presumably have more forceful measures than their U.S. counterparts to effect their objectives, yet experience indicates that in a credit bubble’s terminal phase it is a formidable challenge to rein in the excesses: “As we witnessed here at home, a point is reached where policymakers view the risks of bursting the bubble as too great – and they justify and rationalize. Too many – individual and institutions – become dangerously exposed to inflated asset prices. The unbalanced and maladjusted economy becomes acutely vulnerable to a downward spiral. Erratic behavior engulfs assets markets, economic activity and speculative flows, creating confusion and policymaker paralysis. And, especially relevant to the current Chinese predicament, an increasingly unequal distribution of (bubble economy) wealth creates a volatile social backdrop.”

That is a pretty good description of what has happened in the U.S. One can only hope the Chinese manage a softer landing than their largest debtor.

I believe it was sometime in late 2002 – or perhaps early 2003. I recall one of the major macro hedge fund managers appearing on CNBC. He made what I thought at the time was an extraordinary comment: “The government wants me to buy junk bonds, so I am buying junk bonds.”

It was always my view that Fed chairman Greenspan directly targeted the leveraged speculating community, as necessary, for use as a mechanism for monetary stimulus/reflation. The Greenspan Fed would actively manipulate market interest-rates, hence speculative profits. When financial crisis erupted – such as with the collapse of Long-Term Capital Management, the bursting of the Tech Bubble, or 9/11 – Greenspan would immediately collapse short-term borrowing costs, assure the marketplace ample liquidity and, accordingly, inflate the price of most fixed income securities.

This signaled to the leveraged players that it was an opportunistic time to buy risk assets – especially corporate debt and mortgages. These purchases would reduce market borrowing costs, increase credit availability, and boost marketplace liquidity. And like clockwork, ultra-loose financial conditions would work their magic on equities and real estate prices, as well as the real economy. After awhile, speculators simply loaded up on risk assets – anticipating the next crisis and Fed-induced speculative profit bonanza.

The leveraged speculating community evolved into the most powerful monetary force in history – and the Federal Reserve was soon playing with a bonfire.

With the Fed able and willing to manipulate speculative profits and (along with the GSE) “backstop” marketplace liquidity, leveraged speculation flourished and expanded to unimaginable dimensions. The leveraged speculating community evolved into the most powerful monetary force in history – and the Federal Reserve was soon playing with a bonfire.

July 8 – New York Times (Edmund L. Andrews): “Reacting to the violent swings in oil prices in recent months, federal regulators announced ... that they were considering new restrictions on ‘speculative’ traders in markets for oil, natural gas and other energy products. The move is a big departure from the hands-off approach to market regulation of the last two decades. It also highlights a broader shift toward tougher government oversight. ... In the case of oil and gas trading, regulators made it clear that they were willing to move, without waiting for Congress to act on Mr. Obama’s overhaul, invoking their existing powers. The Commodity Futures Trading Commission said it would consider imposing volume limits on trading of energy futures by purely financial investors. ... ‘My firm belief is that we must aggressively use all existing authorities to ensure market integrity,’ said Gary Gensler, chairman of the commission. ... He said regulators would also examine whether to impose federal ‘speculative limits’ on futures contracts for energy products.”

Mr. Gensler’s comments really caught the markets off guard. Is he not a long-time Wall Street, free-markets guy? And while one can view the clampdown on “speculative” energy trading as simply part of the tough new post-bubble regulatory backdrop, I suspect there is more to it.

The inevitable day had arrived when speculation was viewed as one huge problem in a gigantic mess.

The good ole’ days of policymakers enticing the leveraged players into junk bonds and mortgages have past. Recall that the Bernanke Fed cut rates 200 basis points during 2008’s first quarter. Instead of the typical signal to buy U.S. debt securities, speculative flows rushed to trade out of dollar securities for real things that are not so easily devalued away. Over several months, commodities prices rocketed to record highs, as crude oil reached an astounding $145 a barrel. At that point, the leveraged speculating community had been lost as a reliable Fed monetary management tool. Indeed, the inevitable day had arrived when speculation was viewed as one huge problem in a gigantic mess.

Washington has a dilemma. Unprecedented monetary and fiscal stimulation are being employed in hopes of spurring rapid economic recovery. But these policy measures risk unwieldy – and self-reinforcing – speculative flows out of dollar securities and into “undollar” assets such as energy and commodities. And recall that it was about a month ago that the dollar was breaking down, commodities were on a run, and crude was approaching $75. At that time, 10-year Treasury yields jumped to almost 4% and Mortgage Backed Securities yields spiked to 5.07% (up more than 100bps in a month). Housing and economic recoveries were in trouble.

Ironically, stock investors a month back were interpreting the rise in commodities and market yields as positive confirmation that recovery was taking hold. Fast forward a month – with crude and commodities now sinking – and sentiment has shifted somewhat negatively. I tend to hold the view that markets fluctuate – and news/analysis is there waiting to follow market direction. I do not want to over-read commodities price moves as an indicator of the vitality of global reflation.

As expected, the U.S. economy is lodged in deep mud. Europe remains very weak. But the global reflation thesis rests first and foremost upon happenings in China and Asia. China, in particular, is living up to all my reflationary expectations – and then some.

The Chinese credit system appears to have commenced the “terminal phase” of credit excess.

China’s preliminary June bank lending data was out this week. Incredibly, loans increased by $224 billion. First half loan growth surpassed $1.0 trillion, about three times the year ago rate and way above government forecasts. As a credit analyst, these numbers gave me the chills. The Chinese credit system appears to have commenced the “terminal phase” of credit excess. Export industries may remain weak, but Chinese housing, auto and equities markets – the current focal point of credit expansion – are generally robust.

Perhaps Chinese authorities are already moving behind the scenes to try to rein in excesses. Yet a key facet of a credit bubble’s “terminal phase” is that it becomes a formidable challenge to muscle the Genie back in the bottle. Over time, bubble economies become increasingly unstable. As we witnessed here at home, a point is reached where policymakers view the risks of bursting the bubble as too great – and they justify and rationalize. Too many – individual and institutions – become dangerously exposed to inflated asset prices. The unbalanced and maladjusted economy becomes acutely vulnerable to a downward spiral. Erratic behavior engulfs assets markets, economic activity and speculative flows, creating confusion and policymaker paralysis. And, especially relevant to the current Chinese predicament, an increasingly unequal distribution of (bubble economy) wealth creates a volatile social backdrop. When push comes to shove, authorities will generally feed the credit beast – and the unchecked “terminal phase” is left to run completely out of control.

Washington seems poised to move against unhelpful speculation. Do not be surprised if it turns out to be a case of light coddling.

“Macro” analysis remains today as fascinating as it is challenging. Here at home, Washington seems poised to move against unhelpful speculation. The marketplace has good reason to fear heavy-handedness. But do not be surprised if it turns out more a case of light coddling: “Speculators please take notice that it is to your advantage to buy corporate bonds and mortgages instead of oil futures contracts.” Fiscal and monetary policymakers are formulating a recovery strategy. I would expect them to pull out all the stops – and not give up easily – in their efforts to accomplish objectives.

And despite the recent bludgeoning meted out in the commodities markets, I am not keen to abandon the global reflation thesis. At its root, global reflation is premised upon a synchronized global government finance bubble consequent to bursting credit bubbles and the breakdown in the global dollar reserve system. I am comfortable with the thesis yet recognize the analysis is tough and the circumstances fluid. Mostly, uncertainty and market volatility are as expected.

The global system remains in historic, uncharted, troubled and uncertain waters.

The global system remains in historic, uncharted, troubled and uncertain waters. But with $2 trillion of U.S. federal debt issuance on tap this year – perhaps matched by upwards of (a previously unimaginable) $2 trillion of Chinese bank credit growth – ongoing “monetary disorder” remains the best bet. And, of course, our policymakers are keen to this dynamic, and it would be typical of policymakers in such a predicament to resort to increasingly creative means to try to stabilize a desperately unstable pricing system. Can Washington rein in speculative flows? Can they channel and mobilize them?


If we must have “too big to fail” banks, they must be made safe and boring.

Martin Hutchinson revisits the idea of regulating “too big to fail” financial institutions by making them “too big to take major risks.” He deems Goldman Sachs “the most egregious example of the moral hazard that the ‘too big to fail’ doctrine can cause. ... Doubtless a substantial portion of its returns have come from the field of credit default swaps ... In this area in particular, its operations are almost entirely to the detriment of the U.S. economy as a whole, since it is able to profit by manipulating markets into creating bankruptcies – the ability to profit from CDS on AIG while at the same time receiving a taxpayer bailout of losses on CDS written by AIG was truly egregious.”

Do we detect the foul idea of government regulation? Horrors! But of course propping up “too big to fail” institutions is also government intervention. Without wholesale reform – major sarcasm alert – “we have lost the possibility of allowing the free market to reign supreme through providing deposit insurance, over-expanding the money supply, regulating and guaranteeing home mortgages and bailing out the banking system.”

British Chancellor of the Exchequer Alistair Darling has proposed a new banking regulation regime under which very large “too big to fail” institutions should be compelled to carry more capital than smaller banks. At first sight, this looks sensible, but on further examination the change may go in the wrong direction, having the perverse effect of making the “too big to fail” problem worse.

The idea that a very large bank is “too big to fail” is a relatively modern one in the United States, created by the mass bank amalgamation movement of the 1980s and 1990s. The first time I remember hearing it was at the time of the Continental Illinois collapse in 1984, when the Federal Deposit Insurance Corporation (FDIC) infused $4.5 billion to rescue the bank. However, the precedent was actually set four years earlier, in the 1980 collapse of First Pennsylvania Bank, which had lost money through an incredibly doozy policy of buying fixed-rate Treasury bonds and funding the purchase with short-term deposits – the sharp rise in interest rates in 1979-80 made it effectively insolvent, even though the accounting of that period did not require it to admit this. First Pennsylvania was not allowed to fail, as had previously been the practice, nor sold to another bank (in those days prior to interstate banking, only Mellon Bank of Pittsburgh would have been large enough to buy it), but was granted a $300 million loan from the FDIC and $1.2 billion in other loans because it was “essential.” Since its “essential” quality consisted only in its size, the “too big to fail” doctrine was born.

Looking back in history, the “too big to fail” doctrine could have had application earlier. In the United States, the Second Bank of the United States should probably have been considered “too big to fail” in 1841 – it had after all been the country’s central bank. On the other hand, Jay Cooke & Co. (1873), Knickerbocker Trust (1907) and the Bank of United States (1930) could not reasonably have been considered “too big to fail” in terms of size, although Cooke was certainly central to the U.S. financial system.

In Britain, Pole Thornton, which crashed in December 1825, was relatively small, although its network of correspondent banks was extensive and its failure brought down many other banks. Gurney, which fell in 1866, was certainly large enough to apply a “too big to fail” doctrine, but had been known to be in trouble for five years, so the smart money had got out. Barings was not considered “too big to fail” either when it was rescued (1890) or when it was not (1995), although on the former occasion it was deemed too good a name to be allowed to collapse. Finally Northern Rock, which was rescued at enormous taxpayer expense in 2007-08, was a gimcrack empire that should never have been allowed to grow so large, and whose collapse should have been welcomed.

In Continental Europe, the most important precedent of all was that of 1931, when Austria’s Creditanstalt, which had more than 50% of Austrian deposits, was rescued by the Rothschilds and the Austrian National Bank. Fears of the inflationary effect of the rescue caused a run on the Austrian currency that spread the panic first to Germany then to Europe as a whole, turning a moderate recession into the Great Depression. In that case, the policy decision to consider Creditanstalt too big to fail brought down the entire European economy, suggesting that “too big to fail” designations are not without risk.

Darling’s proposal to make it more difficult for “too big to fail” banks to require bailing out thus addresses a real problem. However, it seems unlikely to provide a solution. Increasing the capital base required of large banks will make them uncompetitive with their smaller brethren on simple, low-risk businesses, because their capital costs of, for example, additional lending business will be greater. It will therefore force them into higher-risk businesses, where smaller banks are less able to compete because of their lack of specialist staff.

In particular, such a requirement is likely to drive the largest banks towards businesses whose capital requirements are modest (often because regulations have not caught up with reality) and whose risks are large. That would include securitization, through which they will be able to take assets off their balance sheets altogether, and credit default swaps, where they will be able to assume gigantic credit risks while reporting only the modest “mark-to-market” value of all CDS save those relating to companies near default. Public and private equity business will also become relatively more attractive for such banks, because their capital requirements on equity holdings will not be increased further and their cost of leverage will be extremely competitive.

The Darling proposals would thus turn the largest banks into hedge funds, their losses guaranteed by the taxpayer. Not a move in the right direction. A tax on liabilities above a certain absolute level would work better, since it would encourage the largest banks to divest assets so as to remain below the threshold, but would also tend to force their operations towards riskier and more profitable businesses. The regulation of “too big to fail” banks should restrict them to the less risky portions of the financial services business, leaving the highest-risk businesses to be carried out by smaller entities whose failure would not endanger the banking system.

This is not something that can be left to fester. On Friday, it was announced that Goldman Sachs’s profitability and potential bonuses are running ahead of 2007 levels. This cannot be through carrying out low-risk business, nor through sophisticated advisory work, the market for which has been distinctly depressed. It can only be through “principal trading” and the like – the activity that since 1990 has turned Goldman Sachs into the world’s largest insider-trading hedge fund, profiting from its access to corporate decision-making, its deep knowledge through its trading desk of financial flows on a day-to-day basis and its superb “crony capitalism” network of contacts to carve out superior returns at the expense of the market as a whole.

Goldman Sachs, which currently operates under a banking license, is the most egregious example of the moral hazard that the “too big to fail” doctrine can cause.

Goldman Sachs, which currently operates under a banking license, is the most egregious example of the moral hazard that the “too big to fail” doctrine can cause. Its activities distort markets, because it is able to profit as principal from transactions in which its prestige and standing are deemed essential. Doubtless a substantial portion of its returns have come from the field of credit default swaps, in which it was bailed out by taxpayers after the AIG failure to the tune of $13 billion. In this area in particular, its operations are almost entirely to the detriment of the U.S. economy as a whole, since it is able to profit by manipulating markets into creating bankruptcies – the ability to profit from CDS on AIG while at the same time receiving a taxpayer bailout of losses on CDS written by AIG was truly egregious.

Hence any effective “too big to fail” regulation needs to cut Goldman Sachs down to size, before taxpayers’ pocketbooks are hit with yet another gigantic loss. The advisory role of traditional investment banking is essential; it is extremely inefficient to outsource high-level market and securities design expertise to every borrower and investor that needs it. It is also necessary to have an underwriting mechanism for new issues, although the London merchant banks demonstrated that this function could equally well be assumed by investment institutions, with the bank acting as mere arranger and broker. The hedge fund function of a proprietary trading desk is also valuable in moderation, but should be separated from the advisory and underwriting functions, because of the gigantic conflicts of interest involved. None of these operations should be guaranteed by taxpayers.

Institutions that benefit from a “too big to fail” guarantee should be sharply restricted in their operations.

The solution is thus clear. Institutions that benefit from a “too big to fail” guarantee should be sharply restricted in their operations, becoming modeled on the pre-1986 UK clearing banks. They would be able to advise, underwrite in moderation, lend and take deposits, but their activities beyond the commoditized sectors of financial services would be sharply restricted by regulations specific to their “too big to fail” position. In turn, they would have lower funding costs than their competitors because of their low risks and effective government guarantee, thus being highly competitive in low-risk product areas.

Principal trading, credit default swaps (if legal) securitization and other high-risk operations would be assumed by institutions whose size was limited by statute, both in terms of assets and capital. Essentially, most of the high-risk business would be done by hedge funds, whose size and leverage would be restricted. That way, the high-risk businesses that had true profit potential would be done by low-regulation institutions, which would in their turn have relatively high funding costs (lending of “too big to fail” banks to such entities would be tightly restricted). By separating the guaranteed institutions by business line rather than by capital requirements or tax, the principal functions of a free market would be preserved.

It is government regulation, yes. But propping up “too big to fail” institutions with taxpayer money is also government intervention, and without wholesale reform we have lost the possibility of allowing the free market to reign supreme through providing deposit insurance, over-expanding the money supply, regulating and guaranteeing home mortgages and bailing out the banking system.

A root and branch reform of the financial system, including a “Volckerization” of the Fed to prevent it over-expanding credit, would be ideal but is presumably politically impossible. As a second-best solution, if we must have “too big to fail” banks, they must be made safe and boring. Taxpayers deserve no less.


On Foundation of Lies, Recovery Is Impossible

Gold continues to hang tough in the midst of oil’s nasty selloff. Although August crude has fallen more than 14%, from [the July 2] peak of $73.38, a Comex Gold futures contract expiring the same month lost just 2.5% of its value during the same period, falling from $947 to $924. The fact that gold has not plummeted in sympathy with oil strongly hints that it will be quite feisty when selling in the oil pits finally lets up. It was triggered by fears that the alleged global economic recovery is much weaker than had been thought. One might have expected investors to be prepared for this turn of events, but apparently not. The selling of oil began in earnest in connection with an uptick in job losses reported last week by the Department of Labor, and a 0.1 increase in the U.S. unemployment rate. But it has snowballed since, lending weight to the notion that investors really were surprised by signs of renewed weakness in the U.S. economy. ...

Just Look Around You

Unfortunately, we can see no end to the nation’s economic miseries. To the contrary, the lies that we are being asked to believe about a recovery that exists only faintly in statistics can only impair the economy’s ability to right itself. Whatever the statistics, and however the Obama Administration tries to spin them, nearly all Americans recognize how grave our problems are. They have seen their retirement dreams go up in smoke, and they know that they will not be able to borrow against home equity to put their kids through college.

They also understand that the middle class faces huge tax increases to pay for President Obama’s grandiose plans, and they know that healthcare costs are spiraling beyond the threshold of affordability – not only for individuals and employers, but for a U.S. Government that has the brazen nerve to tell us healthcare will somehow cost less when the government takes it over completely.

Until we get past all of these lies there can be no hope whatsoever for an economic resurgence.