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

W.I.L. Finance Digest :: Febuary 2009, Part 5

This Week’s Entries :

We have frequently featured Peter Schiff’s commentary (archives here) on these pages. We find his explanations of the macroeconomic situation we find ourselves in to be lucid and compelling. We read his book Crash-Proof: How to Profit From the Coming Economic Collapse in late summer 2007 and found it informative and the basic reasoning – from the Austrian School of economics theory of the credit cycle – to be well grounded. All the statistical data in the book demonstrating the debt buildup and credit inflation excesses in the U.S. economy made a forceful case for an eventual severe downturn just by itself.

Many is the slip, Schiff is learning, betwixt the cup of sound economic theory and the lip of investment success. Schiff was public with his forecasts of a collapse in the U.S. housing market, stock market and economy in general. Needless to say this did not win him a lot of friends in the mainstream media or Wall Street. The investment strategy he created to take advantage of those grim forecasts, however, did not work out well in 2008 when those forecasts actually came to pass.

In his brilliant and instructive book My 60 Memorable Games, Bobby Fischer quoted a chess instructor from an earlier generation after a game where a single wrong move converted a brilliant victory into a crushing loss: “It is not enough to be a good player ... you must also play well.” Mike “Mish” Shedlock, who we have also featured frequently, points out below that Schiff had no Plan B – no stop losses or other indicators that his investment approach was wrong even as some of his more prominent predictions were panning out.

"I know of but one sure tip from your broker ... your margin call,” said Jesse Livermore. Even when not buying on margin it makes sense to act as if you are.

Schiff has a showman’s flare for delivering his message. This has perhaps turned out to be the biggest issue. There is a place for showmanship in generating concensus. That is fine where community leadership is called for; in the investing world concensus is often the last thing you should seek out. Schiff claims that longer term his advice has worked well, and that it will yet; 2008 was just an off year. All well and fine in the abstract but, as so often happens, Schiff garnered maximum attention and adherents just as the trends he had ridden so successfully – bull markets in overseas stocks, commodities, and other “anti-dollar” trades – were culminating. People who bought into and acted on Schiff’s thesis and investment advice at that point did not benefit from how well those ideas had worked through mid-2008, but boy did they get hurt by how badly the ideas misfired when the crash came. Losses of 60% were apparently not uncommon.

There are a lot of lessons to be drawn from what happened to Peter Schiff’s clients in 2008. Details are in the “Mish” commentary below.

We became aware via Schiff’s postings on his Euro Pacific Capital site that certain critics of his investment performance were getting a public hearing. We initially were inclined to take his responses at face value, figuring that the long-and-wrong ex-bulls were making use of what small opportunity they had to get back. Only later did we figure out that a certain “very small money manager” who used “his popular financial blog to promote his fledgling business by attacking the recent poor performance of my long-term investment strategy” (see here) was “Mish”. Shedlock strikes us as having looked more deeply into the workings and shorter-term machinations of the credit system than Schiff – he foresaw the advent of deflation without getting stuck on certain forecasts a la Robert Prechtor (we are still waiting for the opportunity to buy gold at $150 ... heck, we would even settle for $300) – and navigated the shoals of 2008 as well as anyone we were familiar with.

Below we start with Shedlock’s dissection of Schiff’s investment advice, which we find fundamentally valid. It does not address the longer-term performance of Schiff’s approach, and perhaps “Mish” is attempting to “promote his fledgling business.” On the other hand, in the immortal words of baseball great Dizzy Dean: “It ain’t bragging if you can back it up.” Shedlock’s own investment performance is noteworthy, especially so in 2008. As long as he is not misrepresenting his investment acumen, including by making it look artifically good in comparison to a straw man, we say “whatever.”

After the intial post we include two of Schiff’s responses, followed by two of his recent comentary which we find wholly on-target.

PETER SCHIFF WAS WRONG, SAYS “MISH”

“Most of the praise heaped on Schiff is simply unwarranted.”

This sets out Shedlock’s thesis clearly enough!

There are numerous YouTube videos, articles, and references to Peter Schiff being “right” rapidly circulating the globe. While Schiff was indeed correct about the U.S. imploding, most of the praise heaped on Schiff is simply unwarranted, and I can prove it.

First, let us start with a look at the claim being made. Peter Schiff concludes many of his articles, books, etc. with the following statement.
Mr. Schiff is one of the few non-biased investment advisors (not committed solely to the short side of the market) to have correctly called the current bear market before it began and to have positioned his clients accordingly.
Highlight in red is mine.

I would like to see some proof of that statement. Specifically I would like to see the average returns posted by EuroPacific clients for 2008.

I have talked with many who claim they have invested with Schiff and are down anywhere from 40% to 70% in 2008. There are many other such claims on the internet. They are entirely believable for the simple reason Schiff’s investment thesis was flat out wrong.

I have an actual portfolio statement from one of Schiff’s clients at the end to discuss, for now let us discuss the main points of Schiff’s thesis.

Schiff’s Overall Thesis Schiff was correct about point number 1 above. The U.S. equity markets crashed. That was a very good call. Unfortunately, his investment thesis centered on shorting the dollar in a hyperinflation bet, and buying foreign equities rather than shorting U.S. equities.

Furthermore, Schiff made no allowances for being wrong and had no exit strategy whatsoever.

What happened in 2008 was that foreign equities sold off much harder than U.S. equities, and a strengthening U.S. dollar compounded the situation.

In other words, Schiff failed where it matters most: Peter Schiff did not protect his client’s assets. Let us take a look how, and more importantly why, starting with charts of various foreign indices.

Charts shown are:

2008 Equities Bloodbath

2008 was a global equities bloodbath. Clearly there was no decoupling. The Shanghai index (China), Nikkei (Japan), TSX (Canada), AORD (Australia), and virtually every world equity index collapsed along with the S&P 500, the Dow Industrials, and Nasdaq in the U.S.

Many, if indeed not most, foreign equity markets did worse than the U.S. indices. The Shanghai index fell from 6124 to 1665, a whopping 72.8% decline top to bottom.

Let us investigate why this happened, starting with the decoupling thesis itself.

Global Decoupling Thesis

Please consider this excerpt from the Little Book of Bull Moves in Bear Markets, page 41:

“I’m rather fond of the word decoupling, in fact, because it fits two of my favorite analogies. The first is that America is no longer the engine of economic growth but the caboose. [The second] When China divorces us, the Chinese will keep 100% of their property and their factories, use their products themselves, and enjoy a dramatically improved lifestyle.”

I mentioned decoupling many times previously but declared it officially dead on January 22, 2008 in Global Decoupling Myth Shattered In Equity Selloff. There are some interesting charts on currencies in that post as well.

Here is a snip from Tail Wags Dog Theory Blows Up written November 1, 2008.
Tail Wags Dog Theory Blows Up

At every peak there are always ridiculous predictions. In the dot-com bust, it was all about the “gorilla game,” the “new economy” and “click counts.” When the Shanghai Stock Index rose from 998 to 6124 in about two years, we heard the same sort of thing about growth in China. Instead of click counts, the theory in vogue was called decoupling. China was supposed to be the 800 lb. gorilla with insatiable demand for commodities and perpetual growth for the next decade.

That decoupling theory was based on the belief that the U.S. no longer mattered, that China demand was self-sustaining, that China could grow forever with no problems, etc. Such beliefs eventually became a religion.

The tail does not wag the dog no matter how many people think otherwise.
Let us explore decoupling by looking at manufacturing, employment, and capital flows.

Global Manufacturing Contracts

Please consider U.S. Manufacturing Orders at 60 Year Low, China Contracts 5th Straight Month. That is not decoupling, that is a worldwide recession.

Millions of Chinese Struggle to Find Jobs

In the wake of a global slowdown, Chinese export shrink, civil unrest is a worry, and unemployment is rising as noted in Xinhua says there will be more unemployment and social revolts in 2009:
State council adviser Chen Quansheng, warns that unemployment is much more serious than portrayed by the official statistics. According to Chen, so far at least 670,000 small industries have been closed, leaving 6.7 million people unemployed, but this number refers only to registered workers. But there are millions of people working in the underground economy, coming from the countryside, who are being fired and are forced to return to their villages without any unemployment benefits.

The academy of social sciences is also warning about the worrisome number of firings. In 2009, the government will have to create work for at least 33 million people, including migrants, young people seeking their first jobs, and new graduates.
The odds of China finding work for 33 million workers without printing vast amounts of money are slim.

Hot Money Outflows Exacerbate Chinese Problems

Inquiring minds are reading Monetary conditions might exacerbate the Chinese adjustment by Prof. Michael Pettis.

Synopsis: Chinese monetary policy has locked the country into a dangerously pro-cyclical trap. Hot money flowed into China and pushed the economy into overheating. Those inflows have reversed sharply, perhaps by as much as $100 billion last quarter, equivalent to around 8% of Q4 GDP. These outflows are causing a credit contraction and an even sharper economic slowdown at exactly the worst possible moment.

One Tail Cannot Wag Six Dogs

Those hot money inflows were all part of the global credit boom that is now unwinding. Much of China’s boom centered on exports. Now that the U.S. consumer has thrown in the towel, a key question arises:

Can China expand enough to make up for the contraction in US and European demand given that the two economies are more than six times the size of China?

The answer to that last question is an emphatic no. One tail cannot wag six dogs.

Here is another way to look at it. The U.S. is the world’s largest economy. Housing had already weakened but commercial real estate had not. U.S. retail stores and malls were being built at an unsustainable blowoff pace and those stores were crammed with goods coming from China and Japan.

The decoupling theory was that loss of the U.S. consumer would not matter to the commodity producers like Canada and Australia or the manufacturers like China and Japan. How could any economist have thought that? Many did. Schiff was one of them.

Peter Schiff on 2009-2010 USA Hyperinflation

Here is a partial transcript of a Schiff Audio On U.S. Hyperinflation
The whole idea is to get out of the U.S. Dollar. It is on the verge of collapse. The people who do not get out of the U.S. dollar are going to be completely broke and that is obvious. Look at what Ben Bernanke did. Interest rates are zero. Money is free.

Bernanke is going to run up printing presses as fast as he can. This is pure inflation Latin American style. This is hyperinflation; this is Zimbabwe; this is the identical monetary policy of the Weimar Republic.

I am just as convinced that people who have their money in U.S. dollars are going to be just as broke as people who have their money with Madoff.

I do not know how much time you have. With the dollar dropping 5% a week at this point, could it snap back? But what if it keeps falling? What if it is down 5% next week? And 5% the week after that? And then what if it drops 10%? and another 10%? At some point a year from now the dollar could be dropping 5% a day.

The inflation rate in Zimbabwe is over 100 million percent a year.
Hyperinflation or Hyperventilation?

Schiff asks “But what if it keeps falling? What if it is down 5% next week? And 5% the week after that? And then what if it drops 10%? ...”

That was quite some rant, enough to scare many who listened. Schiff is indeed very charismatic.

He never bothers to ask, “What if it does not?” The answer was not so pretty for his clients. The simple fact of the matter is Schiff was wrong where it mattered.

Schiff has been ranting about hyperinflation for years. The dollar is substantially higher now than it was at the start of 2005. His explanation for the recent rally is there is no “real demand” for dollars, it is just deleveraging.

I agree that deleveraging is indeed happening.

But why is deleveraging happening? The answer is everyone herded into anti-dollar plays based on decoupling and hyperinflation theories that did not pan out. Those trades are now being forcibly unwound. The bulk of the carnage is likely over but the losses have been immense.

Unlike Schiff, I called for this U.S. dollar rally. On November 9th, I went neutral on the dollar as the US dollar index came close to hitting my target.

In 2001-2002 the US$ index peaked at 121. Since then there was a massive flight out of U.S. dollars into anything else. That flight continued into 2008 even though the fundamentals were changing.

The fundamentals of China and the commodity producers were simply not very good once the U.S. consumer threw in the towel.

Schiff simply did not see this coming.

U.S. the Next Zimbabwe?

Schiff continually compares the U.S. to Zimbabwe. Such comparisons are silly. Please consider Zimbabwe to launch 100 trillion dollar note.
Zimbabwe’s central bank will issue a 100 trillion Zimbabwe dollar banknote, worth about $33 (22 pounds) on the black market, to try to ease desperate cash shortages, state-run media said Friday.

Prices are doubling every day and food and fuel are in short supply. A cholera epidemic has killed more than 2,000 people and a deadlock between President Robert Mugabe and the opposition over power sharing has dampened hopes of ending the crisis.

Hyperinflation has forced the central bank to keep issuing new banknotes which quickly become almost worthless. There is an official exchange rate, but most Zimbabweans resort to the informal market for currency transactions.
Does that sound like anything that is happening or is going to happen in the U.S.? I think not.

However, let us assume for a moment that hyperinflation is going to happen. Where then could one get the most bangs for their buck to take advantage? The answer to that question is in real estate, where one can buy on 5% down. Nowhere else can one easily get such leverage.

Note that there has never been hyperinflation in history where real property declined in value. Therefore, if Schiff really believes in hyperinflation, he ought to be suggesting that his clients buy houses.

However, Schiff thinks housing prices will continue to crash. So do I. And if they do, you can kiss hyperinflation theories goodbye.

EuroPacific Thoughts on the Financial Crisis

I do not expect every advisor at every company to think alike, but I did find these Thoughts on the Financial Crisis by Andre Sharon, Consulting Research Analyst for Euro Pacific Capital rather interesting.
What Now?

Only three possible outcomes:

1. We inflate to the level of the debt, i.e., we “fulfill” debt obligations, but in mini-dollars

2. We take the hit, cleanse the system of excesses and move on. Result: deflation, bankruptcies, high unemployment, etc. ...

3. We disinflate veeeeeeeeeeeeeeeeeeeeeeeeeeeeeeeeeeeery slowly, like Japan. Will not happen: the American psyche will not take 16-odd years of no growth. Different cultural mindset: you cannot prick a balloon slowly here.

My guess: combination of 1 and 2. I would hope for a bias towards 2. Terrible for many, but healthier for the system long-term. Schumpeter’s concept of creative destruction trumps Keynes, in my book. That is life, and progress, with all its faults and flaws.
My pick is a combination of 2 and 3 (2 is not by choice but rather by force) for reasons explained in Brink of Debt Disaster.

But what I find interesting is that a Europacific advisor believes that Keyensian economics can be trumped (I do as well, Japan proved it), but also that Andre Sharon at least in part is calling for “Result: deflation, bankruptcies, high unemployment, etc. ...”

I would advise Schiff to toss his hyperinflation theories out the window and listen more to his research analyst. However, Schiff cannot and will not change because he has two books calling for hyperinflation.

On the other hand, I can change. I called for deflation and it is here right now. I do not have to wait for it. The only debate is how long it lasts.

At the appropriate time, I expect to transition my stance towards a stagnant slow growth period in which there will be inflation but not by a lot. In such a scenario, the U.S. would hop in and out of recessions for up to a decade, much like Japan.

Time will tell whose model is correct. I reserve the right to change my model. It is too late for Schiff to change his. The damage has already been done.

Closer Look At Currency Fundamentals

The U.S. economy is clearly in shambles. However, when the U.S. dollar index crashed to 70 the dollar was priced as if the U.S. alone was in trouble. That was hardly the case. Europe, China, Australia, Canada, the UK, are in shambles as well.

On August 8 2008, “Trichet Put the Spotlight on the Euro, Dollar” by saying economic growth in Europe would be “particularly weak". That was a clear signal all was not well in the Eurozone. Most, including Schiff ignored the signal.

Although the U.S. had a massive housing bubble, so did Spain, Ireland, and other parts of Europe. Also note that European banks invested in U.S. mortgage debt.

Finally, European banks invested heavily in Latin America and the Baltic states. The U.S. did not make those mistakes.

The credit crunch now threatens the sacrosanct

On January 19 2009, New Europe reported “The credit crunch now threatens the sacrosanct.”
Last October, the ECB signed a currency swap agreement with the Swiss National Bank. The obvious purpose was to support the solvency of the Swiss Franc. The reason why the franc needed support was that the country’s banks had undertaken huge obligations in foreign currencies, which exceed the Swiss national income, probably by many times. Who knows how many? Last week this agreement was renewed and extended in volume.

The case is similar with Iceland. That tiny country was one of the richest and most reliable in the world, a kind of small Switzerland. But Iceland’s banks were found at the beginning of the credit crisis to have huge obligations in foreign currency. When the banks started to go insolvent the government of Iceland stepped in and nationalised them.

In the case of Switzerland – along with the ECB – came the American central bank, the Fed, to support the solvency of the franc with foreign swap agreements. Who on earth wants the Swiss banks to fail? In short, nothing has been settled in the credit crunch crisis and the entire world continues to support those who created the problems in the first place.
Think the Swiss Franc is a safe haven? I don’t.

So what about the Euro? Here are a few headlines to ponder.

Germany Faces Worst Post-War Economic Decline

Synopsis:

Germany is facing its biggest economic downturn since the Second World War with Chancellor Angela Merkel’s government saying ... it expects Europe’s largest economy to contract by 2.25% this year. Germany’s Economics Minister Michael Glos and Finance Minister Peer Steinbrueck released the latest data ... revising their prior 2009 forecast down sharply from last October’s prediction of 0.2% growth.Since then, German exports have declined precipitously and are expected to be down 8.9% for the year.

Berlin Sees No Limits to Economic Intervention

Synopsis:

As part of her efforts to combat the economic crisis, German Chancellor Angela Merkel is increasing the state’s influence in the market, buying holdings in banks and bailing out individual industries and companies.Is Germany turning into a planned economy? Only a few weeks ago, Chancellor Angela Merkel spoke out against “arbitrary, unfocused economic stimulus programs” and large-scale government intervention in the real economy.

Trichet Vision Unravels as Italy, Spain Debt Shunned

On January 16, 2009 Bloomberg reported “Trichet Vision Unravels as Italy, Spain Debt Shunned.”
European Central Bank President Jean-Claude Trichet’s vision of economies converging behind the shield of a shared currency may be unraveling.

The gap between the interest rates Spain, Italy, Greece and Portugal must pay investors to borrow for 10 years and the rate charged to Germany has ballooned to the widest since before they joined the euro. The difference may grow further as Europe’s worst recession since World War II hurts budgets and credit ratings across the region.

Diverging bond yields hurt Trichet’s argument that the ECB’s inflation-fighting mandate ushered in an era of stability for nations that once suffered rampant price growth.

They also make it tougher for the ECB, which cut its key rate to a record yesterday, to set one benchmark for all 16 euro nations. That may delay recovery as governments try to fund stimulus plans.
Monetary union has left half of Europe trapped in depression

Ambrose Evans-Pritchard at The Telegraph is writing “Monetary union has left half of Europe trapped in depression.”
Events are moving fast in Europe. The worst riots since the fall of Communism have swept the Baltics and the south Balkans. An incipient crisis is taking shape in the Club Med bond markets. S&P has cut Greek debt to near junk. Spanish, Portuguese, and Irish bonds are on negative watch.

Dublin has nationalized Anglo Irish Bank with its half-built folly on North Wall Quay and Eur73 billion (£65 billion) of liabilities, moving a step nearer the line where markets probe the solvency of the Irish state.

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

Each is a victim of ill-judged economic policies foisted upon them by elites in thrall to Europe’s monetary project – either in EMU or preparing to join – and each is trapped.

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

Latvia’s property group Balsts says Riga flat prices have fallen 56% since mid-2007. The economy contracted 18% annualized over the last six months. Leaked documents reveal – despite a blizzard of lies by EU and Latvian officials – that the International Monetary Fund called for devaluation as part of a €7.5 billion joint rescue for Latvia. This was blocked by Brussels – purportedly because mortgage debt in euros and Swiss francs precluded that option.

Spain lost a million jobs in 2008. Madrid is bracing for 16% unemployment by year’s end.

Private economists fear 25% before it is over. Spain’s wage inflation has priced the workforce out of Europe’s markets. EMU logic is wage deflation for year after year. With Spain’s high debt levels, this is impossible.

Italy’s treasury awaits each bond auction with dread, wondering if can offload €200bn of debt this year. Spreads reached a fresh post-EMU high of 149 last week. The debt compound noose is tightening around Rome’s throat. Italian journalists have begun to talk of Europe’s “Tequila Crisis” – a new twist.
On page 157 of Little Book of Bull Moves in Bear Markets, Peter Schiff writes “The Euro could possibly replace the United States dollar as the world’s reserve currency.”

I suggest a breakup of the Eurozone has a greater chance than that. While I agree that U.S. dollar hegemony will end eventually, ideas that the Euro will replace the U.S. dollar as the world’s reserve currency are farfetched.

Looking far ahead, there may not be any one reserve currency per se. Ideally we will return to a gold standard but at the moment that does not seem particularly likely either.

So what about Australia? Can it decouple?

Australia is one of Peter Schiff’s favorite countries for investing. Please consider “Aussies hit by 50 year record wealth decline.”
CommSec equities economist Savanth Sebastian says that is the worst fall in records dating back to 1960.

“It is no doubt that it will have a big impact on consumer spending going forward adding further downward pressure after we saw those job losses in terms of full-time employment,” he said.

“So it suggests that for the Reserve Bank and for the government further stimulus will need to be on the agenda.”
That additional “stimulus” is the same thing Schiff rails about in the U.S. every time he speaks. The whole world is stimulating now.

Australia Won’t Hesitate To Stimulate

Australia Treasurer Wayne Swan says “Australia’s government won’t hesitate to stimulate the economy further” should the need arise amid the global recession.
"We will not hesitate to take whatever further action is necessary to support growth and jobs,” Swan, 54, said in speech notes received via e-mail. “Major financial institutions, some of which have withstood world wars and the Great Depression, have either collapsed or been bailed out.”
The Australian dollar is one of Schiff’s favorites. “While other countries are creating inflation, Australia’s central bank is raising interest rates to keep inflation in check.” – page 161

Australia May Cut Interest Rate Below 2%

Former Reserve Bank Governor Fraser suggests “Australia May Cut Interest Rate Below 2%.”
Fraser, Reserve Bank of Australia chief during the nation’s last recession in 1991, said policy makers may reduce the overnight cash rate target to less than 2% from 4.25% now. The bank’s board gathers for the first time this year on Febuary 3.

“This recession will be deeper and longer than the last recession in 1991,” Fraser said in a phone interview today from his home near Canberra. “The Reserve Bank could go below 2 percent; they will go as low as they need to and a further stimulus from the government will be required.”
Australia started reducing rates at the fastest rate ever in 2008, culminating with a surprise cut of 100 basis points in December. More rate cuts are coming.

One of the biggest drivers for currencies is relative differentials in interest rates, as well as expectations of future increases in interest rates differentials. The Fed is not cutting any more so future rates cuts in Australia may increase the unwinding of various carry trades (borrowing in dollars or yen, and investing in Australian dollars or Euros).

Peter Schiff did not see or simply ignored the ramifications of the unwinding of various carry trades. All gains in the Australian dollar have been wiped out since 2003.

US$ Trading Range Theory

China, the UK, the Eurozone, Canada, Australia, and Japan are all slashing interest rates. And every country above is printing like mad. Finally, European banks are in dire straits because of bad loans to the Baltic states and Latin America on top of bad investments in U.S. mortgage backed securities.

Schiff simply ignores those problems, or worse yet is not even aware of them.

Given the severe stress everywhere, and given the race to zero interest rates by all, the odds favor a wide trading range rather than a collapse of the dollar. Hyperinflation is simply not in the cards, at least for the US. Ironically, China or Russia is at far greater risk.

What About Commodities?

The following is from a chapter in his book called “Hot Stuff” on page 105.

Schiff writes: “What I want you to take away from this chapter is the knowledge that there is extraordinary excitement in commodities, which are in the early stages of a historic secular bull market.” ...

[Chart: $CRB Commodities Monthly Index with comments noting turning points.]

“There is extraordinary excitement in commodities.”

Indeed there was. However, the time to invest in anything is not when there is extraordinary excitement but rather when there is no excitement at all.

When there is no excitement, the likelihood of investing safely for a long period increases. The above chart shows what happens when you invest for the long haul during periods of high excitement.

The Little Book of Bull Moves in Bear Markets nailed the exact cyclical peak in the commodities boom. Ironically, the subtitle to his book is “How to Keep Your Portfolio Up When the Market Is Down".

Peter Schiff was wrong about deflation.

There is no debate (at least there should not be a debate) that the U.S. is in deflation. The conditions in the U.S. are exactly what one would expect to see in deflation. The score is a perfect 15 out of 15. Please see Humpty Dumpty On Inflation for details.

I believe I know Schiff’s rebuttal. He will talk about soaring money supply. Yes, money supply is indeed soaring, but destruction of bank balance sheets is happening faster. He will counter that it is money that matters, not credit.

History proves otherwise, but I willing to debate on the basis of money supply alone.

[Chart: “Base Money Percentage Change From A Year Ago"]

Using monetary expansion alone, one would conclude there was massive inflation during the great depression, starting in 1931!

Any definition that suggests that there was inflation in 1931 is silly. Some might counter, as one person recently did “It is not silly. When gold was confiscated by FDR and then revalued 70% higher in dollar terms, was this not inflation?”

My reply is “During the Great Depression, the purchasing power of the dollar went up vs. everything but gold. If the purchasing power of gold vs. the dollar is the sole judge of the inflation-deflation debate, then deflation ruled from 1980 to 2000, a ridiculous proposition.”

It is important to pick definitions of inflation carefully. A definition based on money supply and credit successfully predicted interest rate trends, stock prices, the price of gold, housing, and numerous other things.

A definition of inflation based on the CPI failed miserably in predicting interest rates.

A definition based solely on an increase in money supply failed miserably in predicting interest rates, the recent strengthening of the U.S. dollar, gold’s decline from 850 to to 250 between 1980 and 2000, and numerous other things.

Soaring money supply simply is not proof “Big Inflation Is Coming” just as it was not proof that “Big Inflation” was coming in 1931. There cannot possibly be any other logical conclusion when confronted with the data.

Is Peter Schiff Early?

Some will claim that Schiff is simply “early". However, from the perspective of The Little Book of Bull Moves In Bear Markets, Schiff was 5 years too late.

Schiff responded as much a couple of weeks later: “Our Investing Plan Is Right, if Slightly Ahead of the Times". Our post on item is included below.

To be fair, he was talking about commodities and foreign equities long before that, but as is often the case, such books come out at a time of “Peak Excitement". Schiff’s book was the ultimate contrarian indicator.

Let us Return to Schiff’s Investment Thesis.

Schiff’s Investment Thesis 12 Ways Schiff Was Wrong in 2008 That is a lot of things to be wrong about, especially given all the “Peter Schiff Was Right” videos floating around everywhere. The one thing he was right about was the collapse of U.S. equities and no part of his investment strategy sought to make a gain from that prediction.

Peter Schiff concludes many of his articles, books, etc. with the claim he saw this coming and “positioned his clients accordingly.”

Fortune Magazine Examined The Hype

Peter Schiff: Oh, he saw it coming

“Dr. Doom” became a star by predicting last year’s market meltdown. And now his 2009 forecast is even scarier.

Schiff did not invest for doom; he invested for a bull market that did not exist. He was wrong where it mattered most, protecting client assets. For this amazing feat, people think of him as a star.

[Image: An Actual Schiff Portfolio]

The above statement is from a person who claims to have additional portfolios invested with Schiff over the past 2 years. In total (not just this portfolio), my contact says he invested $70,000 and is now down to $27,000. That is a loss of 61%.

I have talked with another person who claims to be down 72%, and many others who claim 40% or more.

Schiff’s entire invest thesis seems to boil down to “Buy and hold foreign stocks, foreign currencies, and commodities, come hell or high water, and hold on to them.” Hell has arrived for those following Peter Schiff’s philosophy.

Perhaps I have stumbled on the worst of Schiff’s portfolios. There is one way to find out.

I challenge Schiff to post the average returns for his clients on a year-by-year basis, just as Sitka Pacific [Shedlock’s brokerage firm] does. That is the only way to see just how right (or wrong) his investment thesis is.

Note that Schiff has claimed (see below) that as a broker S.E.C. regulations preclude him from publically disclosing results, e.g., aggregated brokerage account results. To be sure, coming up with some aggregate of that sort would be a daunting task – fraught with opportunities to misrepresent actual results. Nevertheless, Shedlock does not seem similarly contstained from posting average results, as we see ...

Sitka Pacific vs. Europacific Philosophies

Rather than take a rigid position as to what the market “should do", Sitka Pacific Capital Management tries to position itself for what the market is doing. At times we may like a particular stock group, commodity, or currency, and at other times not.

We do not think this is a good time for buy and hold strategies for either foreign or domestic stocks or currencies. Moreover, we certainly do not think it was prudent to put 100% on foreign stocks and currencies, with virtually no exit strategy if wrong.

We do feel a long-term position in gold on a percentage of assets is a reasonable proposition.

Schiff’s slogan is “Because There’s A Bull Market Somewhere. ™” but for a year he failed to find one with the exception of physical gold. Ironically, one of his most hated asset classes (U.S. treasuries), had one of their best years in history.

Sitka Pacific Strategies

The two key strategies at Sitka Pacific are called Hedged Growth (a long-short, primarily domestic strategy), and Absolute Return (a global strategy that can invest in domestic stocks, foreign stocks, gold, and currencies, hedged at times with inverse index ETFs).

Absolute Return may at times bear some resemble to Schiff’s strategy but we are not dogmatic about it. If we do not like market action in stocks and commodities, we are on the sidelines and heavy in cash or treasuries.

Absolute Return had a 34% position in long dated treasury ETFs in 2008, now well less than half that after cashing out.

[See “Chart of Hedged Growth Since Inception,” comparing the strategy’s performance from June 2005 to December 2008 with that of the S&P 500, and the concommitant table.]

Note the 0.17 correlation to the S&P 500 and Hedged Growth.

Correlations run from -1 (perfect inverse, think inverse ETF) to +1 (think buying every stock in the S&P). Zero is no correlation. A correlation of 0.17 is very low. What it means is the strategy is not dependent on market direction. Many hedge funds make that claim, but the average hedge fund got lost well over 20% in 2008.

Hedged Growth achieves its performance by picking a basket of stocks long and a basket of stocks short. Market direction, inflation-deflation debates, interest rates, etc., simply are not a concern for this strategy. The idea is to pick a winning basket of good stocks vs. poor stocks on a relative basis.

The most we ever put on a short position is 1.7%, and we only take a position in liquid issues. We never add to short positions. This is for risk management purposes.

[See “Absolute Return Since Inception” chart, comparing the strategy’s performance from August 2005 to December 2008 with that of the S&P 500, and the concommitant table.]

The chart shows a monthly correlation to the S&P at 0.36. That is a low number, which is a good thing.

The chart also shows we had a significant drawdown between June and October. That drawdown was based primarily on an expectation that gold and gold miners would diverge from the market on a seasonal trend. That seasonal pattern did not happen. We are not going to get everything correct, but no one else will either. We made much of that drawdown back in late November and December while Hedged Growth was flat.

One additional thing I would like point out is that none of our strategies was net short in 2008. Our most cautious stance is market neutral. Thus, we were neutral to long the whole year, and our two key strategies finished solidly in the green even though the S&P finished down 38.5%.

90+% of Sitka Pacific accounts are either Hedged Growth or Absolute Return.

To lay everything out in the open, we also offer Commodities Focus (a portfolio of commodity related stocks and ETFs). Commodities Focus does not hedge and will tend to track a blend of energy stocks and mining stocks. It was down 34.5% on the year. Only 2% of our clients are in this strategy, approximately 0.5% by total asset value.

Commodities Focus is best suited for those who want anti-dollar plays for a hedge or for those with a very long time horizon as opposed to boomers headed into retirement with their nest egg.

We also offer Dividend Growth for IRA clients who cannot short. Dividend Growth is similar to Hedged Growth, except it may or may not hedge. When it does hedge, it uses inverse ETFs as opposed to shorts. Dividend Growth was down 4.6% for the year, a good achievement compared to the S&P 500 which was down 38.5%.

Gains Needed To Get Even

10% —   11%
50% — 100%
70% — 233%

If you are down 10% you need to gain 11% to get back to where you were, at 50% down you need a 100% gain to get back to even, and at 70% down you need a 233% gain to get even. This is why risk management and capital preservation is paramount.

Boomers significantly down hoping to get back to even may find it will take a decade or more. Those close to, or already in retirement, simply do not have a decade to make up for losses. That is the problem with buy and hold strategies.

Buy and hold was wrong nearly everywhere, but especially for those in or approaching retirement.

Client Letters

We post our client letters online, on a 2 month delayed basis. The letters come out sooner if you subscribe. Subscription is free. Interested parties may register for Sitka Pacific Monthly Newsletters. Subscribe at the bottom of the linked-to page.

In the wake of various scandals, a certain question invariably comes up.

How Sitka Pacific differs from Madoff, hedge funds, and mutual funds.

We are the very opposite of hedge funds or mutual funds.

High Risk, High Reward Strategies

Placing everything one has on anti-dollar bets is a type of high risk, high reward strategy. There is little room for error, especially if there are no risk management controls, which Schiff does not seem to have. “The whole idea is to get out of the U.S. Dollar. It is on the verge of collapse. The people who do not get out of the U.S. dollar are going to be completely broke and that is obvious. ... people who have their money in U.S. dollars are going to be just as broke as people who have their money with Madoff.”

Such arguments can easily be construed as “fear tactics.” Listen to the previously mentioned Schiff Audio On U.S. Hyperinflation and make your own determination. While it is certainly prudent to have some diversification, it is not prudent, in my opinion, to bet the farm on a complete hyperinflationary collapse of the U.S. dollar that did not occur and in my estimation will not, at least for a long time.

Undiversified, unhedged portfolios may succeed spectacularly. They also risk catastrophic loss. Many who rolled the dice on Schiff’s philosophy came up snake eyes: a catastrophic loss that depending on the exact portfolio, may take a decade or longer to recover.

Where To In 2009?

The question as to where the market is headed comes up all the time. The truth is, no one really knows. However, we see no real value here. Fundamentally stocks are not cheap. Earnings are sinking, unemployment is rising, and this was the biggest debt bubble in history. Logic dictates the biggest bubble should be followed by the biggest crash.

To pick a range for a bottom something like 450-600 on the S&P 500 would seem about right. If so, that is quite a drop from here, and one would certainly want to be hedged if that happens.

However, if the market starts to behave like there is some value now, we will change our tune.

We strongly doubt the dollar will crash, but we will take notice if it breaks out of its trading range. We do like gold here but that can change. Commodities may have bottomed. We doubt stocks have. Foreign stocks may outperform but remember they were clobbered more in 2008.

We are not permabears or permabulls, nor do we daytrade. We review and reposition our strategies monthly, but if something noticeable happens mid-month, we try to react to it.

Unlike Schiff, we attempt to position our clients for what the market is actually doing, not what we think it ought to be doing. The distinction is paramount, especially when such thinking just might be wrong.

PETER SCHIFF RESPONDS TO HIS CRITICS

Peter Schiff, author of the 2007 bestseller Crash Proof: How to Profit from the Coming Economic Collapse, correctly predicted the collapse of the U.S. financial markets and economy well before they actually occurred. But as we mentioned above, those who came late to the party and acted on his more aggressive investment strategies got killed last year.

Schiff has basically had the audacity to be vocally and visibly correct where the mainstream establishment pundits and policy makers were flat out wrong, and disastrously so. He can expect flack whenever he is not indisputably right, as was the case in spades in 2008. If Schiff is wrong he is not going to be so silently: “My critics have often referred to me as a stopped clock. I believe that the accusation is best leveled at the accusers. Having been wrong for so long, they are now enjoying their brief moment in the sun. They should enjoy it while it lasts.”

Just who is “they"? Washington and Wall Street “accusers” are one thing, and can be dismissed. Mike Shedlock is another matter entirely. Shedlock and Schiff are fellow travelers when it comes to economics and philosophy. But Schiff has something to learn from Shedlock. Schiff would do well to adjust his capital preservation tactics going forward and explain these adjustments to all. Dismissing Shedlock’s criticisms as being “distorted” and “twisting the facts to support his own preconceived conclusion” and “nothing more than an overt advertisement” does not cut it. They suggest someone whose ego has elbowed its way to the front of the line ahead of the facts. We have one word to say to Peter: humility.

Words are words, and performance is performance. The coach of 3-time Superbowl champion New England Patriots, Bill Belichick is famous for his rote pronouncement (which has become something of a cliché) on the outcome of a football game: “It is what it is,” meaning forget all the stories about why the result was in some sense an inaccurate expression of underlying reality ... time to move on. Time for Peter Schiff to move on and stop defending 2008’s results. Especially zip the lip on any insinuations that he is right and the market is wrong.

The market is what it is. It is bigger than all of us. It is nothing if not humbling. Get over it.

My popularity on television and the internet has led a very small money manager to use his popular financial blog to promote his fledgling business by attacking the recent poor performance of my long-term investment strategy. The post is causing quite a stir and compels me to provide some badly needed context.

To achieve his ends, this individual has distorted much of what I have been saying and writing, and has twisted the facts to support his own preconceived conclusion. In essence, his piece is nothing more than an overt advertisement (and a highly deceptive one at that) to use my popularity to advance his career. In so doing he has given my critics, particularly some who have been embarrassed by their roles in the “Peter Schiff was Right” video, their moments of retribution. In addition, some members of the press who have never been among my greatest fans are seizing the opportunity to discredit me as well.

The crux of the blogger’s arguments are that my beliefs in “decoupling, hyperinflation, and that the dollar is going to zero” have been completely discredited by the events of 2008, and that the resulting investment losses suffered by my clients last year confirms the fatal flaws in my approach.

In addition to mischaracterizing many of my beliefs, he also is confusing short-term market fluctuations with long-term economic trends.

First of all, the hyperinflation issue is a straw man at best. While I often talk about the possibility of hyperinflation, I have always said that it would be a worse-case scenario that would play out over many years. The fact that it did not appear in the first year of the economic crash (2008) does not invalidate my position. I have always maintained that this worst-case scenario will likely be avoided by what will ultimately be a dramatic shift in policy once our leaders come to their senses. However, until then the dollar will likely lose a substantial portion of its value.

Second, I never said that the dollar would go to zero, either in 2008 or any year thereafter. I have said that in the event of hyperinflation the dollar’s value would approach zero. My actual forecast in my book Crash Proof was that the Dollar Index would fall to 40 (currently about 85), with a realistic worst case scenario, assuming very high but not hyperinflation, of 20 or lower.

Third, the blogger points out that because the decoupling theory (foreign economies improving while the U.S. falters) that I wrote about in Crash Proof has yet to occur, that the theory itself was ridiculous. In my book I wrote that this process would not occur overnight, that initially our creditors would come to our aid, and in so doing our problems would become manifest abroad. I wrote that it would take time for the world to realize that what had been decoupled from the economic train was not the engine but the caboose. In fact, that is precisely the way it is playing out.

Chapter 10 of Crash Proof is specifically focused on the need to keep funds liquid to take advantage of the buying opportunity that would initially develop once our stock market began its collapse. I specifically mentioned that when U.S. stocks began to fall, we could expect sympathetic declines overseas. While I did not know the precise timing of those events, I advised readers to prepare.

I did not expect the huge dollar rally of 2008. But to discredit my long-term view of the dollar based on an 8-month move is absurd. So while I believed that a weak dollar would cushion the temporary decline I expected in foreign stocks, a strong dollar ended up exacerbating it. In the meantime, I believed that the high dividends these stocks were paying would make it easier to ride out any correction. The problem was that the dollar fell so far leading up to the crisis (in 2005-2007) that by the time the crisis finally erupted the dollar was poised for a bounce.

Central to the argument that my investment thesis is wrong is the belief that the crisis is over or that the recent trends will continue until it is. But the crisis is just beginning and the movements thus far in the dollar, commodities, and foreign stocks, are mere head fakes. Once the speculators have been flushed from the markets, the underlying long-term trends I have been following should return in earnest.

To illustrate the flaws in my investment strategy the blogger has posted a client’s statement that shows a loss in excess of 60%. In addition, he claims to know of other Euro Pacific clients who have experienced similar losses. The inference of course is that most, or all, of my clients must have suffered similar losses, and the existence of such losses proves that I am wrong. In fact, some have gone a step further, claiming that such losses prove that I am a fraud.

First let’s deal with the one client’s account. I have been following several key investment themes for the past 10 years. The basis for my strategy is that recent U.S. prosperity has been false, and that the consequences of the bursting of our bubble economy would ultimately play out in a substantial decline in the value of the U.S. dollar, higher commodity prices, the re-monetization of gold, and foreign equities substantially outperforming U.S. markets. From an investment perspective, those themes played out extremely well in the eight years from 2000-2007. Recently we have seen a sharp, and I believe temporary, reversal of these trends. Those that came late to the party (at least based on where we are today) now have to ride out a particularly difficult correction.

For example, the account in question belongs to the son of a long-standing Euro Pacific client, who is still adding funds to his accounts. Without specifically commenting on the performance of the father’s account, it must have been compelling enough to finally persuade the son to come on board himself in early 2008. However, as is often the case, by the time he came on board, foreign stocks and commodities were about to sell off, and the dollar was about to begin its unexpected rally. Following such a sharp correction, the son now regrets his decision and must blame me for my part in helping him make it.

Perhaps as a stockbroker I should have persuaded the son to wait for a correction. However, while this clearly would have been the right call with the full benefit of hindsight, it was certainly not as clear given the information I had at the time. However, I never held myself out to be a market timer. My advice was always geared to long-term investors. Given the thousands of clients that I have, and the large number who joined near the recent dollar bottom and market tops, it is no wonder that a few have contacted this blogger to complain; especially since he has actively sought them out. Of course, the fact that the overwhelming majority of my clients are not complaining, to him or anyone else for that matter, says a lot more about what is really going on.

To the extent that the long-term trends I have been following continue, I am confident that even those whose short-term timing was bad will still do well in time. This is especially true if they take advantage of this pull back by adding to their accounts, either with new funds or by re-investing their dividends. However, to examine the effectiveness of my investment strategy immediately following a major correction by looking only at those accounts who adopted the strategy at the previous peak is unfair and distortive.

Since I have been advising investors to follow these trends for 10 years, I will leave it to the public to draw their own conclusions as to how long-term followers of my strategy have fared. However, for those who only recently adopted my approach in 2007 or 2008, the road has been a lot bumpier than they or I thought it would be when they climbed on board. Yet if these long-term trends re-emerge, though the journey may be different than planned, the ultimate destination will remain the same.

The blogger in question implies that all of my clients are down by levels similar to the account he cites. He has asked me to refute his allegations by providing broader performance figures for more clients. But, since Euro Pacific Capital is a brokerage firm and not a Registered Investment Advisor, I am prohibited by regulators from providing any details on the investment performance achieved by my clients. The blogger in question makes his challenge knowing full well that I am legally prevented from accepting it. He then uses my failure to refute his false claim as validating its accuracy.

In addition, consider that 70% of the account in question happens to be invested in mining and energy stocks. These were the two sectors that got hit the hardest in the recent downturn. This is a very aggressive exposure to those sectors and not typical of Euro Pacific clients. While it is true that many of my clients are interested in these two sectors and specifically seek portfolios heavily weighted in these areas, most take a more balanced approach, with mining and energy typically representing 20% to 30% of their portfolios. I also have clients with minimal or no exposure to these sectors.

All Euro Pacific client accounts are different reflecting the individual objectives of each client. In general the goals of my clients are to get out of the dollar and hedge against inflation. However the way each client chooses to pursue these goals varies. Some choose a relatively conservative approach, consisting mainly of utilities, property trusts and bonds, others choice a more balanced approach, adding exposure to infrastructure, agriculture, energy trusts, and transportation, while some are more aggressive with heavy exposure to resources, junior mining companies, and oil and gas exploration companies. Some clients specifically seek to gain or avoid exposure to certain regions, sectors or currencies. Some are focused more on long-term preservation of purchasing power, while others look to maximize long-term appreciation. Most of our accounts are yield oriented, but many of our clients specially request more aggressive growth oriented portfolios. In a down market to evaluate my investment strategy based solely on the performance of the most aggressive accounts is completely unfair. Doing so ignores the better performance of less aggressive accounts that were not hit nearly as hard.

In addition, to look only at the performance of foreign stocks, while ignoring other aspects of my investment strategy only tells part of the story. What about gold, foreign bonds, short positions in financials, home builders and subprime mortgages (or merely avoiding long exposure to those sectors), or other investments people have made, either at Euro Pacific or elsewhere based on my insights? What about dividends earned, or gains realized on closed positions?

Mainstream economists, journalists, and investment professionals have never liked my message and have never resisted the temptation to shoot the messenger. When my investment strategies were performing well, I got little credit for it. Instead, all the attention was focused on the apparent failure of my dire economic predictions to materialize. Now that the economy is collapsing along the lines that I correctly forecast, criticism is being focused on the recent poor performance of my investment strategy (a fact that I have never tried to hide). Of course by the time my investment strategy is once again in step with my economic forecasts, an event that I believe will occur sooner than most people think, it will likely be too late for most people to do adopt it.

My critics have often referred to me as a stopped clock. I believe that the accusation is best leveled at the accusers. Having been wrong for so long, they are now enjoying their brief moment in the sun. They should enjoy it while it lasts. For now, they are creating fodder for some future “Peter Schiff was Right” piece where those who now criticize my investment performance will look just as foolish as those who once criticized my economic forecasts.

RIGHT FORECAST BY SCHIFF, WRONG PLAN?

The piece above and this Wall Street Journal article were published the same day (1-30). The charges of failure against Schiff’s approach here essentially recapitulate Michael Shedlock’s above in far less detail. A quoted critic goes further than Shedlock in some respects, saying Schiff’s investment strategy was a focused bet on a single outcome, rather than risk management for investors looking to protect assets from an economic collapse: “He is a speculator; he thinks he can see the future. That is not really risk control.”

Perhaps. Lack of diversification per se does not indicate riskiness if the investor truly understands what they are doing. The question is whether Schiff really did understand how risky his approach was, or was he taken by surprise like just about every other Wall Street schmo?

Peter Schiff predicted a collapse of the U.S. financial system. The bust-up he did not foresee was the one that made mincemeat of investors who took his advice in 2008.

Mr. Schiff’s Darien, Connecticut, broker-dealer firm, Euro Pacific Capital Inc., advised its clients to bet that the dollar would weaken significantly and that foreign stocks would outpace their U.S. peers. Instead, the dollar advanced against most currencies, magnifying the losses from foreign stocks Mr. Schiff steered his investors into.

Investors open accounts at Euro Pacific to take advantage of Mr. Schiff’s investment advice, which generally involves shunning investments in dollars. Individual returns can vary. Some investors may like gold-mining stocks, while others prefer energy-focused stocks.

Most had one thing in common last year: heavy losses. A number of investors said their Euro Pacific portfolios lost 50% or more in 2008, worse than the 38% drop in the S&P 500 stock index last year. People familiar with the firm say that hardly any securities recommended by Euro Pacific brokers gained ground in 2008.

Such losses came as something of a surprise. Mr. Schiff’s prescient call for the collapse of the U.S. housing market and the weakening of the financial system helped him gain fame as an economic guru and savvy investor who promised shelter from the financial storm.

In his 2007 book, Crash Proof: How to Profit from the Coming Economic Collapse, he recommends that investors pile into gold, commodities and overseas stocks that spit out steady dividends.

When global markets were soaring, many Euro Pacific investors’ accounts experienced strong performance. For several years, investors saw returns in excess of 20% a year as foreign stocks and commodities surged, according to people familiar with the firm.

In 2008, investors nervous about the state of the U.S. economy who were impressed by Mr. Schiff’s track record poured money into Euro Pacific, nearly doubling the number of accounts to 16,000. But many did so at the worst time possible, much like investors who piled into Internet stocks as the dot-com bubble peaked.

Mr. Schiff, 45 years old, says the downturn in his strategy is a short-term setback. He argues that it is only a matter of time before the dollar collapses, pressured by massive government bailouts, triggering outsize returns for his investors.

“I think the dollar is going to get destroyed,” he says. Investors with the staying power to wait out what he sees as a temporary phase of irrational confidence in the dollar will reap huge rewards, he argues.

Mr. Schiff is still riding high on his housing-market call. This week, he spoke at a global competitiveness conference in Riyadh, Saudi Arabia, alongside former heads of state, prime ministers and American gold-medal swimmer Michael Phelps. He is the subject of more than 3,000 YouTube videos, including one called “Peter Schiff Was Right.”

His admirers even created Web sites supporting a possible run for the U.S. Senate in 2010. Mr. Schiff, who was economic adviser to Republican presidential candidate Ron Paul in 2008, says he has no plans to run for the Senate but “anything’s possible.”

Critics say Mr. Schiff’s strategy is much riskier and more aggressive than many investors realize. David Yeske, managing director of Yeske Buie, a Vienna, Virginia, money manager, says Mr. Schiff’s investment strategy was a focused bet on a single outcome, rather than risk management for investors looking to protect assets from an economic collapse. “He is a speculator; he thinks he can see the future,” says Mr. Yeske, former chairman of the Financial Planning Association. “That is not really risk control.”

One of Mr. Schiff’s biggest forecasts was that many overseas economies would “decouple” from the U.S., gaining strength even as the American economy struggled. Instead, overseas stock markets plunged as much or more than U.S. stocks in 2008 as the global economy skidded. Prices for commodities also tanked, torpedoing another favorite investment theme of Mr. Schiff’s. After last year’s losses, his firm has about $845 million in assets.

Early last year, Richard De Gennaro, a retired Harvard University librarian, put $100,000, about 15% of his assets, into a Euro Pacific account that included Canadian Oil Sands Trust, which focuses on crude-oil projects in Canada, and the India Capital Growth Fund, which holds investments in companies that do business in India.

Both investments took big hits in 2008, compounded by the fact that the Canadian dollar and the Indian rupee fell 18% and 19%, respectively, against the U.S. dollar. The 83-year-old retiree’s account is now worth about $37,000, a 63% plunge. Mr. Schiff “goes around saying that he was right,” says Mr. De Gennaro. “He was right about one thing and wrong about everything else.”

Among investors who turned to Mr. Schiff’s firm just as his strategy began to falter, Brian Kullberg, a design engineer in Portland, Oregon, says he started to worry about the state of the U.S. economy in early 2008. He put $70,000 into a Euro Pacific account, hoping it would benefit as the U.S. economy and the dollar weakened. By late January 2009, his investment had shrunk to about $25,000.

“It is curious,” says one longtime client of Mr. Schiff’s who works in finance. “His thesis of how things are going to collapse and crumble and fall apart is not effectively executed in [my] account.” The account, which is largely invested in gold, mining and infrastructure stocks from Canada to Australia, was down roughly 35% last year, the client estimates. The Australian dollar weakened 19% against the U.S. dollar in 2008.

Mr. Schiff says one year’s poor performance does not prove he was wrong. He has admitted in notes to clients that his investment thesis has not performed as expected, particularly with respect to the U.S. dollar. But he holds fast to his convictions and has been telling investors to scoop up a number of depressed stocks.

Some clients are inclined to agree. “The decoupling he talked about has not happened,” says Barbara Hearst, a clothing entrepreneur who ... has invested with Mr. Schiff since 2000. But “longer term or medium term, I do not discount what Peter says.”

I Was Not Wrong, Just Early, Says Peter Schiff

Schiff’s dramatic and correct predictions of collapses in the U.S. housing market, general economy, and financial markets got him some favorable publicity. But his corollary premise that the resolution would be massive U.S. dollar inflation has not panned out – not yet, and not yet on the horizon either. Investment strategies derived from that premise, such as buying foreign and commodity stocks, worked well for several years leading up to 2008 but failed miserably in 2008 – unfortunately very soon after, as so often happens, many investors piled in at the peak of the strategy’s success.

The Wall Street Journal, in the article posted immediately above, highlighted the losses certain investors sustained following Schiff’s strategies, and cited critcisms leveled at the riskiness of Schiff’s strategy.

That criticism is probably valid, in our view, especially given there was no “What if I am wrong?” exit strategy. Here Schiff responds by saying, in effect, that he will soon have the last laugh. Certainly a one-year reversal in no way discredits an investment strategy, but the charge that one is taking excessive risks in order to achieve expectable returns deserves an answer. A legitimate defense would be to look, e.g., at his 5-year performance versus his peers or some relevant benchmark. But, according to Schiff, he is “prohibited by regulators from providing any details on the investment performance achieved by my [brokerage] clients” – fellow broker Shedlock’s unqualified provision of his results notwithstanding.

It would buttress his case if certain clients of Schiff’s would step up to the plate and voluntarily provide some numbers which support his assertion that his long-term results are indeed “solid.” Otherwise such assertions are vulnerable to charges of misrepresentation and hucksterism. For such charges to stick around would be too bad, as Schiff’s is a voice that deserves to continue being heard. Witness the posted commentary from him below.

The year 2008 produced horrific investment returns for nearly every investor. Although I have never made any assertions that Euro Pacific Capital clients avoided the pain, the Wall Street Journal took it as newsworthy that some who had adopted my more aggressive strategies early last year had losses that outpaced the drop in the Dow ("Right Forecast by Schiff, Wrong Plan?,” Money & Investing, January 30).

My central investing premise, a weakening dollar and safety in gold, commodities and foreign stocks, did not materialize in 2008. But all the ingredients were (and remain) present for those movements to occur. Over the past year, market reactions that I didn’t foresee – massive global deleveraging, a knee-jerk “flight to quality” into U.S. Treasurys and a sharp countertrend rally in the U.S. dollar – have kept the scenario from playing out.

Throughout my career, I have never claimed great ability to time markets. I was against tech stocks in 1998, and homebuilders and financials in 2004. These stands cost me (and my clients) short-term profits. In contrast, my record of long-term forecasts is well above par and has produced solid long-term results. My clients understand this and, backing their belief with their dollars, have largely remained invested.

It is not insignificant that while U.S. markets are testing new lows, the dollar is no longer rallying, gold and other commodities are rising, and many foreign exchanges are well off their 2008 lows.

A LIST

Here is our list of lessons to be drawn from Peter Schiff’s 2008 experience, with thanks to the various people we have stolen from:

CREDIT WHERE CREDIT IS DUE

This following three pieces are good examples of the cogent thinking and instructive writing of Peter Schiff. He explains the proper role of credit in the economy, and how creating more money and credit out of nothing can only harm the economy. The one weak point that creeps in is his insistent warnings about inflation. Certainly that is a risk down the road, but a useful forecast requires time and price. Right now the wind is blowing deflation.

Among contemporary followers of the Austrian School of economics one finds many brilliant minds and good writers. Surf on over to LewRockwell.com or the Ludwig von Mises Institute website and you will readily find examples. But few of them have Schiff’s popular audience or simplicity of rhetoric.

This week, in a speech before the London School of Economics, Fed Chairman Ben Bernanke offered a perverse economic theory in his quest to gather support for never-ending Wall Street bailouts: “This disparate treatment, unappealing as it is, appears unavoidable. Our economic system is critically dependent on the free flow of credit, and the consequences for the broader economy of financial instability are thus powerful and quickly felt.” In other words, credit is the lifeblood of our economy, and the continued operation of credit providers is an issue of national security.

In truth, not all economies run on credit. But over the last decade, the United States became a bubble economy that needed unlimited credit to keep from collapsing. In a legitimate economy, it is not credit that fuels spending and investment, but simply income and savings. It is too bad our Fed chairman does not understand the difference.

That American families now routinely rely on credit to make every-day purchases is a habit that needs to be broken and not encouraged. What we need in America is more restraint and less indulgence. For example, Americans in the current economy should not go into debt to buy new cars. Given the level of debt that weighs down the typical family, Americans should defer such purchases until they have paid down existing debt, or replenished their savings to the point where they can afford to pay cash. Until that time, Americans should continue driving their old cars. In the meantime, the untapped savings could be made available to local businesses that would use it to finance badly needed capital investments.

But such a drastic reversal in financial culture represents the kind of change that no one in the outgoing or incoming Administrations appears willing to consider. By providing perpetual support to lenders who have bankrupted themselves through bad loans, the government merely guarantees that bad economic behavior will continue.

Credit is indeed vital to an economy, but it does not constitute an economy within itself. The important thing to remember is that credit is scarce, and is limited by the stock of savings. Savings loaned to one individual is not available to be loaned to another until it is repaid. If it is never repaid, the savings are lost. Loans to consumers not only crowd out more productive loans that might have been made to business, but they have a far greater likelihood of ending in default. In addition, while business loans increase our capital stock and lead to greater productivity, loans made to consumers are merely spent, and do not create conditions that will make repayment easier. When businesses borrow to fund capital investments, the extra cash flows that result are used to repay the loans. When individuals borrow to spend, loans can only be repaid out of reduced future consumption.

One of the reasons we are in such dire straits is that consumers have already borrowed and spent too much. Many did so based on the false belief that ever-appreciating real estate would ultimately provide the means to repay their debts and finance their lifestyles. Now that reality has finally set in, why should the spending spree continue? The fact that a GDP comprised of 70% of consumption is currently contracting should not surprise anyone. In fact, such a contraction is long overdue and the government should not do anything to interfere.

In trying to perpetuate the illusion, the government wants to revive the spending spree that has led us to this disaster. But how can such actions possibly help? How will more debt improve the economy? Would our circumstances not be vastly improved if we paid off some of our debts and replenished our savings? Would we not be in better shape if instead of buying more stuff we concentrated on producing it?

The unpleasant reality is that years of bad monetary and fiscal policy have over encumbered our economy with debt and undermined our industrial capacity. The sooner we can begin to repair the damages, the sooner we can right the ship. If instead we merely administer more of the same, the ship will sink in a sea of inflation.

Obama’S Opening Salvo

There is nearly universal agreement that the opening salvo of the Obama Administration’s campaign to restore health to the financial system, delivered this week by new Treasury Secretary Geithner, fell with a loud and ugly thud. The most common criticism is that the announcement was short on detail. What is abundantly clear, however, is that the new Administration intends to push spending back up to pre-crash levels and to fill the entire credit void that has disappeared into the black hole of the American financial system. Whether or not the prior levels of spending and lending were justified by market conditions then, or now, appears to be largely unexamined.

In the worldview of Geithner and like-minded economists, credit, rather than savings, is the central figure in the economic equation. Therefore, he sees anything that eases the process of lending to be an effective economic policy. With such a view in mind, the centerpiece of Geithner’s plan is the commitment of up to $1 trillion to revive the collapsed market for securitized debt. In the lead up to the Crash of 2008 securitization, more than anything else, permitted Americans to borrow more than they had ever borrowed before.

Developed primarily over the last 10 years, securitization permitted loans of all shapes and sizes to be packaged into investment-ready securities. The system worked, fueling unprecedented levels of lending in the home, auto, student, and credit card sectors. But in the last few years as the collateral underpinning these securities has collapsed in value, the trillions of dollars of securitized debt now in circulation has become the toxic sludge at the bottom of our financial pit. Geithner is making the false assumption that cleaning up and rebuilding the securitization market is a prerequisite for a healthy economy.

Our nation’s short history with wide securitization has simply shown that the process can lead to massive mispricing of assets and risk. By artificially rebuilding the securitization market, and committing taxpayer funds as collateral, the U.S. economy will be pushed farther and farther out on a leveraged limb, until no amount of market medicine can prevent a total economic collapse.

In truth, the only vital function provided by securitization was that it offered foreign savers a pathway to lend directly to American consumers, and Wall Street executives a new asset class to over-leverage for massive profits. Our economy must dispense with these gimmicks if it hopes to pursue a meaningful recovery.

After more than a decade of unsustainable borrowing and spending, the private sector is currently attempting to restore balance through reduced consumer and mortgage credit, greater savings, and lower asset prices. With its trillions of dollars of credit injections and stimulus programs, the government hopes to allay this process by force-feeding Americans a diet of more borrowing. They feel that a restored securitization market will help. It won’t. It will just grease the skids for a quicker collapse.

Credit, whether securitized or not, cannot be created out of thin air. It only comes into existence though savings, which must be preceded by under-consumption. Since savings are scarce, any government guarantees toward consumer credit merely crowd out credit that might otherwise have been available to business. During the previous decade too much credit was extended to consumers and not enough to producers (securitization focused almost exclusively on consumer debt). The market is trying to correct this misallocation, but government policy is standing in the way. When consumers borrow and spend, society gains nothing. When producers borrow and invest, our capital stock is improved, and we all benefit from the increased productivity.

Consumers default on credit much more frequently than businesses. This is because businesses typically use loans to expand, and then have greater cash flow to repay the debt. In contrast, consumers typically borrow to consume and in the process do not improve their ability to repay. As a result, one would expect consumer credit to be harder and more expensive to obtain. But that is currently not the case. Government guarantees have altered the playing field, so that now consumers are still being offered credit while businesses are being shown the door. By shifting credit away from producers, fewer goods and services will be produced for consumers to buy and fewer employment opportunities provided for them to earn money with which to buy the goods.

To restore prosperity, credit (derived from savings rather than a printing press) must flow to producers. Greater liquidity for business will lead to legitimate job creation, increased production, and rising living standards. By further encumbering the economy with burdensome regulation, and by transferring business decisions to vote-seeking politicians who will bail out the irresponsible, reward failure and punish success, the government will create a society destined for misery.

In an interview following his announcement, Geithner stated that government should replace the demand lost by the private sector. However, those with even a marginal grasp of economics know that demand is unlimited. It is the ability to spend that is not. While Americans still want all the things they wanted years ago, they have made the rational choice that they can no longer afford to buy at the same levels they once did. Using a printing press to replace this lost “demand” will simply cause consumer prices to rise. Printed money does not create new purchasing power, but merely redistributes it from savers to borrowers. And since the plan will severely undermine the real productive capacity of our economy, there will not be much purchasing power left to redistribute!

Obama Puts the Economic Cart Before the Horse

In his first televised speech before Congress, President Obama asserted that prosperity will return once the government restores the flow of credit in the economy. It may come as a surprise to him, but an economy cannot run on consumer loans. Furthermore, credit stopped flowing in the U.S. for a very good reason: There was no more savings left to loan. Government efforts to simply make credit available, without rebuilding productive capacity or increasing savings, are doomed to destroy what is left of our economy.

The central tenets of Obamanomics appear to be that access to credit will enable people to borrow money to buy stuff, the spending will spur production and employment, and thus the economy will grow. It is a neat and simple picture, but it has nothing whatsoever to do with how an economy works. The President does not understand that consumption is made possible by production and that credit is made possible by savings. The size and complexity of modern economies has obscured these simple concepts, but reducing the picture to a small scale can help clear away the fog.

Suppose there is a very small barter-based economy consisting of only three individuals, a butcher, a baker, and a candlestick maker. If the candlestick maker wants bread or steak, he makes candles and trades. The candlestick maker always wants food, but his demand can only be satisfied if he makes candles, without which he goes hungry. The mere fact that he desires bread and steak is meaningless.

Enter the magic wand of credit, which many now assume can take the place of production. Suppose the butcher has managed to produce an excess amount of steak and has more than he needs on a daily basis. Knowing this, the candlestick maker asks to borrow a steak from the butcher to trade to the baker for bread. For this transaction to take place the butcher must first have produced steaks which he did not consume (savings). He then loans his savings to the candlestick maker, who issues the butcher a note promising to repay his debt in candlesticks.

In this instance, it was the butcher’s production of steak that enabled the candlestick maker to buy bread, which also had to be produced. The fact that the candlestick maker had access to credit did not increase demand or bolster the economy. In fact, by using credit to buy instead of candles, the economy now has fewer candles, and the butcher now has fewer steaks with which to buy bread himself. What has happened is that through savings, the butcher has loaned his purchasing power, created by his production, to the candlestick maker, who used it to buy bread.

Similarly, the candlestick maker could have offered “IOU candlesticks” directly to the baker. Again, the transaction could only be successful if the baker actually baked bread that he did not consume himself and was therefore able to loan his savings to the candlestick maker. Since he loaned his bread to the candlestick maker, he no longer has that bread himself to trade for steak.

The existence of credit in no way increases aggregate consumption within this community, it merely temporarily alters the way consumption is distributed. The only way for aggregate consumption to increase is for the production of candlesticks, steak, and bread to increase.

One way credit could be used to grow this economy would be for the candlestick maker to borrow bread and steak for sustenance while he improves the productive capacity of his candlestick-making equipment. If successful, he could repay his loans with interest out of his increased production, and all would benefit from greater productivity. In this case the under-consumption of the butcher and baker led to the accumulation of savings, which were then loaned to the candlestick maker to finance capital investments. Had the butcher and baker consumed all their production, no savings would have been accumulated, and no credit would have been available to the candlestick maker, depriving society of the increased productivity that would have followed.

On the other hand, had the candlestick maker merely borrowed bread and steak to sustain himself while taking a vacation from candlestick making, society would gain nothing, and there would be a good chance the candlestick maker would default on the loan. In this case, the extension of consumer credit squanders savings which are now no longer available to finance other capital investments.

What would happen if a natural disaster destroyed all the equipment used to make candlesticks, bread and steak? Confronted with dangerous shortages of food and lighting, Barack Obama would offer to stimulate the economy by handing out pieces of paper called money and guaranteeing loans to whomever wants to consume. What good would the money do? Would these pieces of paper or loans make goods magically appear?

The mere introduction of paper money into this economy only increases the ability of the butcher, baker, and candlestick maker to bid up prices (measured in money, not trade goods) once goods are actually produced again. The only way to restore actual prosperity is to repair the destroyed equipment and start producing again.

The sad truth is that the productive capacity of the American economy is now largely in tatters. Our industrial economy has been replaced by a reliance on health care, financial services and government spending. Introducing freer flowing credit and more printed money into such a system will do nothing except spark inflation. We need to get back to the basics of production. It will not be easy, but it will work.

President Obama would have us believe that we can all spend the day relaxing in a tub while his printing press does all the work for us. The problem comes when you get out of the tub to go to dinner and the only thing on your plate is an IOU for steak.