The S&P soared 2% today on the back of central bank chatter in addition to Japan embarking on yet another round of its own version of quantitative easing (QE or printing money out of thin air to buy worthless paper assets). Not to be undone, Charles Evans, Chicago Federal Reserve President, added his voice to the daily chorus of Federal Reserve members openly advocating a second round of quantitative easing. The market anticipates that the FOMC will formally announce QE2 following its November 3rd meeting. This drove the dollar down 2% against gold as the precious metal jumped $25 to settle at $1,340. So the S&P, denominated in dollars, rose 2% while the dollar dropped 2% against gold and 1% against a basket of equally deficient currencies. This equates to no real return for the day as the dollar’s continued debasement serves to nominally inflate a stock market totally dependent on the FED for life support. After all, equities immediately turned back down in April of this year following the conclusion of the FED’s first round of asset purchases.
To further solidify my point, let’s take September’s equity performance as the most recent example. The headlines read “Stocks post best September in 71 years” as the 7.7% run-up in the DOW supposedly confirmed that the economic recovery is intact and progressing as planned. The press conveniently glossed over gold’s 5% increase and the dollar’s 7% drop against the Euro alone during the month. In aggregate, the dollar index dropped 5.4% in September. So the DOW’s “real” return adjusted for the dollar’s decline was only 2.3% (7.7% DOW increase - 5.4% dollar decline). Again, chatter from the Federal Reserve walloped the dollar as it communicated that it would ease further if economic conditions warranted. The market interpreted the remarks that the Federal Reserve stood by to engage in a second round of QE, which was confirmed once again today.
If QE1 had worked as intended, why would the FED need to engage in a second round of easing? Zero interest rates are no longer enough to stimulate the economy given that the capital markets will perpetually decline each time stimulus is removed prompting the need for additional asset purchases. As a result of the FED’s continued treasury purchases, the yield on the 10-year has dropped below 2.5%. Historically, such low yields in treasuries would have implied an S&P 500 value below 800 as the bond market is pricing in a much lower growth rate than what stocks currently reflect.
Anyone following my thoughts over the past several years knows how bearish I am on the economy. In early May 2009, I called a nominal top on the DOW of around 8,400, completely underestimating the impact that the ocean of liquidity created by central banks would have on commodity, bond and equity markets alike. I did qualify my forecast by stating that currency fluctuations and a weak dollar could artificially inflate stock and commodity prices. It appears that this exact scenario has played itself out over the past 18 months as most asset classes continue to climb in tandem driven by cheap money flows into risky assets. However, upon closer examination, the DOW’s 30% run-up since I called “the top” was far surpassed by the gold price 49% increase over the same period. In other words, the DOW, priced in gold, has dropped 12% despite nominally rising 30%.
Date DOW Gold DOW/Gold Ratio
5/4/2009 8,400 900 9.33
10/5/2010 10,945 1,340 8.17
% Change 30% 49% -12%
Gold is an excellent indicator of true value. It filters out currency fluctuations and the corresponding debasement of the US Dollar. Once this same ratio is applied over the past decade, the results are, in a word, stunning:
Date DOW Gold DOW/Gold Ratio
5/4/2009 8,400 900 9.33
10/5/2010 10,945 1,340 8.17
% Change 30% 49% -12%
The DOW, currently hovering at just under 11,000, has dropped 80% since Y2K once priced in gold. The dollar index has dropped from 103 to just 78 over the same period, representing a 32% decline. Now this number may seem farfetched, but let’s take a simple real world example to illustrate. In early 2000, gas prices were $1/gallon and have now climbed to roughly $3/gallon, representing a threefold increase in just over 10 years. This run up is not limited to gold and oil as many key commodities have experienced triple digit percentage increases as highlighted below. All the while, wages in the U.S. have remained stagnant, barely keeping up with the cost of living. Commodity prices refuse to decline despite the official unemployment rate doubling. However, at the height of the credit crisis in early 2009, commodity prices collapsed as liquidity evaporated from the system. The sharp decline in commodities during that period proves that it is cheap money and the weak dollar driving prices, not underlying demand. Refer to the commodity data below for a summary of pricing by key commodity. Note that current wheat prices may be exaggerated as droughts in Russia have led to a suspension of wheat exports, driving global wheat prices up sharply over the past several months.
Commodity 10/5/2010 Avg. 1999 price % Change
Oil $82.72 $16.56 400%
Copper $3.73 $0.71 425%
Corn $4.91 $2.14 129%
Soybeans $10.72 $4.69 129%
Wheat $6.63 $3.17 109%
Although China’s explosive growth over the past 10 years explains a percentage of this increase, it does not come close to accounting for the magnitude of these price increases. Bulls will argue that robust demand from emerging markets is the primary driver underlying today’s prices. However, any sane market participant would conclude that it is liquidity, leverage and speculation aided by the weak dollar and artificially low interest rates supporting prices.
Commodity and equity markets are in a bubble. The average person does not care to understand the detail behind the financial headlines they see on TV or read in the paper. They only know two colors, green and red. The massive trillion dollar bailouts only served to pile on more debt to an already overleveraged system. The collapse of ‘08/’09, leading to oil in the $30 range and an S&P of 666 was the market’s way of trying to cleanse itself of the excess leverage. The FED’s actions continue to interfere with the free market by artificially inflating paper assets through the issuance of debt that only serves to debase the dollar. Make no mistake about this, with asset correlations at all time highs, and all assets rising in tandem, a breaking point will soon be reached.
Investors must recognize that traditional cyclical responses will not address the deep rooted structural issues currently plaguing the global economy. From the earnings conference calls that I have listened to over the past twelve months, most CEOs still falsely believe that the economy is near the trough of the business cycle. In reality, the economy is only 3 innings into what will be the greatest deleveraging structural correction ever experienced. Companies looking to make acquisitions during this period are basing their projections on revenue streams that will never materialize in a deflationary environment.
Despite all the statistics thrown around by the talking heads, there is only one fact that matters. Consumption has risen to 70% of the US economy, an unsustainable level by any rational metric as it historically comprised 65% of GDP. America had a robust manufacturing base that supported this 65% consumption rate. The disappearance of industry has made it impossible to even maintain 60% consumption without individuals incurring untenable debt levels. Structural imbalances have fueled this binge as taxpayers and governments alike continue to employ excessive amounts of leverage to finance this addiction.
I am not a market timer so I will keep my projections longer term:
1) Systemic risk will rise to all time highs as Central Banks have all but eliminated market risk. Greece was the first domino to fall, but by no means the last. Portugal, Ireland, Italy and Spain (the remaining PIIGS countries) have significant structural imbalances and the Euro will fail as the European banking system is more leveraged than America’s. I will be shocked if the Euro does not at least trade at parity with the dollar by the end of 2012.
2) California will be the first state requiring a bailout from the Federal government, but it will not be the last. The municipal bond market will start to crack by 2012 as states will be unable to address their deficits fast enough to account for much lower than anticipated tax revenues.
3) The FED’s efforts to inflate asset prices will fail as servicing debt is inherently deflationary. Any real improvement in the economy will be met by prohibitively high commodity prices that will shock the system back into a sharp decline, alas the summer of 2007. It is no accident that the $140/barrel oil directly preceded the onset of the great recession in December 2007. Oil settled near $82 today despite comfortable supply levels amidst a weak global back drop. The question has to be asked; what if the Western economies actually show sign of life? Oil will skyrocket and push the economy into an sharper contraction. Thank you FED for your endless supply of cheap dollars.
4) Emerging markets will not be the safe haven that many investors anticipate. Contrary to popular belief, the Chinese and Indian economies are primarily export based as austerity measures in Europe and declining U.S. based demand will hit China and India hard. Their respective populations will not make up for the lost purchasing power of the developed Western economies overnight. Given my outlook on greatly reduced global demand, I personally think that you would have to be a fool to invest in emerging markets at these levels.
5) The US equity market, priced in gold, will continue to decline. However, I think that all asset classes will sell off sharply as final demand continues to decrease and the real unemployment situation worsens. The U6 unemployment rate, which factors in discouraged and underemployed workers, equaled 16.7% in August. I expect this number to climb north of 20% by the end of 2012.
6) According to Bloomberg, current analyst consensus estimates is for S&P operating earnings of $95 in 2011, or a 15% projected increase over 2010. Why is the FED in pure panic mode if companies are in a position to grow annual earnings by 15%? Further, how is projected GDP growth of 2% in developed economies going to drive earnings 15% higher after companies have already cut expenses to the bone? Margin compression seems more probable.
The domestic equity markets are clearly outperforming the real economy in anticipation of a recovery that is yet to materialize. GDP growth in the prior quarter already slowed to 1.7%, well below what is needed to make any meaningful dent in the unemployment rate. My advice is simple; do not get caught holding risk assets when the herd realizes that the FED is the only buyer left in the market. Governments cannot cure debt with the issuance of more debt. It really is that simple.
Tuesday, October 5, 2010
Monday, November 9, 2009
Bailout Bubble Growing Ever Larger
The weak dollar carry trade has finally made its way to the mainstream financial media in recent weeks as the plunging dollar continues to drive equities higher. Commentators have finally eluded to this relationship absent any other explanations for the market's continued run-up. In a strange twist of fate, Wall Street continues to cheer adverse economic data as the weak economy keeps the Fed from raising interest rates. So the toxic brew of low rates and cheap money that led to the first collapse will somehow cure all of the structural deficiencies currently plaguing our economy.
It's no accident that the S&P hit its year high on the same day the dollar index hit a 15 month low on the back of bearish comments coming out of the G20 meeting this weekend. Apparently, the G20 has concluded that the US dollar is still overvalued and will most likely post further declines in the coming months. These comments coupled with the group's stance to keep economic stimulus measures in place helped drive the S&P up 2.2% today on top of the 3% gain sported last week. Oil and gasoline prices also rose over 2% alone today as a barrel of oil straddles the $80 mark. Gold also hit a new nominal high at over $1,100/oz. As much as I like gold as a long term investment, I would not touch it at these levels. It has benefited from the excess liquidity and leverage in the system. Once interest rates increase and the aforementioned carry trade reverses, gold will post precipitous declines. The gold trade is crowded and once the retail investor decides that they want to own some gold, it's probably a good idea to go ahead and unload it on to them.
The truest measure of unemployment as measured by the Bureau of Labor Statistics has risen to 17.5%. Contrary to what Keynsian economists may lead you to believe, unemployment statistics are not a lagging indicator. The jobs lost today will not be coming back, they have permanently disappeared.
The unemployment rate has more than doubled since the start of the recession in December 2007, yet US equities have only dropped 26% over their record close in October 2007. Although the weak dollar helps explain part of this discrepancy, low interest rates can only take stocks so far. Incidentally, equities peaked two months before the official onset of the recession, directly challenging market forecasters who claim that the market always prices assets out six to nine months into the future.
Both commodities and equities are in bubble territory. Specifically, oil and gasoline are grossly overvalued based on fundamentals. Eventually, not even the weak dollar will serve as support because the coming collapse in demand will result in a severe and sharp price drop. Oil is at least 50% overvalued at these levels.
On the equities side, technology, retail, and financial stocks are just ridiculously overvalued. I made the same call in June and it's obvious that I was early in my call to short these stocks, but I'm confident that when the bubble bursts, and it will burst, these stocks will see 50%+ haircuts. My top equity shorts based on valuation are 1)Baidu, Inc (BIDU, $425.87) 2)Amazon (AMZN, $126.67), 3) Sears Holdings (SHLD $70.51). Additionally, tech bell weathers such as Google ($562.51) and Apple ($201.46) have approached or eclipsed their all time highs. Although these valuations are more reasonable, consumer and advertising spending will not support these share prices over the next several years. I have put my money where my mouth is with respect to my short positions, but I am prepared to wait until 2010 to see any significant pullback in equities.
The current administration continues to pursue easy money policies favorable to financial markets but detrimental to the country's long term economic health. The average American's standard of living along with saving rates declined during the 20 year stock market bull run from 1987-2007. These measures will result in extreme economic turmoil and the emergence of legitimate political third parties to offset the disastrous policies enacted by both Democrats and Republicans over the past five decades.
It's no accident that the S&P hit its year high on the same day the dollar index hit a 15 month low on the back of bearish comments coming out of the G20 meeting this weekend. Apparently, the G20 has concluded that the US dollar is still overvalued and will most likely post further declines in the coming months. These comments coupled with the group's stance to keep economic stimulus measures in place helped drive the S&P up 2.2% today on top of the 3% gain sported last week. Oil and gasoline prices also rose over 2% alone today as a barrel of oil straddles the $80 mark. Gold also hit a new nominal high at over $1,100/oz. As much as I like gold as a long term investment, I would not touch it at these levels. It has benefited from the excess liquidity and leverage in the system. Once interest rates increase and the aforementioned carry trade reverses, gold will post precipitous declines. The gold trade is crowded and once the retail investor decides that they want to own some gold, it's probably a good idea to go ahead and unload it on to them.
The truest measure of unemployment as measured by the Bureau of Labor Statistics has risen to 17.5%. Contrary to what Keynsian economists may lead you to believe, unemployment statistics are not a lagging indicator. The jobs lost today will not be coming back, they have permanently disappeared.
The unemployment rate has more than doubled since the start of the recession in December 2007, yet US equities have only dropped 26% over their record close in October 2007. Although the weak dollar helps explain part of this discrepancy, low interest rates can only take stocks so far. Incidentally, equities peaked two months before the official onset of the recession, directly challenging market forecasters who claim that the market always prices assets out six to nine months into the future.
Both commodities and equities are in bubble territory. Specifically, oil and gasoline are grossly overvalued based on fundamentals. Eventually, not even the weak dollar will serve as support because the coming collapse in demand will result in a severe and sharp price drop. Oil is at least 50% overvalued at these levels.
On the equities side, technology, retail, and financial stocks are just ridiculously overvalued. I made the same call in June and it's obvious that I was early in my call to short these stocks, but I'm confident that when the bubble bursts, and it will burst, these stocks will see 50%+ haircuts. My top equity shorts based on valuation are 1)Baidu, Inc (BIDU, $425.87) 2)Amazon (AMZN, $126.67), 3) Sears Holdings (SHLD $70.51). Additionally, tech bell weathers such as Google ($562.51) and Apple ($201.46) have approached or eclipsed their all time highs. Although these valuations are more reasonable, consumer and advertising spending will not support these share prices over the next several years. I have put my money where my mouth is with respect to my short positions, but I am prepared to wait until 2010 to see any significant pullback in equities.
The current administration continues to pursue easy money policies favorable to financial markets but detrimental to the country's long term economic health. The average American's standard of living along with saving rates declined during the 20 year stock market bull run from 1987-2007. These measures will result in extreme economic turmoil and the emergence of legitimate political third parties to offset the disastrous policies enacted by both Democrats and Republicans over the past five decades.
Thursday, October 22, 2009
Ignorance Is Bliss (A Peter Schiff Commentary)
The economic commentary article below authored by Peter Schiff perfectly summarizes why we are far from recovery.
While all the talk at present is about economic corners turned and markets charging ahead, no one is paying much notice to an American economy deteriorating before our eyes. These myopic commentators seem to be simply moving past the now almost-universally held conclusion that before the crash of 2008, our economy was on an unsustainable course. If these imbalances had been corrected, then perhaps I too would be joining in the euphoria. But evidence abounds that we have not veered at all from that dangerous path.
Last week, the Bureau of Economic Analysis reported that consumer spending as a percentage of U.S. GDP has risen to 71%, a post-World War II record. This level is notably higher than other wealthy industrialized countries, and vastly higher than the levels sustained by China and other emerging economies. At the same time, our industrial output is contracting, our trade deficit is expanding once again (after contracting earlier in the year), and our savings rate is plummeting (after an early year surge).
The data confirms that government stimuli are worsening the structural imbalances underlying our economy. The recent ‘rebound’ in GDP is not resulting from increased economic output, but merely from the fact that we are borrowing more than ever. That is precisely how we got ourselves into this mess. An economy cannot grow indefinitely by borrowing more than it produces. Not only is such a course untenable, but the added debt ensures a deeper recession when the bills come due.
This soon-to-be-called depression will not end until the pendulum of consumer spending habits swings violently in the other direction. This will be a jarring change, but it is the splash of cold water that we need to return our economy to viability. I believe that consumer spending as a share of GDP will need to temporarily contract to roughly 50% of GDP, before eventually moving toward its historic mean of 65%. Such a move would indicate a restoration of our personal savings, a decline in borrowing and trade deficits, and an increased industrial output. That would be a real recovery.
In the meantime, the higher the spending percentage climbs, the more painful the ultimate decline becomes.
Consumers and governments must spend less so their savings can be made available to businesses for capital investments. Businesses, in turn, will produce more products and employ more people – increasing domestic prosperity. However, rather than allowing a painful cure to return our economy to health, the government prefers to numb the voting public with a toxic saline-drip of deficit spending and cheap money.
The primary factor that enables our government to peddle economic snake oil is the dollar’s unique role as the world’s reserve currency, and our creditors’ willingness to preserve its status. By buying up dollars and loaning them back to us through Treasury debt, productive countries give American politicians carte blanche to play Santa Claus.
Ironically, as foreign governments finance our spending spree, they are simultaneously scolding us for our low savings rate. At the recent G20 meeting in Pittsburgh, all agreed – including President Obama – that resolving the global economic imbalances was a top priority. By definition, this would require Americans to spend less and save more. However, with foreign central banks continuing to buy our debt, the President has shown no political will to encourage this change.
Normally, if politicians run up the government deficit, voters soon suffer the unpleasant consequences of higher inflation and rising interest rates. Yet, if foreign central banks keep supplying the funds, these consequences are indefinitely postponed. As a result, there is no need for American politicians to ever make the tough choices required to solve our problems.
Instead, the burden may fall squarely on the citizens of those governments doing all the lending. The conflict is that within the creditor states, a vocal minority actually benefits from this subsidy (owners of Chinese exporters, for example) while the overwhelming majority fails to make the connection. Thus, foreign politicians have the same incentives as ours to keep playing the game.
The bottom line is that foreign governments can lecture us all they want about the need for prudence but if they keep lending, we’ll keep spending. Any parent knows that if you give your child a curfew yet never impose any penalties when it’s violated, it will not be respected. My gut feeling is that foreign governments are tiring of our conduct and on the verge of finally imposing some discipline. That means the dollar’s days as the world’s reserve currency are numbered, and the days of American austerity are about to begin.
While all the talk at present is about economic corners turned and markets charging ahead, no one is paying much notice to an American economy deteriorating before our eyes. These myopic commentators seem to be simply moving past the now almost-universally held conclusion that before the crash of 2008, our economy was on an unsustainable course. If these imbalances had been corrected, then perhaps I too would be joining in the euphoria. But evidence abounds that we have not veered at all from that dangerous path.
Last week, the Bureau of Economic Analysis reported that consumer spending as a percentage of U.S. GDP has risen to 71%, a post-World War II record. This level is notably higher than other wealthy industrialized countries, and vastly higher than the levels sustained by China and other emerging economies. At the same time, our industrial output is contracting, our trade deficit is expanding once again (after contracting earlier in the year), and our savings rate is plummeting (after an early year surge).
The data confirms that government stimuli are worsening the structural imbalances underlying our economy. The recent ‘rebound’ in GDP is not resulting from increased economic output, but merely from the fact that we are borrowing more than ever. That is precisely how we got ourselves into this mess. An economy cannot grow indefinitely by borrowing more than it produces. Not only is such a course untenable, but the added debt ensures a deeper recession when the bills come due.
This soon-to-be-called depression will not end until the pendulum of consumer spending habits swings violently in the other direction. This will be a jarring change, but it is the splash of cold water that we need to return our economy to viability. I believe that consumer spending as a share of GDP will need to temporarily contract to roughly 50% of GDP, before eventually moving toward its historic mean of 65%. Such a move would indicate a restoration of our personal savings, a decline in borrowing and trade deficits, and an increased industrial output. That would be a real recovery.
In the meantime, the higher the spending percentage climbs, the more painful the ultimate decline becomes.
Consumers and governments must spend less so their savings can be made available to businesses for capital investments. Businesses, in turn, will produce more products and employ more people – increasing domestic prosperity. However, rather than allowing a painful cure to return our economy to health, the government prefers to numb the voting public with a toxic saline-drip of deficit spending and cheap money.
The primary factor that enables our government to peddle economic snake oil is the dollar’s unique role as the world’s reserve currency, and our creditors’ willingness to preserve its status. By buying up dollars and loaning them back to us through Treasury debt, productive countries give American politicians carte blanche to play Santa Claus.
Ironically, as foreign governments finance our spending spree, they are simultaneously scolding us for our low savings rate. At the recent G20 meeting in Pittsburgh, all agreed – including President Obama – that resolving the global economic imbalances was a top priority. By definition, this would require Americans to spend less and save more. However, with foreign central banks continuing to buy our debt, the President has shown no political will to encourage this change.
Normally, if politicians run up the government deficit, voters soon suffer the unpleasant consequences of higher inflation and rising interest rates. Yet, if foreign central banks keep supplying the funds, these consequences are indefinitely postponed. As a result, there is no need for American politicians to ever make the tough choices required to solve our problems.
Instead, the burden may fall squarely on the citizens of those governments doing all the lending. The conflict is that within the creditor states, a vocal minority actually benefits from this subsidy (owners of Chinese exporters, for example) while the overwhelming majority fails to make the connection. Thus, foreign politicians have the same incentives as ours to keep playing the game.
The bottom line is that foreign governments can lecture us all they want about the need for prudence but if they keep lending, we’ll keep spending. Any parent knows that if you give your child a curfew yet never impose any penalties when it’s violated, it will not be respected. My gut feeling is that foreign governments are tiring of our conduct and on the verge of finally imposing some discipline. That means the dollar’s days as the world’s reserve currency are numbered, and the days of American austerity are about to begin.
Thursday, October 1, 2009
The Eye of the Hurricane
Putting today's pullback aside, equity markets have continued their tear over the past several months with the S&P sitting comfortably above 1,000. The dollar index has fallen another 2% since my June post, providing additional support for equities. Although the rally extended further than I originally anticipated, as I was early calling for investors to short cyclical stocks, my original premise remains intact. The fundamentals have only gotten worse over the past quarter, and it's only a matter of time before equities begin to price in the actual economic state, not projected recoveries or wishful thinking. Below are the main drivers underlying the recent stock market run-up as I see them:
Government Capital Market Manipulation
The mainstream media has the general public convinced that equities are simply reflecting the improved economic state and inevitable rebound that is destined to take place over the next several quarters. The reality, however, is a little more sinister. Market observers agree that trading volume has been anemic over the past six months, so the rally is not as broad based as they would lead you to believe. Low volume makes the conditions ripe for government manipulation of the market. This is accomplished through open purchases of futures contracts in the open market with the assistance of large investment banks.
The chart below perfectly illustrates my point. This represents an S&P e-minis futures daily one minute chart for Friday, May 29. It was a sleepy Friday with no news released and very low trading volume throughout the day as depicted by the volume bars below the main line graph. In the last few minutes of trading, enormous buy orders hit the market with over 200,000 contracts purchased right before the market close. This volume spike immediately pushed the S&P up roughly 10 points for no valid reason. I am not a conspiracy theorist by nature, and I'm well aware of the program trading that often takes place near the end of the trading day, but this pattern has continuously repeated itself over the past several months. Downside volatility has disappeared while the major indices often closed right at the highs of the day. Even during the market meltdown in late 2008 and early 2009, equities experienced vicious upside volatility through short covering and government bailouts.
With a large percentage of Americans having seen their 401Ks decimated, I am not at all surprised to see the government try to restore confidence in the economy. It is also no accident that consumer confidence has risen with the stock market, but this correlation will prove short lived as unemployment continues to soar.
Massive Government Stimulus Programs
I underestimated the short term impact that the coordinated response of governments around the world would have on equities and economic activity. I am a strong advocate of free market capitalism and tend to analyze such programs from a longer term perspective. Long-term, debt based government spending adds no value and only serves to increase the national deficit. Although in the near term, such policies act as stimulant, akin to an addict getting his fix. The euphoria will wear off leading to a more violent crash once participants realize that despite the government's best efforts, the long term contraction has only been slowed.
The cash for clunkers program is a perfect paradigm for our current economic state. Some analysts have gone as far to suggest that the four year decline in auto sales may have reached a turning point with the success of the program. The government of course allocated billions it doesn't have to fund the program, representing yet another example of taking from the taxpayer (or borrowing from the Chinese in this instance) to artificially create an increase in auto sales. Even with the deep cuts made by the auto manufacturers over the past several years, the sad truth is that there are still too many dealers and too much excess capacity still remaining in the system. As a result, auto sales showed a nice bump over the past several months, but this only shifted future sales to the present.
I've had many people come up to me over the past several weeks pointing to the stock market's recent performance as an indication that the worst has past and we are on the road to recovery. They also point to the housing uptick and question my long term bearish stance on the economy. I have two words for these individuals.....just wait! The FHA is providing mortgage loans with as little as 3.5% equity that has resulted in 50:1 leverage on their books. Although this is better than the 100:1 leverage sported by the Fannie Mae and Freddie Mac, the risk has only been shifted from the private sector to the tax payer.
A brief note on my investment strategy. I do not buy or sell individual stocks but instead sell deep out of the money naked call options on stocks, commodities and broad-based equity ETFs. Through time decay on these options and proper risk management, I have not had one losing trade in 2009. However, it has taken me longer to realize my profits as a result of the market run-up. The early cyclical names that I highlighted in my prior post represent excellent shorting opportunities if you have the patience and the wherewithal to profit from the coming collapse in consumer spending. Consistent with my prior posts, I fully expect the S&P to drop below 500 by the end of 2010 with the only risk to my forecast being a weak dollar that artificially inflates equities.
Ask yourself these two questions: If the equity rally was for real, why is gold trading over $1,000/oz? Second, how in the world is cheap credit and increased personal spending going to lead us out of this "recession" when these were the primary drivers leading to the excesses in the first place?
Government Capital Market Manipulation
The mainstream media has the general public convinced that equities are simply reflecting the improved economic state and inevitable rebound that is destined to take place over the next several quarters. The reality, however, is a little more sinister. Market observers agree that trading volume has been anemic over the past six months, so the rally is not as broad based as they would lead you to believe. Low volume makes the conditions ripe for government manipulation of the market. This is accomplished through open purchases of futures contracts in the open market with the assistance of large investment banks.
The chart below perfectly illustrates my point. This represents an S&P e-minis futures daily one minute chart for Friday, May 29. It was a sleepy Friday with no news released and very low trading volume throughout the day as depicted by the volume bars below the main line graph. In the last few minutes of trading, enormous buy orders hit the market with over 200,000 contracts purchased right before the market close. This volume spike immediately pushed the S&P up roughly 10 points for no valid reason. I am not a conspiracy theorist by nature, and I'm well aware of the program trading that often takes place near the end of the trading day, but this pattern has continuously repeated itself over the past several months. Downside volatility has disappeared while the major indices often closed right at the highs of the day. Even during the market meltdown in late 2008 and early 2009, equities experienced vicious upside volatility through short covering and government bailouts.
With a large percentage of Americans having seen their 401Ks decimated, I am not at all surprised to see the government try to restore confidence in the economy. It is also no accident that consumer confidence has risen with the stock market, but this correlation will prove short lived as unemployment continues to soar.
Massive Government Stimulus Programs
I underestimated the short term impact that the coordinated response of governments around the world would have on equities and economic activity. I am a strong advocate of free market capitalism and tend to analyze such programs from a longer term perspective. Long-term, debt based government spending adds no value and only serves to increase the national deficit. Although in the near term, such policies act as stimulant, akin to an addict getting his fix. The euphoria will wear off leading to a more violent crash once participants realize that despite the government's best efforts, the long term contraction has only been slowed.
The cash for clunkers program is a perfect paradigm for our current economic state. Some analysts have gone as far to suggest that the four year decline in auto sales may have reached a turning point with the success of the program. The government of course allocated billions it doesn't have to fund the program, representing yet another example of taking from the taxpayer (or borrowing from the Chinese in this instance) to artificially create an increase in auto sales. Even with the deep cuts made by the auto manufacturers over the past several years, the sad truth is that there are still too many dealers and too much excess capacity still remaining in the system. As a result, auto sales showed a nice bump over the past several months, but this only shifted future sales to the present.
I've had many people come up to me over the past several weeks pointing to the stock market's recent performance as an indication that the worst has past and we are on the road to recovery. They also point to the housing uptick and question my long term bearish stance on the economy. I have two words for these individuals.....just wait! The FHA is providing mortgage loans with as little as 3.5% equity that has resulted in 50:1 leverage on their books. Although this is better than the 100:1 leverage sported by the Fannie Mae and Freddie Mac, the risk has only been shifted from the private sector to the tax payer.
A brief note on my investment strategy. I do not buy or sell individual stocks but instead sell deep out of the money naked call options on stocks, commodities and broad-based equity ETFs. Through time decay on these options and proper risk management, I have not had one losing trade in 2009. However, it has taken me longer to realize my profits as a result of the market run-up. The early cyclical names that I highlighted in my prior post represent excellent shorting opportunities if you have the patience and the wherewithal to profit from the coming collapse in consumer spending. Consistent with my prior posts, I fully expect the S&P to drop below 500 by the end of 2010 with the only risk to my forecast being a weak dollar that artificially inflates equities.
Ask yourself these two questions: If the equity rally was for real, why is gold trading over $1,000/oz? Second, how in the world is cheap credit and increased personal spending going to lead us out of this "recession" when these were the primary drivers leading to the excesses in the first place?
Tuesday, June 2, 2009
Smoke and Mirrors
Illusion #1: Nominal Returns
With today’s close, the S&P has soared 42% off of its most recent bear market low of 666 set in early March. However, during the same period, the dollar index has plummeted 11.4% from 88.5 on March 6 to 78.4 on June 2. So in real dollar terms, the S&P is up just over 30%. In my prior post, I stated that the S&P could run another 5% to 920 back when it was trading at 877. As of today, the S&P is up 7.7% from its May 1 close, surpassing my target by 2.7%. Should I admit defeat and move on? Not quite as the dollar index has shed 7.2% over the same period, resulting in a real dollar gain from May 1 – June 2 of only .5%. In other words, the S&P must pass 980 holding the dollar index constant at today’s levels to violate my original call. All of the gains enjoyed over the past month are an illusion, only making up for the loss in the dollar’s value.
The devaluation of the dollar artificially improves equity performance given that real returns over the past month were less than 1%. America thinks in nominal terms, and the shrewd policy makers have developed an uncanny ability to pull the wool over the general public’s eyes. The average person watching TV every night sees a continuous stream of positive headlines and concludes that the economy seems to have turned the corner. All the while, national gas prices have soared over 50% in 2009 to a national average of $2.52/gallon on the back of lower refinery production and the weaker greenback. Note that each 1 penny rise in the retail price of gasoline costs American consumers $1B a year. Oil priced in gold will fall sharply once this most recent round of speculation reverses by mid-summer. In general, I believe that commodity prices will crash again as people realize that the anticipated economic recovery will not take place.
Illusion #2: Second Derivative Data
The main driver underlying Monday’s 2.6% rally was the better than expected ISM index of 42.8 against the consensus estimate of 42. Any reading below 50 still represents contraction, although new orders for the month rose above 50 for the first time in 17 months, which is the main data point that equities rallied on during Monday’s session. The Chinese manufacturing survey, also released Monday, showed growth for the third straight month and helped set a positive tone for trading in Europe and the U.S this week. I fully expected this economic uptick because of all the money that has been thrown at economies by governments worldwide. These stimuli coupled with second derivative economic statistics have and will create the illusion of improvement over the next several months.
Second derivative means the change of the change. For example, house prices are often analyzed by the change over the prior year or month. So if home prices fall 20% in May over the prior year, this means the real change from the peak is actually worse (maybe 30% lower than 2006) since home values had already started falling as of May of 2008. Eventually, the rate of decline will slow or show slight improvement because the comparisons will be made against depressed economic data. Markets are fixated on this second derivative data, but it only serves as noise over the long run because the trend will only continue lower. The talk by year end will shift from this change to fears of a double dip recession that will lead to the next leg down in the equity markets.
Illusion #3: The Emerging Market Mirage
The biggest smoke screen that I have seen recently, however, is the emerging market mirage. Many strategists believe that the Asian growth economies are going to lead the global economy out of this recession. As a result, many firms and individuals have emerged advocating full investment in foreign markets in order to shield investors from the low growth developed economies.
Chinese, South Korean, and Indian equities have sharply outperformed their American and European counterparts during the most recent bear market rally. The prevailing thought by money managers blindly throwing money into these markets is that this is where the growth lies during a potential economic rebound. This school of thought is flawed for several reasons:
1) Contrary to popular belief, these economies benefited from much of the fake growth that took place over the past decade fueled by cheap credit. As a result, the deleveraging process that still needs to unwind will impact these markets significantly.
2) These economies remain heavily dependent on exports. Thus, the decoupling theory, or belief that their domestic economies can more than offset the reduced demand in developed economies is ludicrous. Many U.S. equity bears continue to shift funds into emerging markets thinking that those economies have or will soon decouple from the U.S. economy. They point to the outperformance of the Chinese Composite, the Hang Seng index in Hong Kong and the Indian Sensex as these indices have outperformed U.S. equities during the most recent bear market rally. They conveniently exclude the fact that these indices had fallen much more sharply than U.S. indices as of November 2008. These strategists have concluded that China and India, sporting populations well in excess of 1B people each (or roughly 37% of the global population) will easily step in and replace the purchasing power of the U.S. I agree with this school of thought over the long term, however, it took decades for this relationship to develop, and it will not unwind over the course of several months.
At first glance, it is difficult to argue against the potential purchasing power of over 2B people in China and India, but of China’s 1.3B people, 130M live on less than $1 a day. Additionally, 8% of the Chinese population lives below the poverty line. Although Chinese GDP for 2008 amounted to $7.8T, 40% of its GDP was based on exports to the U.S., Japan, South Korea, and Germany. Unlike U.S consumption, which accounts for 67% of the economy, only 36% of the Chinese economy is based on consumption. This does not even begin to address the huge gap between the rich and poor in both China and India as their respective middle classes attempt to establish themselves. People also cannot ignore the practical environmental limitations of having over 2B people try to live an American lifestyle.
Those clamoring to gain emerging market exposure will see their portfolios decimated during the next wave down in the late summer and early fall. Expecting these economies to replace American consumption is akin to asking a high school student to support a family with their part-time mall job after both parents have been laid off. China and India will grow, but not until they have been weaned off the Western economies.
Given my thoughts above, I will highlight several key concepts underlying my current investment strategy:
1) I do not expect equity markets to pull back meaningfully until this fall, but I believe that certain names within the consumer cyclical, technology and financial sectors in the U.S. are now attractive shorts. For example, Goldman Sachs, Amazon, Google, and Apple all have rich valuations and have significant downside risk once investors realize that the economic recovery will not take place nearly as soon as expected.
2) If yields in the treasury market continue to rise, this will have an immediate and sharp impact on stocks. The yield on the 10-year note has already risen to over 3.6%, and that is with the Fed in the market purchasing treasuries. Investors (mainly China) continue to reallocate funds from longer dated notes to short term bills because of inflation concerns. This has resulted in widening spreads between bills and notes although mortgage rates remain artificially suppressed because of government controls and subsidies.
3) Starting in August, I will begin shorting basic materials and related stocks such as Rio Tinto. I decided to delay this strategy because commodities still have room to run as people continue to rotate out of the dollar and into hard assets.
4) I will short emerging markets in late August because they are not the safe haven that everyone assumes.
With today’s close, the S&P has soared 42% off of its most recent bear market low of 666 set in early March. However, during the same period, the dollar index has plummeted 11.4% from 88.5 on March 6 to 78.4 on June 2. So in real dollar terms, the S&P is up just over 30%. In my prior post, I stated that the S&P could run another 5% to 920 back when it was trading at 877. As of today, the S&P is up 7.7% from its May 1 close, surpassing my target by 2.7%. Should I admit defeat and move on? Not quite as the dollar index has shed 7.2% over the same period, resulting in a real dollar gain from May 1 – June 2 of only .5%. In other words, the S&P must pass 980 holding the dollar index constant at today’s levels to violate my original call. All of the gains enjoyed over the past month are an illusion, only making up for the loss in the dollar’s value.
The devaluation of the dollar artificially improves equity performance given that real returns over the past month were less than 1%. America thinks in nominal terms, and the shrewd policy makers have developed an uncanny ability to pull the wool over the general public’s eyes. The average person watching TV every night sees a continuous stream of positive headlines and concludes that the economy seems to have turned the corner. All the while, national gas prices have soared over 50% in 2009 to a national average of $2.52/gallon on the back of lower refinery production and the weaker greenback. Note that each 1 penny rise in the retail price of gasoline costs American consumers $1B a year. Oil priced in gold will fall sharply once this most recent round of speculation reverses by mid-summer. In general, I believe that commodity prices will crash again as people realize that the anticipated economic recovery will not take place.
Illusion #2: Second Derivative Data
The main driver underlying Monday’s 2.6% rally was the better than expected ISM index of 42.8 against the consensus estimate of 42. Any reading below 50 still represents contraction, although new orders for the month rose above 50 for the first time in 17 months, which is the main data point that equities rallied on during Monday’s session. The Chinese manufacturing survey, also released Monday, showed growth for the third straight month and helped set a positive tone for trading in Europe and the U.S this week. I fully expected this economic uptick because of all the money that has been thrown at economies by governments worldwide. These stimuli coupled with second derivative economic statistics have and will create the illusion of improvement over the next several months.
Second derivative means the change of the change. For example, house prices are often analyzed by the change over the prior year or month. So if home prices fall 20% in May over the prior year, this means the real change from the peak is actually worse (maybe 30% lower than 2006) since home values had already started falling as of May of 2008. Eventually, the rate of decline will slow or show slight improvement because the comparisons will be made against depressed economic data. Markets are fixated on this second derivative data, but it only serves as noise over the long run because the trend will only continue lower. The talk by year end will shift from this change to fears of a double dip recession that will lead to the next leg down in the equity markets.
Illusion #3: The Emerging Market Mirage
The biggest smoke screen that I have seen recently, however, is the emerging market mirage. Many strategists believe that the Asian growth economies are going to lead the global economy out of this recession. As a result, many firms and individuals have emerged advocating full investment in foreign markets in order to shield investors from the low growth developed economies.
Chinese, South Korean, and Indian equities have sharply outperformed their American and European counterparts during the most recent bear market rally. The prevailing thought by money managers blindly throwing money into these markets is that this is where the growth lies during a potential economic rebound. This school of thought is flawed for several reasons:
1) Contrary to popular belief, these economies benefited from much of the fake growth that took place over the past decade fueled by cheap credit. As a result, the deleveraging process that still needs to unwind will impact these markets significantly.
2) These economies remain heavily dependent on exports. Thus, the decoupling theory, or belief that their domestic economies can more than offset the reduced demand in developed economies is ludicrous. Many U.S. equity bears continue to shift funds into emerging markets thinking that those economies have or will soon decouple from the U.S. economy. They point to the outperformance of the Chinese Composite, the Hang Seng index in Hong Kong and the Indian Sensex as these indices have outperformed U.S. equities during the most recent bear market rally. They conveniently exclude the fact that these indices had fallen much more sharply than U.S. indices as of November 2008. These strategists have concluded that China and India, sporting populations well in excess of 1B people each (or roughly 37% of the global population) will easily step in and replace the purchasing power of the U.S. I agree with this school of thought over the long term, however, it took decades for this relationship to develop, and it will not unwind over the course of several months.
At first glance, it is difficult to argue against the potential purchasing power of over 2B people in China and India, but of China’s 1.3B people, 130M live on less than $1 a day. Additionally, 8% of the Chinese population lives below the poverty line. Although Chinese GDP for 2008 amounted to $7.8T, 40% of its GDP was based on exports to the U.S., Japan, South Korea, and Germany. Unlike U.S consumption, which accounts for 67% of the economy, only 36% of the Chinese economy is based on consumption. This does not even begin to address the huge gap between the rich and poor in both China and India as their respective middle classes attempt to establish themselves. People also cannot ignore the practical environmental limitations of having over 2B people try to live an American lifestyle.
Those clamoring to gain emerging market exposure will see their portfolios decimated during the next wave down in the late summer and early fall. Expecting these economies to replace American consumption is akin to asking a high school student to support a family with their part-time mall job after both parents have been laid off. China and India will grow, but not until they have been weaned off the Western economies.
Given my thoughts above, I will highlight several key concepts underlying my current investment strategy:
1) I do not expect equity markets to pull back meaningfully until this fall, but I believe that certain names within the consumer cyclical, technology and financial sectors in the U.S. are now attractive shorts. For example, Goldman Sachs, Amazon, Google, and Apple all have rich valuations and have significant downside risk once investors realize that the economic recovery will not take place nearly as soon as expected.
2) If yields in the treasury market continue to rise, this will have an immediate and sharp impact on stocks. The yield on the 10-year note has already risen to over 3.6%, and that is with the Fed in the market purchasing treasuries. Investors (mainly China) continue to reallocate funds from longer dated notes to short term bills because of inflation concerns. This has resulted in widening spreads between bills and notes although mortgage rates remain artificially suppressed because of government controls and subsidies.
3) Starting in August, I will begin shorting basic materials and related stocks such as Rio Tinto. I decided to delay this strategy because commodities still have room to run as people continue to rotate out of the dollar and into hard assets.
4) I will short emerging markets in late August because they are not the safe haven that everyone assumes.
Sunday, May 3, 2009
The Top Is Near
The equity market has continued its impressive rally with the S&P rising nearly 32% off of its March 6th low. About half of the S&P 500 companies have reported earnings, with over 65% beating sharply reduced estimates. On average, operating profits have fallen 30% over the prior year. I stated back in my March 29th post (after the S&P had already rebounded 23%) that the rally could last another 10%. We have almost reached that target as the S&P rose an additional 9% in April. I'm revising my prior projection upward by about 5% from current levels, which will result in a short term S&P target of around 920. Let me reiterate my stance; this rally is completely unjustified from a fundamental perspective and the result of technical oversold conditions. Many stocks that I follow are trading at multiples that are unsustainable given the current and future economic climate.
Treasury yields have soared despite the Fed's treasury purchase program as the 10-year note has risen to 3.15%. Money has flowed from treasuries to equities and corporate bonds as risk appetite and inflation fears return. Foreigners have also scaled back on treasury purchases as China remains a vocal critic of the government's recent policies. On March 25th, I recommended that investors consider TBT, (a double inverse ETF that increases with yields) which has risen 9% in the past five weeks. The equity market has gone from properly pricing in risk to underpricing risk over the past six weeks. Treasury yields will decline as risk aversion re-enters the market and deflation concerns return.
Commodities (and related stocks) have risen sharply on hopes of an economic recovery in the second half this year. Oil settled above $53/barrel on Friday while wholesale gasoline climbed to over $1.51/gallon. This represents nearly a 70% increase over the December gasoline lows of around $.90 as refiners cut back on production to boost profit margins. As a result, retail gasoline prices have risen back to $2.20/gallon throughout most of the nation despite the fact that the economy remains mired in the midst of the worst post-war recession. I would hate to see what happens to oil prices if the dollar actually weakens as the recent run-up has been driven entirely by speculation that the economy will improve within the next six months.
The problems plaguing this economy are structural, not cyclical, so the conventional wisdom applied by money managers in prior downturns will not apply this time around. I am therefore providing a 12-18 month S&P price target of approximately 500, representing a 43% decline from Friday's close. As illustrated by the excel table below (obtained directly from Standard & Poor's), the S&P is currently trading at 15X full year 2009 operating earnings estimates of 58. Valuations even look attractive once 2010 is considered with a forward PE of "only" 11.60 based upon Friday's close. But hold on a second, analysts are forecasting a sharp recovery in 2010 with operating earnings expected to jump 30% over the current year. Even if the pace of economic decline slows over the next 12 months, these projections border on the absurd. With a real unemployment rate of just over 15% and rising, the consumer is only now beginning to feel the impact of the upcoming depression.
Source: http://www2.standardandpoors.com/portal/site/sp/en/us/page.topic/indices_500/2,3,2,2,0,0,0,0,0,0,6,0,0,0,0,0.html
The figures above represent operating results, not reported GAAP earnings that are often lower because of write-downs and other one time adjustments. Over the past several decades, the spread between GAAP and operating earnings have increased, artificially lowering PE ratios. In any event, 2010 earnings estimates will prove overly optimistic and should decline over the next four quarters. S&P operating earnings will not surpass $50 in 2010, well below the current $75 estimate. Accordingly, the PE ratio will contract to below 10 as investors price in a severe multi-year contraction. Historically, bear markets trough in the 6-10 P/E range, well below the current levels. Once we apply a 10 P/E on $50 of earnings, we arrive at an S&P of 500. I will most likely revise this preliminary estimate downwards as I review additional data.
This argument really comes down to one simple question. Do you believe that the worst is over? The bulls will say that the economy is near a bottom while the bears believe that the worst is yet to come. There is one important distinction, however. If you buy the bear's argument, you are buying the facts and prescribing to common sense while the bulls are trying to sell a mystery tonic that promises way more than it could ever deliver. There will be the buying opportunity of a lifetime....just not yet!
Treasury yields have soared despite the Fed's treasury purchase program as the 10-year note has risen to 3.15%. Money has flowed from treasuries to equities and corporate bonds as risk appetite and inflation fears return. Foreigners have also scaled back on treasury purchases as China remains a vocal critic of the government's recent policies. On March 25th, I recommended that investors consider TBT, (a double inverse ETF that increases with yields) which has risen 9% in the past five weeks. The equity market has gone from properly pricing in risk to underpricing risk over the past six weeks. Treasury yields will decline as risk aversion re-enters the market and deflation concerns return.
Commodities (and related stocks) have risen sharply on hopes of an economic recovery in the second half this year. Oil settled above $53/barrel on Friday while wholesale gasoline climbed to over $1.51/gallon. This represents nearly a 70% increase over the December gasoline lows of around $.90 as refiners cut back on production to boost profit margins. As a result, retail gasoline prices have risen back to $2.20/gallon throughout most of the nation despite the fact that the economy remains mired in the midst of the worst post-war recession. I would hate to see what happens to oil prices if the dollar actually weakens as the recent run-up has been driven entirely by speculation that the economy will improve within the next six months.
The problems plaguing this economy are structural, not cyclical, so the conventional wisdom applied by money managers in prior downturns will not apply this time around. I am therefore providing a 12-18 month S&P price target of approximately 500, representing a 43% decline from Friday's close. As illustrated by the excel table below (obtained directly from Standard & Poor's), the S&P is currently trading at 15X full year 2009 operating earnings estimates of 58. Valuations even look attractive once 2010 is considered with a forward PE of "only" 11.60 based upon Friday's close. But hold on a second, analysts are forecasting a sharp recovery in 2010 with operating earnings expected to jump 30% over the current year. Even if the pace of economic decline slows over the next 12 months, these projections border on the absurd. With a real unemployment rate of just over 15% and rising, the consumer is only now beginning to feel the impact of the upcoming depression.
Source: http://www2.standardandpoors.com/portal/site/sp/en/us/page.topic/indices_500/2,3,2,2,0,0,0,0,0,0,6,0,0,0,0,0.html
The figures above represent operating results, not reported GAAP earnings that are often lower because of write-downs and other one time adjustments. Over the past several decades, the spread between GAAP and operating earnings have increased, artificially lowering PE ratios. In any event, 2010 earnings estimates will prove overly optimistic and should decline over the next four quarters. S&P operating earnings will not surpass $50 in 2010, well below the current $75 estimate. Accordingly, the PE ratio will contract to below 10 as investors price in a severe multi-year contraction. Historically, bear markets trough in the 6-10 P/E range, well below the current levels. Once we apply a 10 P/E on $50 of earnings, we arrive at an S&P of 500. I will most likely revise this preliminary estimate downwards as I review additional data.
This argument really comes down to one simple question. Do you believe that the worst is over? The bulls will say that the economy is near a bottom while the bears believe that the worst is yet to come. There is one important distinction, however. If you buy the bear's argument, you are buying the facts and prescribing to common sense while the bulls are trying to sell a mystery tonic that promises way more than it could ever deliver. There will be the buying opportunity of a lifetime....just not yet!
Thursday, April 16, 2009
US Prices Drop For First Time Since 1955
This was the title for an April 15th Financial Times article following the March Consumer Price Index (CPI) report showing a .4% year-over-year decline. Think about the significance of this statement for a moment. Prices have risen for 53 consecutive years.....53! And you probably thought that Joe DiMaggio's 56 game hitting streak was impressive. However, anyone that has taken an introductory economics course learned that cyclical patterns will lead to either rising or falling prices as the economy expands and contracts. Every basic textbook reminds us that rapidly expanding economies lead to full capacity utilization driving prices upward. The opposite should also hold true as economies slow and these pressures ebb, theoretically pushing prices down. Oddly, this basic free market principle does not seem to apply given inflation's impressive 53-year winning streak.
How is it that prices have continually risen despite the recessions and economic shocks of the past half century? Enter the Central Bank, affectionately dubbed the Federal Reserve, although it is neither Federal nor does it maintain any significant reserves. The Fed, run by a consortium of private bankers, has designed a debt-based system that requires ever-expanding prices to fuel the repayment of all outstanding loans. Although this may sound confusing, bare with me for a moment. If you could call a timeout and pause all economic activity while simultaneously requiring the immediate repayment of any outstanding debt, the global economic system would collapse. More simply, the amount of debt in circulation far exceeds the amount of cash currently in the system, and the ability of debtors to repay their obligations. This makes complete sense when examined from the perspective of an average middle class household. It may have modest savings, but a huge mortgage and credit card debt, which is reliant upon future income to repay, eclipses whatever savings accumulated. These future earnings will not exist without a continuously expanding money supply. Inflation represents the Fed's best and only tool to ensure that enough money is circulating through the system to repay these future obligations.
So the Fed's 1%-2% targeted annual inflation rate is beginning to make a little more sense. The bankers have convinced the general public that our economy cannot achieve sustainable growth without modest inflation, which is a complete a lie. Deflation, per the Fed's mandate, should be fought with all the tools available at its disposal. In a true deflationary environment, income streams will contract, inhibiting businesses and individuals alike from repaying their respective debts. This results in skyrocketing defaults and the failure of every major bank that is reliant on future inflationary earnings for their debtors to repay current obligations.
Deflation is best compared to a forest fire, painful and destructive in the near-term, but instrumental for building a solid foundation for future growth. Other than serving as a pricing mechanism, it encourages saving (through increased purchasing power) and proper capital formation supported by these savings, rather than debt. However, given the current system's complete over reliance on debt, any prolonged period of deflation will also lead to a complete collapse of the system. To further simplify, the current monetary system is structurally flawed and bound to collapse because it violates the most basic economic covenant; that prices must rise and fall with the cycles.
This brings me to my final question. Is the foundation of modern finance built on a flawed theory "that a dollar today is always going to be worth more than a dollar tomorrow?" After all, in a true free market, shouldn't bank lending models at least factor in for the possibility of a deflationary environment? Economic principles and common sense tell us that nothing happens 100% of the time, not even inflation. The most recent monthly CPI report proves this fact.
I realize that this post may seem overly theoretical, but I believe that these questions are essential to understanding the issues that plague our economy and declining standard of living. Make no mistake about the future of this topic, however, as people begin questioning the viability of the current monetary system.
How is it that prices have continually risen despite the recessions and economic shocks of the past half century? Enter the Central Bank, affectionately dubbed the Federal Reserve, although it is neither Federal nor does it maintain any significant reserves. The Fed, run by a consortium of private bankers, has designed a debt-based system that requires ever-expanding prices to fuel the repayment of all outstanding loans. Although this may sound confusing, bare with me for a moment. If you could call a timeout and pause all economic activity while simultaneously requiring the immediate repayment of any outstanding debt, the global economic system would collapse. More simply, the amount of debt in circulation far exceeds the amount of cash currently in the system, and the ability of debtors to repay their obligations. This makes complete sense when examined from the perspective of an average middle class household. It may have modest savings, but a huge mortgage and credit card debt, which is reliant upon future income to repay, eclipses whatever savings accumulated. These future earnings will not exist without a continuously expanding money supply. Inflation represents the Fed's best and only tool to ensure that enough money is circulating through the system to repay these future obligations.
So the Fed's 1%-2% targeted annual inflation rate is beginning to make a little more sense. The bankers have convinced the general public that our economy cannot achieve sustainable growth without modest inflation, which is a complete a lie. Deflation, per the Fed's mandate, should be fought with all the tools available at its disposal. In a true deflationary environment, income streams will contract, inhibiting businesses and individuals alike from repaying their respective debts. This results in skyrocketing defaults and the failure of every major bank that is reliant on future inflationary earnings for their debtors to repay current obligations.
Deflation is best compared to a forest fire, painful and destructive in the near-term, but instrumental for building a solid foundation for future growth. Other than serving as a pricing mechanism, it encourages saving (through increased purchasing power) and proper capital formation supported by these savings, rather than debt. However, given the current system's complete over reliance on debt, any prolonged period of deflation will also lead to a complete collapse of the system. To further simplify, the current monetary system is structurally flawed and bound to collapse because it violates the most basic economic covenant; that prices must rise and fall with the cycles.
This brings me to my final question. Is the foundation of modern finance built on a flawed theory "that a dollar today is always going to be worth more than a dollar tomorrow?" After all, in a true free market, shouldn't bank lending models at least factor in for the possibility of a deflationary environment? Economic principles and common sense tell us that nothing happens 100% of the time, not even inflation. The most recent monthly CPI report proves this fact.
I realize that this post may seem overly theoretical, but I believe that these questions are essential to understanding the issues that plague our economy and declining standard of living. Make no mistake about the future of this topic, however, as people begin questioning the viability of the current monetary system.
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