Posts Tagged ‘Inflation’

Why Invest in Gold?


By Levik Dubov

Simple Answer:

The reason why investors own precious metals, is to insure themselves from a debasement of currency at a greater rate than available market returns. Few people actually own precious metals physically, and those who do often do for the wrong reasons.

Gold is not a reliable vehicle for appreciation, yet it is an outstanding store of value. The sensible capitalist does not “invest” in gold. He merely safeguards his wealth in the form of non-financed physical-assets in times when currency competency comes into question, and waits until either the inflation subsides or an opportunity of adequate returns to be restored.

As one hedge fund manager recently put it: “All investments have their day, and right now gold is having its day”.

In-Depth Analysis:

For all those who aren’t familiar with Talmudic-style dissection, Get ready!

Some people are natural cynics and approach everything with a good dose of skepticism. (These people often spend years owning nothing but AAA-bonds and Market Funds). Others are opportunists and approach everything with a gullible zeal. (These people are often looking for the next Microsoft). We see ourselves as mere realists, in an attempt to approach everything with a logical and objective frame of mind.

To understand results we must first find reason…

Questions Scott Adams poses:

I am referring to a recent article by famed Dilbert cartoonist, Scott Adams. I enjoy his posts very much and I hope this article will clarify his perplexities regarding precious metals investment.

1. “People aren’t good at predicting the future, no matter how obvious the future path seems”.

It is for precisely this reason, that when things do change, (such as the turn of the English Empire), so few expect it and are prepared. Ask people interested in precious metals, exactly how many ounces of physical metal they own. You’ll notice how few people truly stand behind the words they’ve spoken. As a matter of fact, just glancing through the comments on Adams’ blog, it seems that most of the forum comes across as hypothetical folks who either own too little of a position, or are influenced by invalid reasoning.

2. “Warren Buffett isn’t putting all of his money in gold”.

I will get to the reason behind this in a moment, but it must be understood that Mr. Buffett is a “Common Stock Man”. That’s what fascinates him, that’s what engages him, that’s what he does best. So why should he invest in gold when he has found far greater returns in an under-valued marketplace?

3. “My failure to imagine how the debt can be contained might be just that: a failure of my imagination”.

When it comes to debt there is far too many variables to consider (i.e. Chinese Bond-ownership, Dollar Replacement, Federal Bankruptcy, Currency Revaluation, The Gold Standard). In other words, the ownership of gold stands not as an investment with the intention of appreciation, but as an clever insurance policy against a catastrophic hyper-inflation or currency debasement.


In “The Intelligent Investor” written by Benjamin Graham (Buffett’s famed mentor), which was revised as of 1971, Graham says in Chapter 2, “The Investor and Inflation”, in the article “Alternatives to Common Stock as Inflation Hedges”:

“The standard policy of people all over the world who mistrust their currency is to buy and hold gold… the holder of gold has received no income return on his capital”.

He adds in summation:

“There is no certainty that a stock component will insure adequately against such inflation” [emphasis ours].

A few points need to be highlighted:

1) Graham informs us that the hoarding of gold was an age old practice. This made total sense as in fore-times bank panics, currency debasement and depressions occurred just about once a decade.

2) He cites the years between 1935-71 as “proof” that gold has been a lousy and inadequate investment class. However, between the years of 1969 and 1981, gold appreciated phenomenally, outperforming each and every other asset class by a wide margin. Had Graham witnessed this spectacle there is strong reason to believe that he would have reconsidered his position, and may have made room for precious metals in a conservative portfolio.

3) In that paragraph he also frowns upon investing in real estate claiming that it is subject to “wide fluctuations” and “serious errors”. His only advice to such business is:

“Be sure it’s yours before you go into it”.

What Graham is telling us here, is that any asset is a bad investment if done for speculative reason, or with improper judgement.

4) In his closing remark, Graham even warns that even while common stocks offer great opportunity, they may nevertheless fail to overcome the challenges of inflation, or currency debasement.

What’s Changed?

Much! Too much actually. As a matter of fact, from an economic standpoint America is no longer similar to the America Graham was familiar with. For one, America has lost its status as the world’s largest manufacturer of goods, and has gained a frightening lead in terms of consumptions and spending. (For those familiar with European history, this is how 16th Century Spain lost its position as the world leader in trade and commerce).

The world of currencies have also changed drastically. While I will not delve into the fascinating history of barter, trade and the properties of monetary exchange here, one enormous variable differentiates the Pre-1974 and the Common Eras. In ancient times, every single transaction took place with an element of exchange in mind. Whether it was sea shells, or cattle, or wooden sticks, the value of any transaction or credit was accurately measured in terms of a monetary exchange unit. With the agreement to terminate convertability from gold to Dollars in 1974, this all changed. No longer would the U.S. Dollar, the “ineffable” reserve currency of the world, be exchangeable for the gold metal.

Thus began, the current era of a universally-accpeted fiat (non-commodity based) currency. No longer would each transaction be measurable in accurate terms. And no longer would any Government, foreign or domestic, be compelled and obligated to abide to the regulations of supply and demand. So long as We The People would accept and stand loyal behind the mere faith and credit of the United States Government, so long would our ever-glorified Dollar endure.

“What happens to the price of gold if people simply change their minds about its value?”

Adams’ question seems pertinently logical. However, there is one crucial question that he fails to address…

What is a currency?

The following I adapt from the works of Doug Casey:

In the 4th century BC, Aristotle defined 5 reasons why gold is money, and they are just as valid today as they were then. A good form of money must be: consistent, convenient, durable, divisible, and have value in and of itself.

Consistent. The lack of consistency is why we don’t use real estate as money. One piece is always different from another piece.
Convenient. That’s why we don’t use, for instance, other metals like lead, or even copper. The coins would have to be too huge to handle easily to be of sufficient value.
Durable. That’s pretty obvious – you can’t have your money disintegrating in your pockets or bank vaults. That’s why we don’t use wheat for money; it can rot, be eaten by insects, and so on. It doesn’t last.
Divisible. Again, obvious. It’s why we don’t use diamonds for money, nor artwork. You can’t split them into pieces without destroying the value of the whole.
Value of itself. The lack here is why you shouldn’t use paper as money.

A 6th reason that Aristotle may have overlooked since it wasn’t relevant in his age, and nobody would have thought of it: It can’t be created out of thin air!

This is not a gold bug religion, nor a barbaric superstition. It’s simply common sense. Gold is particularly good for use as money, just as aluminum is particularly good for making aircraft, steel is good for the structures of buildings, uranium is good for fueling nuclear power plants, and paper is good for making books. Not money. If you try to make airplanes out of lead, or money out of paper, you’re in for a crash.

That gold is money is simply the result of the market process, seeking optimum means of storing value and making exchanges.

Buffett’s Investment in Silver, Style and The Finale of an Era:

Buffett It should be noted, that Buffett did make a significant investment into Silver (not gold) in the late 90s, one that has come under sharp scrutiny in recent years, as few are knowledgeable of exactly what led Buffett to purchase over 100 million ounces of physical silver on the open market, and moreover what ever happened to the holding. Those who know him, have even mentioned his fascination with silver over the decades. All in all, we cannot say that Buffett “only” invested in common securities.

We may also add, that the majority of Buffett’s tenure as the “world’s greatest investor” coincided with an era that was quintessential for the class of Common Stocks. The 50s, 60s, 80, and 90s, were all part of a two-part secular bull-market that captivated the attention of Wall Street and Main Street, concluding in the most absurd valuations for up-and-coming Tech start-ups that had neither money nor model. However, one may realize that Buffett’s years of 50-100% returns are far behind him. With over $100 Billion under his management, investment opportunities are slim as: a) Stocks have become a staple of investment and speculation, thus raising valuations to their highest in modern history, and b) The potential for significant returns diminish greatly as the ability for a multi-national corporation to grow is minimal, if not non-existent. This is known in economic circles as The Law of Diminishing Returns.

All in all, it can be assumed that the heyday in common stock are over, as long as current valuations remain at their elevated levels, and investor exuberance and hopeful optimism remain.

Depleting Commodities:

In summation, I’d like to point out why investors and speculators have begun a gradual influx into commodities and precious metals in particular. In brief: They’re disappearing. This doesn’t mean that there will be none left soon, the same way that Peak Oil doesn’t mean that there’ll be no more oil. It simply means that these goods will no longer be available at these prices. This may sound reminiscent to anyone who experienced oil sky-rocket from $1.50/ barrel to over $40 in the late 70s. When the government capped the price level, supply and demand kicked in: Boom! No more gas! Extended lines of anxious cars waiting to be fueled but to no avail. There is no more gasoline left at the price it sells for.

This is why investors flood commodities when inflationary scenarios take hold. Because with all the over-investment into service companies, manufacturing facilities, tech stocks, real estate developments and paper currencies, people have completely forgotten the elements all that possible: physical goods. Oil, Lumber, Cotton,

So take Adams’ post as you wish. But bear in mind that markets aren’t very intuitive. They tend to evaluate the here-and-now and the probable, and don’t have much patience for abstract and the possible.

I only restate the famed Ben Graham’s empirical warning: “Be sure it’s yours before you go into it”.

Good investing!

Thoughts on the Economy

I don’t like to post on markets that often, as I reserve this blog for more optimistic success-related material that focus more on proactive personal-development than on reacting to news and sentiment.

Nevertheless, in the dog-eat-dog world we live in, I believe its highly important to have a sound knowledge of what the external forces that govern our lives entail.

The one theme I keep noticing time after time in the selective articles I read (no major media, only hand-picked analysts who have proven themselves over time) is: Deflation or Inflation?

Unfortunately, many many people are misinformed when it comes to money. It’s not that they lack an MBA or didn’t understand what they’ve been reading, rather that they misinterpret what seems to be a paradox, but goes hand in hand in reality.

Deflation in Austrian terms is defined as an contraction in the loans of credit provided by a Government (pulling down assets). Inflation is its cousin-scenario where credit is expanded wildly (pushing up assets).

The mistake many make is in confusing the value of the Dollar and the credit/money supply. One is demand, while the other is supply. They may work either together or against each other.

I believe that what we are about to witness, on a grand scale, is a whiplash effect of contracting credit and strengthening currency on one hand, and a failing economy on the other. This will crush the average debt laden consumer as they battle with BOTH rising costs of interests and debt AND the rising costs of living due to monetary inflation.

This is due to a currency who’s printing presses are under no control and MUST outrun any effects of deflation – from real estate, stocks and Dollar buying. The irony here is that the Fed will soon have to choose between letting the Dollar appreciate on its own or pushing it down further. Chances are that they will always choose a falling currency over a rising one due to: a) its bi-centennial policy of monetary easing, and b) the fact that while the US has experienced an intense deflationary scenario (1930-38), we have yet to experience a “hyper-inflationary” one – induced by over-supplying credit and money – at least since Continental scrip was flushed away following the Civil War.

The savvy individual who will deflect such a predicament will be the low-debt high-asset frugal-consumer. This will eliminate high interest payments, appreciating assets and low expenses.

Note that the above applies to both the lower and upper class, since interest on debt and assets effect both the same.

Advice: Own Things! Real estate, commodities, physical gold and silver and strategic undervalued assets all comply. Areas of extreme caution: Stocks of companies that are either overvalued or financially unstable, toxic derivatives and high-interest debt.


It should also be noted that the generational-trends (10-17 year) remain intact: a) generally rising interest rates b) falling P/E ratios in stocks, and c) a falling Dow/Gold ratio.

This implies that Gold acts a safe haven regardless of whether the Dollar/Economy/Market does well since what we are expecting is not a monetary or nominal increase in price but an aggregate reversion to mean and true value.

Over the long run (next 7-10 years) bonds/fixed-income will mostly outperform capital appreciation for stocks, and hard assets will continue to outperform fiscal contracts.

The mindset will shift from growth to value and from wealth creation to wealth preservation. There will be those who do well, but only those who shy away from the general sentiment of things and focus on their own growth and productivity.

Is $1 Million Enough To Retire?

The issue of the decade, and if it isn’t yet it soon will be, is a simple matter of retirement-ability. While $1 Million used to be good enough to get you buy (pun intended), it seems that along with a once strong dollar goes the hope of so many Americans who live the work-40-years then retire-rich mentality. Sure we have our 401ks, IRAs and MEWs, but the fact remains, it just might not be enough.

In a recent U.S. News article, the matter is addressed. Without petty details, there are 3 main issues that must be reckoned with: How much you have, how much you’ll make, and how long you’ll live.

Chances are, what you have isn’t enough to retire on. And chances are that what you make today won’t suffice till tomorrow, especially if Merck comes out with a miracle drug that make you live to 105.

About your “safe” job, who says you’ll last another X years? Service workers in GM 30 years ago were in what they considered the safest job in the World. Today they’re being let go.

And what about Inflation: “I know”, most people will say “I lose about 2-3% annually to a declining Dollar”. No! That’s so 90s. With all the money the Government is pumping into the system to save the economy we are probably looking at 70s-style inflation all over – we’re talking about a possible 10-15% annual increase in the basic cost of living.

So what to do? To make more you have got to think bigger. You may want to consider starting your own business with the skills you’ve accumulated over the years. It’s a lot easier than people think. The problem is that people often don’t.

You may also want to consider alternative investments that aren’t Dollar based. Allocation to gold or may suffice, or maybe some international investments such as foreign real estate or stock funds. But when stuck between two options… always choose a third:

Split up your retirement
In the 4HWW, Ferriss brings great yet simple logic to the table: If you hate your job, why would you want to suffer with it for the next 10, 20, 30 years? If you love it why would you want to retire at 65? If you don’t have the millions necessary for retirement, your job won’t help. If you’re so entrepreneurial that you have made your millions, what makes you believe you’d just resort to sitting on the beach all day once you do turn 65?

By splitting up your life into a series on “mini-retirements” you get the best of both worlds, allowing yourself to enjoy life while you’re still young and saving some for your old age.

“But how do you do that? How can I take time off what I do? How can I have fun for the same price of my current lifetsyle?”. This my freinds is what our blog is all about!


The Real Silver Lining

“To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework. – Ben Graham, 1949

The following is a slightly more in depth analysis of the silver market for those who are edgy as to where we stand and why I remain as bullish than I ever have been. First let us backtrack exactly one year. It was August 2007. Gold and Silver had been in a serious consolidation since May 2006. Few investors were coming to market and analysts were getting tired of plugging the silver bull. Nevertheless, there was much speculation for months already that the next leg up in the long-term trend would begin around September/October. Just then, silver plummeted overnight from $13.50 to just under $12.

Ignorant Support

Support then was at $10 hence many critics were calling for a retracement to that level. Then as now silver crashed through its 200 Day Moving Average, a well known support line. To belie
ve that silver must fall to the lower support level ($14) simply because the higher one ($16) has not held is foolish and investors who wait for such an event can prove costly. $21 will be the new support fairly soon and anything below $18 will be considered cheap.

Relative Strength Then as now, Silver is heavily oversold. (Silver’s RSI – Relative Strength Index – has not been this low over the past 12 months).

Gold Silver Ratio It is interesting that during that August 2007 sell-off the Gold/Silver ratio jumped to 56 and held above 55 before for a few months before declining back to below 50. Remember that the Gold/Silver ratio is in a multi-year down-trend and these upward fluctuations are mere noise.

Seasonal Strength
July and early August are historically weak months while late August and September exceptionally strong months.

Other Factors

The U.S. Dollar – The Dollar is now overbought and has not been so in ages. This may be the final blow-off of the Dollar rally and may now lead to its (ultimate?) downfall. Recent strength may surely be the intervention of the government trying to save the last currency since the Civil War. (For those who think the idea is tin-foil-hat-like read the next sentence).

COMEX Short PositionI’m no conspiracy theorist but I do sympathise with “survivalism”, and that is what we may be witnessing. Anyone who knows how to read a COT report can see that there is serious trouble on the short-side of the silver market. With barely 70 million ounces of investment silver a year its hard to imagine where these short will get a hold of over 300 million ounces of silver. Pretty much anything you answer will prove bullish.

Inflation – The PPI, Price Producers Index (that usually leads Consumer Prices) , has just come out with multi-decade high increases. The fact is that while retailers of all sorts and industries have attempted to hold off increasing prices, that range of revenue vs. profit has just about vanished and the choice is no longer theirs. Expect surging costs and with it surging precious metals prices.

Sale! Many, including India and China, were fretting over the fact that Gold was too high and pushing jewelry, a Eastern culture staple, to incredibly exuberant prices. As luck would have it they got what they had asked for (or manipulated?).

Sentiment Positive interest in Gold and Silver is just downright awful. Analysts (who I have noticed have simply become Chartists) are at a loss as to what to do. But with the fundamentals more bullish than they ever have been (think U.S. Budget, economy, inflation) I see nothing but a G-d given opportunity. (Nevertheless, I still find it incredibly ironic that the little bullish sentiment can be found on none other than… Marketwatch!)

Gold and Silver’s day in the sun will probably be when the recession begins and consumers begin to really feel the brunt of the economy and whiplash of falling wages, employment and earnings/share prices versus rising costs, prices and defaults.

Dow/Gold Ratio – I put this one last since it should be so readily presumed and stands at the center of the long term downtrend in debt-laden share prices and uptrend in unfinanced asset prices. The trend remains intact at 13.59. Any surprises will likely be to the downside heading to a ratio of 7, or even 3, before this recession is over (has it started?).

If you own anything that is long-term bullish in the face of credit crunches, paper deflation, asset inflation and fear (namely Gold, Silver, Yen, Franc, Short ETFs) you are probably destined to see some nice returns in your portfolio over the next few months.

The key words are: Negative Financing.


Fair Value of Gold

And Why Investors Buy

We have commented on what the future has in store for stocks, whether you are buying for dividends sake, or for earnings valuations. Now we care to top it all off with an explanation as to why any conservative investor would and should buy gold.

Why So Unconventional?
In the early chapters of The Intelligent Investor, after explaining the balance between bonds and common stocks, Ben Graham goes into a lengthy analysis regarding earnings-price ratio relative to dividend yields. It does not pay, he explains, for the investor to remain invested in bonds during times when inflation of general goods are rising, and is better off holding stocks, albeit the lesser of two evils.

Mind you, the above is written by a man who experienced markets between the 1920s and early 1970s. Unfortunately, when Graham wrote the above in 1971, gold was still unavailable to the average investor and was still linked to the U.S. Dollar. This means that inflation, although an issue had no weight whatsoever with gold, as nominal loss and Dollar devaluation were synonymous.

If his book were written just a few years later I believe he’d be all the more wiser (and wealthier!) and would have urged investors to buy gold as an adequate hedge against inflation relative to interest rates. Real Interest Rates (IRs minus CPI).

Real Interest Rates and Gold
When real rates turn negative due to rising inflation greater than the return on cash, it makes little or no sense to hold anything currency denominated. This is where gold plays a crucial role that it has not played in over 120 years – the ultimate sound currency.

When investors squabble over gold being a hedge against inflation (flight to assets) or deflation (flight to currencies), what they really refer to are real rates of interest. Gold now has the ability to act as both a currency that retains its value amidst a flight from fiscal assets and debt, and a commodity that rises with the tide of the rush to hard goods.

Dow/Gold Ratio
This trend can be seen on a wide scale from the Dow-Gold ratio. Seemingly, the business cycle runs through years of investment and expansion, with money flowing out of cash into businesses, to times of savings and contraction, with liquidity flowing out of enterprise and into the highest yielding accounts.

Not much explanation should be necessary to understand what this ratio represents. Why would I buy shares trading at 20-40 gold ounces when I can just hold my gold and expect to buy a business at a later date at practically parity?

Hold and Buy!
The ratio reminds us that just as the “buy-and-hold” strategy worked so well for so many throughout the 40s, 50s, 80, and 90s… a “hold-and-buy” strategy would have done just as well during the 30s, 70s and 10s.

What would Buffett Say?
Quite frankly, I believe that the wealthiest investor of our time may have missed out on one of the greatest profit opportunity of the decade (excluding Uranium). Buffett himself expressed his thoughts when he said regarding his silver investment “We bought too early and sold too early”. He knows better than to buy into a rally. He missed out and that’s something he’s gotten used to over the years. If you asked me, I think that the $40 billion pile of cash in his portfolio is filling gold’s role as his savings. And don’t be surprised to see him splurge it all at once in the coming months!

Real Valuations
Many investors look for opportunities that stand square in their favor. With the Dow crossing over the 15 ounce line stocks will soon be trading in the lower buying range. The last chance to buy gold is now!

Unless you know of a stock that has fundamentals set to rally over 300% in the coming years, you may want to look into gold!

Buy Stocks?

I am going to make a very bold statement. The source of my “madness” is 50% educated hypothesis and 50% gut instinct. You’ll understand why I call it madness in a moment.

We all know that while stocks like to trend together, they don’t copy each other exactly. Each follows its own business plans, sales, customers and respective wacky technical charts. On the day of the Great Crash in 1929 there were a number of issues, however few, that actually went up in price. The general trend does not concern each stock. One of the prime reasons that the indexes have been falling is because in each financials weigh heavily.

Nevertheless, it is important to realize that while some stocks set in a major bottom in 1982, others did so in 1978, many in 1975 and a few in 1971. Some swam against the tide altogether.

I believe we are experiencing a major bottom in financial and homebuilding shares. This does not mean that they have bottomed yet but the formation is in the making and we are merely a sharp decline away. Nor does this mean that they have sound books or have written off all their losses – far from it. It does mean that the coming panic (double-bottom) will place banking and home-developing shares at prices and valuations that are simply the lowest they can possibly be discounted. I suspect this may happen in as soon as they next few weeks.

Next, a bottom may set in for one sector that has dominated trading desks for years. Can you guess? Technology. Shares of Retailers, Financials, Homebuilders, Manufacturing, you-name-it have fallen over recent months. But some have held up reasonably well – until now. I think that during the major bottom that I expect sometime in late 2009 will offer bargains in some of the names that investors crazed over 10 years ago – Microsoft, Cisco, Apple, IBM. I think even Google will be selling itself unfavorably.

The key is: Safety and Earnings. I am extremely cautious on the banks not only with concern to their own solvency but more so the solvency of the system and the Central Banks to prevent it. If the financial crisis over blows heavily to the point where balance sheets are no longer legible, I would retroactively suspend my case for the Financials.

As for the Homebuilders, I think that very soon a great opportunity will be upon us and investors who look just a few months passed the carnage and bad earnings reports will see a solid balance sheet with a sound business model.

As for everything else, make sure when the market swoon comes, not only have you read the financial reports, but you are ready with trucks rented.

As for now, you want to be in Cash. But there’s a catch to cash – You don’t want to own currencies as they are just as subject to getting slammed as the banks that trade them. The best currency to hold is gold and silver. Sure the Franc, Aussie and Yen may rally too, but nothing will compare to the rush that will influence the greatest price increase (relative to time) in this Precious Metals Bull Market.

There are few currencies that will be safe from inflation – and not the CPI – but rather real family-oriented price-increases. SaraLee has just reported that they will have to hike the price of meats up 20% by year end. Many companies will follow suit.

The commodity that will most probably emulate that increase is Gold. Retail investors are well aware of its characteristics and it seems that, as predicted, small speculators are beginning to catch on as well. Gold seems to correlate very well with fear, to which inflation (read: falling dollar) will greatly contribute.

At that time, whenever it is upon us I’d say: Sell Half your Gold, and Buy Some Bargains! And Buy with Care! This is going to be the best buying opportunity in 35 years!

Deflation! When smaller is better.

Well, sort of. You see, we’re not referring to commodity prices. We’re talking about consumer prices. Until now we have seen Wal-Mart, the nation’s largest retailer, cutting prices of goods from cereal to coffee (as much as 30% this year). But how?

[The following may also explain the miraculously low CPI reports over the past few months]

Here are some ways to cut costs:

Shrink the goods. Cereal boxes only two-thirds full, Hamburger Helper with denser pasta (allowing the same amount of food to fit into a 20% smaller box at the same price) and even repackaging (the 750ml bottle that was once 1000ml). This cuts resource costs.

Cut out the middleman. Wal-Mart now buys its brand-name coffee directly from a cooperative of Brazilian coffee farmers for its Sam’s Choice brand, cutting out suppliers, cooperatives, roasters. This cuts labor.

Go local. Stores are sourcing more produce locally instead of trucking to distribution centers nationwide. This cuts shipping costs.

Will it last? We don’t know but we are sure of one thing: There are many methods of getting great stuff for damn good prices, be it oil and metals (due to easy, cheap drilling), affordable housing and loans (due to low rates), stocks (due to high profit margins) or even labor (thanks to low-wage paying Asia).

But needless to say these days are passing us and they may be gone for quite a while. Rates are rising, easy oil is depleted, profits are declining, cheap labor is harder to find and those extra money saving efforts are dwindling… and so may the easy money.

For a nation seemingly addicted to Hummers, I think the retailers have begun to think differently: Smaller is better!

The Real Bubbles



“It is the measure of wealth itself [the Dollar] that is overvalued, not the goods that it represents”



I’m beginning to understand what is going on. I hope this article will shed some light on a variety of issues, some of which have been fairly complicated for the common investor to digest.

I will begin with a paragraph of adages and mantras being proclaimed on Wall Street, followed by a thorough analysis of why they are either baseless or misconceived. For the sake of simplicity I won’t use references but they are all available.

Mr. Market says

“The Commodities Bubble has begin to blow over, with everything from gold to oil to potash collapsing from their artificially inflated prices to mediate norms. Much of these gains have been driven by speculator demand, from hedge funds and the like, as well as consumer demand, including China, India and Russia.

“Investors have bought in every premium into these contracts and optimism is high. Furthermore, commodities have been a very poor investment relative to stocks and bonds. Even gold has underperformed inflation. As equities recoup its gains and inflows of capital return, pushing inflation down with it, commodities will be a relic of the past.

“Recessions are times of diminishing consumer demand and this will further help in reducing prices. With much of the investing community already discounting shares due to recession we can expect a bottom in the stock market with a rally beginning just as the economy is officially in recession. Financials and Homebuilders are set to gain the most as they have been beaten down severely, looking awefully cheap from a value prospective.

“The Dollar is set to rally as stark pessimism has oversold it. Recession will strengthen the currency. This will bring in investment flow previously allocated to Euro, Yen and Gold.”

The Problems With Mr. Market and the rest of the Wall Street gang (CNBC)

1. Wrong Biases
Wall Street as we know it is not a the Mutual Fund Industry, a group Hedge Funds or even large network of multi-national corporations. It is simply the media’s opinion of the former. There are few companies that end up becoming large corporations and even fewer speculators-wanna-be-billionaire-investors who actually live up to their own aspirations.

This is due to its ill-conceived sentiment, nothing more. It has all the facts (most do at least) yet the small investor constantly fails to make the integral judgments necessary to fulfill his lifelong ambition of success, or even of financial independence. They run after Enrons, Devalued Russian Rubles and dot coms believing beyond any doubt that they have it made for themselves and they have indeed “beat the street“.

However, the only way to real gains is to bet against the crowd, to look where no one else is looking, or even better, to see past the unsound biases that have plagued investors since the Mississippi Scheme in the early 18th century.

2. Confusing Short and Long Term
This is probably the most extreme variable, one which offers the most profits to he who can see past its vile inadequacies. Many (not all) of the arguements presented in favor of the Dow 36,000 were in one way or another grounded fundamentally. The problem with the gushes of cash inflow was they were based on an economic phenomenon that was years into the future, results that we are only beginning to see today – and interestingly enough by quite a different group of influences. While investors were placing bets on Yahoo and Juno, Google wasn’t yet a public company.

3. Forgetting Premium and Discount
In addition, shares were discounted many times over yet speculators failed to realize it. Any price was a great price because in the mind of these irrational gamblers the gains were infinite it seemed. It was hard for investors themselves to understand that they were betting that the company of purchase was one of sound safety that would last, and therewith deliver on its earnings 100-1000 times over, without any interruption whatsoever.

4. Wall Street too has Seasons
There are financial equinoxes, waxing and waning over decades. Warren Buffett himself cautioned Saturday not to expect big gains from the stock market in future years. Indeed, there are periods when year after year people move from the New York Stock Exchange to the commodity pits of the Midwest in search of better returns.

5. In The Dollar We Trust
A currency is present only to act as a constant method of exchange between goods. Yet the U.S. currency is nothing of the sort. It has become a staple of growth and a signal of everlasting creditability. Unfortunately for many this will not last. Contrary to many pundits the present rally in the Dollar, however great it may seem, is a mere decoy and will be short-lived.

Even Treasury Secretary Paulson has advocated that a weak dollar is in America’s best interest. While this may or may not be a positive development, one thing may be guaranteed by any student of financial history dating back to Cicero in ancient Rome: every fiat currency has failed, frequently bringing its empire down with it.

6. Action and Consequence
Finally it pays dearly for the prudent investor, who has the sole initiative to first protect and only then appreciate his capital, to understand the elements of check and balance. Every action that does not act as a stimulus for long term growth but merely for short term gain will inevitably be met by an equal and opposite loss. Failing to understand this will, for the ignorant, deplete capital faster than you can say “Bear Sterns”.

Commodities will not blow over.
Long term investors understand the need for correction and rest. Things that go straight up are indeed called bubbles and we are not there yet. Like fire feeding off oxygen and fuel, so too do bubbles feed off of extreme optimism and public involvement, both of which can’t disappear over a few weeks. The perceptive analyst will look around and tell with utmost certainty there is no sign of a any euphoria. If anything the investor relies on solid fundamentals, all of which are intact, and buys when the crowds are telling him to be cautious. If he didn’t sell he is sorry but it is insignificant because a bottom is close at hand.

Has all the oil inventories been replenished with years of supply? Have investors the fear that would send each preferring a Krugerrand over a wad of hundreds? Are the cheerleaders over at CNBC telling you to buy Krugerrands and load up on more shares of Nemont Mining?

Market Norms
I have read through many books on markets, investment and financial history yet I have never seen evidence of such a thing. Everything has an intrinsic value and it either sells at a premium to that value or a discount. Professional Traders look for market “norms” in the sense that they seek a short term variable and attempt to trade within that range yet they abandon all affiliation when this trend is broken, that which all may be confident that it will.

The Real Bubble
With pundits of financially-based markets they seem to make two awfully wrong assumptions. Firstly, that the a Commodity Bubble exists in Dollar denominated form and secondly that it has been inflated by artificial and speculative demand.

The first misconception is one that one would almost fail to consider to begin with. After all, the U.S. Dollar has been on the center stage of international trade since the Bretton Woods Agreement shortly after the Great Depression in 1941. Yet since 1913 its intrinsic value relative to goods and services has fallen by over 93%. The fact that there is still any goodwill left to the Dollar at all resembles a Bubble of sorts. It is the measure of wealth itself that is overvalued, not the goods that it represents.

Thus, it is not the goods and services that rise but the Dollars that fall; their inability to maintain their value. Nevertheless instead of markets taking their natural course and correcting itself, the Government is artificially inflating the money supply whilst protecting the very economy that its currency stands for. This devaluing of the Dollar to be able to finance its debts is in no way different than if Enron was given the very ability to print its own currency to continue its business operations or pay out to its shareholders.

This explains the underlying developements we have seen in physical goods, not too different from what we experienced in the 1970s, with a dangerous undersupply of commodities, runaway deficits and financial derivatives of enormous proportions.

I ask of the conscious minded economist, “With over $500 trillion in financial promises, which now seems to be Dollar-backed and secured by the Federal Government, what meager value may be given to the price for real goods, that which feeds and sustains mankind? Furthermore, if demand for goods the world over is rising is it not reasonable to assume that prices rise with it, if not to curb demand, then to act as an incentive for the farmer to increase production? Finally, what would have offset the interest for the speculator to profit from these gains if the fundamental demand continues unabated?”

To quote Charlie Munger “We have convulsions now that make Enron look like a tea party.”

Critical Optimism
Does the financial community really believe that there is excess optimism in commodities? That gold bullion are selling off shelves? That people left and right are participating in buying goods that will benefit from real demand? On the contrary, I see that many have found an opportunity to sell the only gold that they may have in their possessions to take advantage of higher market. This denotes good business sense of buying low and selling high, but certainly not in the realm of exuberance that we have seen in previous meltdowns.

Physical vs. Fiscal
Commodities and Equities. Gold and The Dow. It is a subject that many seem to overlook from a generation-term prospective (considering that Buffett’s long term is 10 years). It is the flaw you will see in every commodity-bearish argument: “Commodities just don’t cut it relative to equities”.

But let us look at the origins for monetary protocol: Traders bartered goods in the marketplace. With many various items coming from numerous townships it was necessary to create a measure of value, a pivot whereby difference between supply and demand may mediate; a method by which payment may be expandable without the physical presence of currency.

Thus began the credit cycle. Producer sold to seller, who bartered with traders, who retailed to the marketplace, who took home their foods from their labor and fed their families.

This “Credit”, unlike the commodity-based currencies of old, had but one restriction: the tolerance of the lender. As long as the lender would risk would the industry borrow. It is of no coincidence that this cycle of credit take years to build and then years to crumble.

The “historical trend”, if we may call it, offers fairly simple advice to the novice merchant who wishes to conserve and grow his capital:

When in times of expansion… lend, invest and do business. In times of contraction and uncertainty… Pay debts, take inventory and accumulate capital.

Recessions of Supply and Demand
It is interesting how mainstream economists will focus on something specific in great detail and fanfare and at the same time fail to see its direct opposite exposure. For instance, it is assumed that a recession diminishes demand for goods and therefore lowers prices overall, not only in the U.S. but also in China. Consequently however, a loss of demand will hurt producers who may decrease production. This will have the opposite effect and raise prices.

Furthermore, it is assumed that as we move into recession, investors have already discounted all the possible losses and write downs. At first glance this possibility seems preposterous. How can a market, however “efficient” it may be, properly and throroughly account for the very speculations that everyone from the companies to the Federal Reserve can only guess at? Besides, it’s quite humorous that Wall Street can call the middle of a recession when they can’t even call the beginning, let alone its happenstance altogether.

It goes without saying that the same case may be made for commodities, in the sense that recessionary results have already been discounted and accounted for, or that they even sell at a discount relative to post-recessionary time-tables.

Capitalism that would make Marx smile?
Capitalism works. And for he who says it doesn’t should look no further than every innovation and technological advancement since the Middle Ages. Nevertheless, it is a process and it may not be looked at point blank. There are times when the advantages of Capitalism may overextend its true worth, while there may be times that it will seem to underestimate it (much like your average share price).

For the last 28 years we have lived in a credit expansion. Yes, there have been pitfalls – the Crash of 87, LTCM, the DotCom collapse – yet we have rolled on. The world has undergone quite a change in that time and has made people sentimentally and physically wealthier than ever before. Liquidity was fluid, credit was available for anyone who needed it, lending was commercialized and industrialized allowing the investor in China to buy equity in a startup in Australia. What the lender would risk would the industry borrow.

Yet now the payments are due, and the funds we have borrowed to finance this wonderful world we have built for ourselves must be paid in full. We are not veering off a path of success, not failing at our ambitions, we are merely paying for what we have taken.

Our past actions have now brought about the future results. For years we benefited when investors fled from commodities to purchase equities and financial paper, suppressing prices through shorting, or “selling forward”, neglecting the farmers and producers. Now we must compensate those to increase supply in order to feed a larger, hungrier, wealthier, more innovated world.

It’s Time to Revisit The Markets

It’s time to reflect on the predicament of the markets. We ran two editorials in late December entitled “Are You Ready for The “Blue” Year?” and “Some Thoughts on the Markets“. We defined a general outlook for the economy for the year of 2008.

We are constantly reminded that “The more things change, the more they stay the same”, it is far easier to predict what we may see in the future. With that I would like to offer clarity to the confused investor.

Dow/Gold Ratio
The ratio currently stands at 15, with a low of 12.5. Our immediate term goal is 7 with an eventual decline to 3 before the economy pulls itself out of recession.

During the brutal 1973 downturn the Dow Jones Industrial Average fell from 1050 to 570, a decline of 45%! Yet this wrecking fall was cushioned by a counter-rally from 800 to 1000, within 5% of its all-time high. Interestingly gold, during this same period, rose throughout the downturn, from 70 to 195 over the 2 years period. Over 178%!

If I were to rewrite that paragraph but multiplying all 1973-75 dates respectively, it would read as follows:

During the brutal 2007 downturn the Dow Jones Industrial Average fell from 14,000 to 7600, a decline of 45%! Yet this wrecking fall was cushioned by a counter-rally from 10,650 to 13,300, within 5% of its all-time high. Interestingly gold, during this same period, rose throughout the downturn, from 700 to 1950 over the 2 years period. Over 178%!

Obviously, history will not repeat itself, but it sure as hell does rhyme. I believe that the DJIA will push above 13,000 temporarily and then resume its decline to 7600 vicinity. While gold will trend ultimately to the $2000 level by late 2009.

[One may ask based on these calculations, that Dow 7600 / Gold 2000 = 3.8, well above our factor of 3. Nevertheless, it is most probable that gold won’t peak at the exact time that the Dow bottoms].

Thus the prudent investor will seek refuge in some words from our December article.

“The truth is, however inverted it may seem, bad is good, bear is better than bull, bust beats boom”.

This simply means the investor can do phenomenally well by simply paying little attention to the media and markets and instead focus on the short yet profitable buying opportunities that present themselves.

With that we move on to some predictions we made back in December of 2007, results since then and what we can expect going into 2009.

The Economy

“When demand is high and supply is low prices must rise, and if by any means they are manipulated or capped they will rise further in no different a logic than the what lead to most of the current problems in housing

This sums up what we’ve been seeing over the last few months, and it can be expected to continue into 2009. The media will keep calling bottoms while credit and leveraged conditions deteriorate.

“There isn’t much we can be sure of in the next year other than the fact that more volatility and election jargon will be stuffed down our throats

This in my eyes was a no-brainer. Tension was all too high and much of the markets movements were based on speculation rather than solid fundamentals.

“Corporate profits will fall causing either p/e’s to rise or prices to fall as well. Don’t be surprise to see us approaching single-digit ratios for the Dow”

This may have been too short an outlook, however it is expected before markets bottom. It’s not if, but when.

“Expect to see more and more consumers turn to their retirement accounts and credit cards to keep them afloat”

This has been seen slightly and is significantly increasing. Foreclosures have doubled year-to-date and increasing amounts of home-owners are just walking away.


Whether or not [we have a Recession]… expect some sort of ‘flation.

So far GDP has been positive so there is no “official” recession. But ‘flation indeed! Stocks have fallen and since found some relief, while commodities have boomed and since corrected. Yet the investor should not be fooled by this.

Interest Rates

“He [Bernanke] really has no choice… right now he sees fear of recession and it’s his job to cater to it”

With rates lowered from 6.25% to 2%, all Fed Discount Windows were opened and inflows have been supplied to the market, not to mention the bailing out of Bear Sterns.


“The Yen and Yuan seem to be holding up fairly well… As for Switzerland? Yeah, I think the Franc should hold up just fine… for the Loony, Real, Ruble and Aussie Dollar the future never looked so bright”

This was mostly due to a declining Dollar. The Dollar may have now found a bottom and this will be sustained when the Fed turns to raising short term rates. Yet if markets follow any similarity to the 1970s, this rally will be short-lived, with the Dollar testing new lows come 2010.


Interest rates are a major part of the equation. The lower rates go the higher the floor for housing prices”

Any economist would agree that the potential damage has been avoided. Yet we are faced with the worst housing recession since the Great Depression and the results will be felt. Low interest rates cannot makeup for decades of careless credit policy.

“Prices fell a record amount for this year. Buffett says it will continue into late 2008. Others say into 2009. Jeff Saut says prices have to either fall 25% tomorrow or streamline for 5 years in order to reevaluate on an price/income basis.

According to the Schiller Index prices are down 12% in many U.S. cities.

Oil and Gas

“Oil at $150? …I think oil has more to run… many others say $150 or even $200 before the year is out… Expect higher prices at the pump”.

Right on the money! Oil has risen as high as $120 recently. (with gas prices expected to possibly reach $8 a gallon before the year is out). This may be due to the fact that many airline fuel storages, were running low. Acting as a catalyst this replenishing pushed up prices.

“Recessions do decrease demand, but with a decrease in demand comes a decrease in productivity… Wall Street’s assumption of $50 oil… may be way off target”

This can be seen with regard to possible production decreases in Nigeria, and with regard to metals production from South Africa.

The Stock Market

“It’s all in the earnings… there will be surprises… there will be opportunities but I doubt there will be any significant bottoms at least until the recession officially begins”.

Earnings have yet to plummet as stocks are currently down a mere 8% from their highs. Yet while we find ourselves amidst a speculative, yet predictive, short-term rally, we remain within a well defined long-term downtrend. (Is the Dow really selling for 64x earnings?)

Small Banks and Homebuilders

“I say not yet. Will I be wrong? Possibly, but at least I’ll be empty handed on the downside risk, and there is some. I still don’t believe Wall Street has revisited pure unadulterated pessimism. A P/E of 8 doesn’t seem that bad until you recognize its all in the denominator.”

This call is still up in the air. Average bottoms have been presented with indexes selling below book value. They currently sell for 1.3x book.

Commodities and Precious Metals

“When people want food, prices rise”

If I say “Rice, Wheat, Soybeans”, need I say more?

“This will benefit all commodities, as well as gold (The Street gives a $1000 projection). Of course Silver has much further to rise as it regains some historical ratio.”

Talk about psychological resistance! Commodities benefited greatly and Gold went straight to $1000 before correcting strongly. In the case of the Gold/Silver ratio now major advancement was seen. The ratio hovered around 48 before heading as high as 53.5

“In the event that commodities… decline in the short-term this should be seen as a buying opportunity”

We have since been offered this buying opportunity.


“China’s bubble will blow over, but not before the Olympics… After that I suggest you get out, especially if USA Today is announcing record high stock prices.”

China has corrected together with the world markets, but has since regained much losses.

Another great quote from the last article

“The perma-bulls tell you to remain 100% invested in the ‘long run’ as stocks are the highest returning asset class over very long periods, like 100 years… But I have yet to meet an investor that either has a 100 year time horizon or can actually sit through all of the bear markets that occur during 100 years.”
Bennet Sedacca


Headline of the Week

International Business Times: Crude Oil Falls On Inflation Concern for US Economy

The following is an actual quote: “A report from the Labor Department showed today that U.S. consumer prices last month rose the most in two years, driven by higher energy costs, reinforces the fears that inflation will weak confidence in the economy”.

So someone in the financial community just came to the realization that the laws of Supply-and-Demand do exist!!! (Maybe that’s the news).

Welcome the Seventies!

No, you won’t get back your Intel 4004, you won’t need to grow back that Afro, nor will you easily get a hold of some new records from the Beegees. But what you are most likely to see a heck of a lot more inflating prices of goods (your favorite dinner) and deflating financial values (your favorite stocks).

The reason why some things just don’t change, is because people don’t. After the roaring 50s and 60s, we had evolved from savers to spenders, from investors to speculators. As the markets began to deflate, the Federal Reserve, along with the help of the U.S. Government Mint, began injecting even more liquidity into the marketplace in attempt to cushion the fall of falling asset prices, such as stocks and bond ratings.

In doing so they created a giant ball of cash that was rolling nowhere since due to its gigantic size was being rejected by the average consumer in favor for safer assets, such as commodities and real estate, and eventually gold.

It’s happened before in the 1970s and before that in the 1930s. Before that at the beginning of the last century. As a matter of fact, it’s been recurring about every 30 years or so, in almost identical cycles: Years of solid growth, followed by years of higher company profits trailed closely by stock prices, and then a euphoric blow-off of speculation and ill-appreciated prosperity. Then came the bust, the “credit crunch” when debts come due, loans are recalled, intrinsic values revisited. All speculative action dies along with the spirits of those who were riding it.

The primary differentiation between the “inflationary” depression of the 1970s and the “deflationary” depression of the 1930s was a simple one: Liquidity. In 1929 after stocks crashed and banks were failing by the day, there was nothing to fall back on. Man’s trust was in gold and its supply was limited. The Treasury was by no means interested in sponsoring such an event with goods of limited supply and unlimited value to those in need.

Today the story has a twist. One that has been in motion since its inception in 1944 with the Bretton Woods Agreement when the U.S. Dollar, became the unilateral global currency, “always” to be redeemable in gold. This was scrapped in 1971 with the closing of the “gold window” when these dollars became backed, not by resource of limited nature rather by the faith and credit of the people, assumed its role as the world’s global currency. This enabled the powers that be with the ability to constantly replenish the world’s liquidity in times of necessity. Unfortunately, this resulted in the same failures seen in the 30s. The rich got richer because they owned things and the poor got poorer because they owed things. Furthermore, how much you had became significantly inferior to what you had.

This being the predicament it has become quite clear in my mind that the scenario to unfold will indeed be that of an “inflationary” depression. the European Central Bank announced that it would make “unlimited” funds available to the banking sector. The Fed will, predictably, react in the same way, running the printing presses overtime.

The only way for the Fed to limit the deflationary affect of illiquidity, would be to increase real value – earnings, commodities and gold. Unfortunately, and contrary to the belief in the Federal Reserve, that’s impossible.

Billions won’t be enough to mop up this mess, but trillions. Even then chances are good that amid the panic, much of that liquidity will get misallocated to places whom those injecting it don’t desire. There is no question in my mind that the damage has been done and one way or another values must realign.

Consumer costs will rise, while stock valuations (as measured between earnings and cost per share) will fall. Debt related issues will suffer, albeit not do to deflationary pressure, rather due to inflation and interest rates.

Tomorrow marks a significant day for hedgers as the deadline for withdrawal at the end of the quarter (45 days). This was obviously discounted as the Dow fell another 200 points.

Mark my words: These days will go down in history.

The Road to Hyper-inflation

“By increasing the number of U.S. dollars in circulation the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services.”
Ben Bernanke

These are the thoughts of a hyperinflationist, no different than the thinking that prevaded over Germany in the 1920s, recent Bolivia and in current Zimbabwe. Inevitably if the trend continues the dollar will become worth less. When people catch on it will become utterly worthless. If we come to our senses later than sooner, we will be served with an economic depression.

Disconnecting the Dots

Risk is selling for too cheap and the Carry Trade is the culprit. These are thoughts that the world most succesful investor seems to agree with but somehow it always gets left off the major highlights of his remarks.

In the market there is a price for everything. For every public company, for every commodity, for every currency. There are even prices for insurance on your portfolio and on the price of risk. The price is usually right. After all they’re scrutinized and evaluated by thousands of analysts and millions of speculators daily.

There are many different types of buyers. Many are there every day, not looking for good value but just something they can sell 10 minutes later at a higher price. Some only show up only once in a while, usually when they hear there’s some sale or issues selling at bargain prices.

Risk Undervalued
But every once in a while, the market as a whole gets it wrong. The 10-minute buyers offer unbelievable bargains for the value-savvy costumers.

In this light, Risk too has a price. You wouldn’t buy hurricane insurance in Kansas, would you? Of course not! But if a hurricane were to show up for all unpractical reasons many home owners would face a major loss of capital. You can afford the risk since your premiums wouldn’t pay off such a far margin of error.

But how about not buying insurance in South Miami because its out of season? That sounds ridiculous. But this seems to be the mistake many investors are making. They are selling risk out of season.

This is demonstrated by the low interest rates seen worldwide. True, they have been rising, but has this essentially performed its duty?

The Carry Trade
Japan has had it tough they had a wonderful economy doing wonderful things, the share market flourished and housing prices boomed. But, then came the inevitable bust that the frenzied public always seem to count as discounted. Japan and everything associated with it tanked.

Just a few years later we have the U.S. and the western world amid such a similar predicament. With the Dow soaring to new highs and a strong economy there wasn’t a dark cloud in the sky.

But then came the moment of transition. But we American’s are so much smarter than the Japanese. After all its been over 70 years since the last depression. So how do we prevent it from happening again? Offer the people what those in the depression lacked most – Cash. The Fed slashed interest rates to a mere 1% and threw cash piles out to the masses.

But it wasn’t just the Federal Reserve who was helping along. Japan at the time was offering a ZIRP or a zero-interest-rate policy. This meant that the government was practically begging for people to take its money, usury aside.

This being the case, even after the Fed began hiking rates investors and companies still found a way to cash in on yesterday’s price of interest. Borrow in Yen. This following later became widely known as the Yen Carry Trade. Yen were purchased on zero interest charges and swapped for higher yielding treasuries such as the U.S., Australian and New Zealand.

Here is what the market is discounting. Eventually, this moat is going to narrow. As a matter of fact this has already begun. Once it begins and the spread becomes less profitable the whole house of cards will collapse no different than the stocks that were selling for 50 times earnings in the past. You can only bet on a phenomenon while its still in motion. Once it stops, and every moving thing that is propelled by nothing more than limited resources does, the game is up.

In an age of knowledge every man and woman, regardless of whether or not they ever stepped into a course on economics has become yen-carry-trading, Chinese-stock-betting maniacs.

A Life Savor for a Dollar
This is what is holding up the U.S. economy. J
apan is supplying it with credit, allowing it to borrow and spend as much as it needs to survive. We then spend this money is low-cost-producing nations such as China and Japan. They in turn reinvest those funds back into U.S. Treasuries benefiting from the interest we will borrow from them to pay them with.

Sounds ridiculous, doesn’t it? But here’s why they continue to do it. If they lose the U.S. they lose their best costumer. As long as he comes in every day and buys half the store, there is no reason to deny him credit.

But Japan is paying out more to keep its best costumer than would be worth to forgo the debt. Real rates in Japan are negative. This means that it far more sensible for people to hold consumer goods which are increasing at the rate of inflation than to hoard cash that compounds at a mere 1/2 percent.

A higher yen as a result of rising inflation fears and higher wages will mean more inflow to economy, raising U.S. rates and consumer prices in the process. This translates as destruction – Hiroshima-style – for the Dollar and the American economy. We will once again face the deflation side of the equation that the Japanese know all too well. The spread between physical goods and its immaterial derivatives will narrow.

You can speculate on a rising Yen, a weaker dollar, a narrower spread for rates on interest and credit, do not however discount what you may not know.

Rethinking Words

In our January article “Let’s Talk Interest Rates” we said

Most of the larger players in the game including commercial institutions and hedge funds understand this game well. They know the risks of the system and in the bets made therein. Many therefore are ready on a minutes notice to liquidate just about everything. This was one of the dynamics experienced during the late 1920s. The speculators, masters and novices alike, new damn well that their money was at risk. But who wouldn’t take on that risk for gains of 20-30% a year? Furthermore, each reasoned with himself that on the first sign of imbalance money would be taken off the table, bets closed and a dashing for the door would be in order.

Of course the financial markets don’t have a very good track record of maintaining peace-of-mind for the investors that push it to sky’s limits… If the wise and intelligent investor were a caveman he’d warn “Catch the beast when its weak and tired not when it’s mad and hungry”.

When the floor drops, as it always does, many will be quite disappointed. Meanwhile with the dam of equities along with the credit of both housing mortgages and the Federal Reserve crashing in, the Fed will face its true debacle. Plummeting house prices, sub-prime loans defaulting all over and stocks being sold fervently, all the while flooding the marketplace with billions if not trillions of dollars of liquidity. Hence, contrary to popular belief inflation will occur regardless of whether or not the Fed and the government attempt to flood accounts with easy credit and loan Repos. Post facto this liquidity would have inevitably been filtered in through financial assets.

We have found this to be half true with its premise intact. We will understand based on our assumed knowledge of inflation. Inflation, once again, is categorized as the increasing of credit and expansion of monetary restriction. When this occurs, we perceive an overall trust in the nations money and in the nature of business expansion as a whole.

Conversely, in regard to deflation we have the opposite. A flee from fiat trusts is formed, as all issues of promise and of future marketed worth, as oppose to physical intrinsic value, are abandoned.

Where we currently stand the latter is inevitable. Financial assets currently sell for far more than they are inherently worth, stocks sell for historically high multiples to earnings, derivatives have infused the system with a breadth that bodes well only for high-net-worth risk-savvy speculators. Many investors are sitting out, while hedge funds scour their way from private equity to the latest IPOs.

When this begins to collapse, and many already believe it has, the Federal Reserve will have its final chance to hold on raising rates and dump as much of their magically created money and credit as they can before the system realizes what has happened. But what will stop it then? Nothing. It will only stall what has been a process in the making since late 1999. More investors are coming to light of the truth, as oppose to those being sucked in as they were at the height of the last century.

So there are two courses the Fed can take. Allow free-markets to unravel themselves, resulting in a deflationary scenario where money is saved and hoarded rather than invested and spent bringing a halt to the momentum that the speculators currently thrive on. Or they can disallow markets to take their course. This would result in hyperinflation – any nation’s worst nightmare – where money becomes absolutely worthless, the dollar goes to zero and the U.S. falls into an economic debacle of cataclysmic proportions.

In regard to interest rates there really isn’t much the Fed can do to help the situation if it isn’t willing to face the facts openly. It can save the dollar from its ultimate value or the economy from recession, but not both. Their policy in the future will dictate their intentions. For now they are watching like so many other investors wondering.

Wondering which, the fiscal assets or the physical, will give way, as it’s assured that one no doubt will.

Questioning the Aces

Alexander Green from the InvestmentU writes

“They [commodities] serve as an inflation hedge. For instance, commodity prices surged during the inflationary ’70s, then steadily declined in the ’80s and ’90s as inflation subsided.”

Now I’m not sure what exactly he is trying to say. He may just be looking for a nicer way to say “the financial asset bubble has bust and along with it all the faith and credit for which it was derived.”

Or maybe he just never understood anything. If he refers to the Keynesian term Inflation, then inflation means the higher prices of goods, read commodities. If he refers to monetary inflation then inflation in no way subsided in the 80s and 90s. In fact it surged. If he speaks in Austrian terms, then the 70s was no era of inflation whatsoever, but rather that of deflation.

“Historically, commodities have rallied when stocks and bonds are falling.”

Well, yes Alexander. That’s the way these things work. The only thing that is really falling is the asset/derivative ratio.

“But recent history has defied conventional wisdom, as history often does. Commodities have soared alongside stocks and bonds, without a major political or economic calamity, and in the absence of hyperinflation.”

I wonder if he understands how close his words are to solid reality. This my friend is how all financial asset bubbles end when there is a rush of liquidity. If this continues, the sense of monetary acceptance will wither and all financial assets, however huge in price, will become worthless – hyperinflation. If it subsides, then we will have a credit crunch no different than any other in history, possibly resulting in a depression (that’s the way the BIS put it).

The matter doesn’t depend on China’s growth, the Federal Reserve or the ability for Joe Boxer to take MEW (Mortgage Equity Withdrawals) out of his home. It is solely in the hands of those holding currencies and financial assets the world over.