When Do You Skip Gold?

In Defense of Capitalism

"The inherent vice of capitalism is the unequal sharing of its blessings.  The inherent virtue of socialism is the equal sharing of its miseries."  -Sir Winston Churchill

Great friend, comedian, and entrepreneur Rajiv Satyal gave a brief critique of Michael Moore's movie Capitalism: A Love Story and asked for my thoughts.  Here is my email response to him:

The thing that bothers me the most is that people like Moore put up our current system as "capitalism" and then blame all the problems and corruption we currently have on it.  Let's be clear --- we do not have free markets and capitalism in this country.  And we are failing and falling behind as a nation because of that.  Capitalism involves risk and reward, success and failure. When you take risks that don't pan out YOU FAIL.  You do not get bailed out by well-placed government agents like Robert Rubin, Tim Geithner, Hank Paulson, Alan Greenspan, Ben Bernanke, and Larry Summers.  What we have -- and this goes for Republican and Democrat administrations alike -- is a type of crony socialism.  You keep your rewards and socialize the risks if they don't pan out.  The Federal Reserve and bought-and-paid-for politicians by large corporations (most particularly Wall Street banks) aided and abetted excessive leverage and risk taking (and still do).  There was a wink-and-nod understanding that Greenspan and then Bernanke would bailout the banks if the shit hit the fan -- this was widely known as the "Greenspan Put".  It happened with the Mexican peso crisis, the "Asian Contagion", Long-Term Capital Management, Nasdaq crash, housing bubble, etc., etc.  Investors became conditioned to being bailed out.  And even today bondholders in Bear Stearns, AIG, and many other firms were made whole by the bailouts.  Yes, taxpayers are making sure Bear Stearns and AIG bondholders and others will lose no money!  That is tragic and IS NOT CAPITALISM.  What happened was that the wealthy and well-connected got bailed out by Main Street, and we are paying for it to this day with massive budget deficits, punitively low interest rates for savers, and a mostly stagnant economy with high unemployment.  It sucks, and it pisses me off, and to blame "capitalism" for it is just ignorant.

In 1920-1921 the U.S. suffered one of its worst Depressions ever.  Nobody got bailed out and the economy suffered through a very painful 18 months.  Those who took the risks got punished, as they should.  But then that was it.  We regrouped and had "The Roaring '20's".  Then 1929 we crashed again, but instead we bailed and subsidized and stimulated ourselves into a 10 year depression that ended with WWII.  But as its been said, "The only thing we learn from history is that man doesn't learn from history".  I contend that had we not bailed out the banks in 2008, we would have had a greater, sharper, but much shorter recession that would not be putting the future of our country's fiscal health in serious jeopardy.  I firmly believe at this point in time we would be well into a real, sustainable economic recovery.

And I would also say to those who currently believe that the coast is clear -- not so fast.  The current economy is entirely dependent upon unsustainable deficits and massive monetary printing, and the consequences of those policies are ahead of us, not behind.  The banks that were deemed "too big to fail" before are much larger now.  The systemic risks are larger, not smaller.  We have put band-aids over gaping, festering wounds.  Optically things may look better, but it's only a mirage.  What will policymakers do when we inevitably hit the next downturn?  We have few bullets left.

And this is all because we did not allow the capitalist system to work.

We had a capitalist system in this country once.  It worked wonders and made us the wealthiest country in the history of the world.  We ought to try it again.

Eat the Rich?

"The liberties of our country, the freedom of our civil Constitution, are worth defending at all hazards... We have received them as a fair inheritance from our worthy ancestors: they purchased them for us with toil and danger and expense of treasure and blood. It will bring an everlasting mark of infamy on the present generation... if we should suffer them to be wrested from us by violence without a struggle, or to be cheated out of them by the artifices of false and designing men."  -Sam Adams

This video puts into perspective how completely out of control the spending and deficits of our government has become.  Deep and wide is the hole we've dug ourselves.  Anyone can make a mistake, but only a fool persists in his errors (video on YouTube is HERE).

America's "Freedom Packages"

“Of all the enemies to public liberty war is, perhaps, the most to be dreaded, because it comprises and develops the germ of every other. War is the parent of armies; from these proceed debts and taxes; and armies, and debts, and taxes are the known instruments for bringing the many under the domination of the few. In war, too, the discretionary power of the Executive is extended; its influence in dealing out offices, honors, and emoluments is multiplied; and all the means of seducing the minds, are added to those of subduing the force, of the people…. [There is also an] inequality of fortunes, and the opportunities of fraud, growing out of a state of war, and … degeneracy of manners and of morals…. No nation could preserve its freedom in the midst of continual warfare."  -James Madison

Obama gave a 20 minute speech this week on opening yet another front in the Middle East (yes, I realize Libya is in N. Africa; close enough) and never mentioned the word "oil" once.  Make no mistake about it, that's the only thing this is about.  I would rather us just be honest about it and say, "Look, we have a $14 trillion economy and it needs something to drive it.  Until we are able to harness the hot air and bullshit that comes out of D.C., that something is oil, and we will do whatever we can to secure it for our use."  That's the truth, freedom and democracy around the world be damned.  The Constitution is but an afterthought these days, as Congress doesn't even declare war anymore.  But then again, truth is the first casualty of war.

I've said before that it's an indictment of our lapdog media and their dereliction of duty that it takes a left-leaning comedian to point out the hypocrisy of our policies.

The Daily Show - America's Freedom Packages
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Using a Short Fuse on a Big (Debt) Bomb

It is incumbent on every generation to pay its own debts as it goes.  A principle which if acted on would save one-half the wars of the world.”  -Thomas Jefferson

The always original Bruce Krasting takes a look at the inevitable and predictable debt blow-up in Portugal, and what it means for us.  This is a slightly different look at our debt situation:

Everyone knew that Portugal would have to roll over and accept a bailout at some point. It was inevitable that this has happened. The lines crossed some time ago. Portugal has too much short-term (ST) debt. The cost of rolling it over (if possible at all) would be too high. Debt service at free market rates would kill the country. So there is no sense in keeping up the charade any longer. It was Portugal’s dependence on ST debt that did them in. This chart shows how the maturity schedule of existing debt simply overwhelmed their capacity to refinance.

What would you call this? ‘Mismanagement’ comes to mind. The Portuguese Treasury put the country at risk. Rather than point fingers it would be ‘nicer’ to conclude that Portugal had no option but to borrow short-term. It would be fair to blame the economic leaders of the EU. They knew for years that Portugal’s ST debt was a time bomb. The lessons of Greece and Ireland and their dependence on money with a short string are fresh in their minds. 

Okay. You got that? ST debt = death. The greater the reliance on ST financing the greater the systemic risk. Now look at the US debt profile. Compare it to Portugal. Who looks worse to you?

So we have to fund our $1.5 trillion+ annual deficits plus rollover all that ST debt each year.  So yes, if you do the math, the U.S. Treasury will be selling over $4.0 trillion of debt in 2011 alone!

If you were able to borrow money at near historically low interest rates, you'd want to lock in that rate for as long as possible, yes?  The Treasury, however, doesn't want to increase interest rates by dumping massive amounts of our unsustainable deficits into the longer-term debt markets.  So they are financing all our debt at the short end of the curve.  The good news is that it temporarily results in an interest expense that is next to nothing (2-year Treasuries yield less than 1%).  The bad news is that when (not if, when) interest rates spike, our interest cost is going to explode very quickly and cause even more massive deficits.  Unless we change our ways, eventually we will hit the wall, too, just like Greece, Ireland, and Portugal.  Tick, tick, tick...

The "Silver" Lining

One of the best leading economic indicators is new home sales and starts.  In fact, new home construction and the subsequent sales has typically been one of the main activities that has driven the economy out of recession.  Except not now.  On March 23 it was announced that the February new home sale figure came in at the lowest of any month in the history of the report (yes, it's seasonally adjusted).  And the figure is actually far worse, since the sales figure is not population-adjusted.

What's amazing is that the recession officially ended nearly 2 years ago, and we are still posting numbers like that.  Auto sales also remain way down off the peak, which is often another key post-recession driver of economic advancement.  Clearly this "recovery" has been turned on its head.

Instead, what has been rocketing to higher levels are the precious metals.  They are very sensitive to monetary policy, particularly its errors.  Most people know by now that gold has been on a huge run.  I've called it "the silent sentinel", as it calls B.S. on the lies of our policymakers.  But if gold is Batman, then silver is its Robin, and it has been on a tear, too.

The huge ramp really started in August, when Bernanke's QE-2 was announced.

So our typical economic drivers are clearly not driving this "recovery".  No doubt by now you know I think the economy is being driven almost entirely by unsustainable deficits and money printing.  The divergence of real economic indicators vs. the action of the precious metals prove this out.

A Closer Look at the P/E Ratio and Profit Margins

"If you torture the data long enough, it will confess to anything."

-Ronald Coase

I've been asked a great question about stock market valuations, specifically about the P/E ratio (probably the most followed valuation metric).  As I've mentioned time and time again, valuations are the key to determining future returns, so this is an important concept.  Many commentators on tv note that stocks today are "cheap" because the P/E ratio is in the 14 area, which is about the long-term average.  Yet I have noted a few times recently (see HERE) that the Shiller P/E is a near-record 24, materially higher than 14.  So what gives?

Well, both are actually correct, but the Shiller P/E is more accurate.  The answer lies in profit margins.  The Shiller P/E factors in a normalized profit margin picture.  The commentators on tv are giving you the actual P/E ratio, which is incorporating profit margins that are currently near all-time highs.  

Over time, profits cannot grow more than the economy (nominal GDP).  Sometimes profits grow more quickly, but then there is the inevitable give back.  John Mauldin noted last week:

As the brilliant Jeremy Grantham says, and I am paraphrasing, corporate profits are among the most mean-reverting of all statistics. And this makes sense unless capitalism is broke. High profits entice competitors to come in and take market share by selling for less.

If corporate profits went back (mean-reverted) to their longer-term average, P/E ratios would be close to 24 at today’s prices. Corporations have some room to absorb some price increases, but at the expense of the bottom line.

As 2000 and 2007 can show you (widely touted as being "cheap" stock markets, too), following the reported P/E can be dangerous to your wealth.

The Stock Market Does Not = The Economy

I just want to make a quick point.  The title is it.

It's getting old watching financial teevee and having the propaganda army from Wall Street and Washington say that the stock market is "looking beyond" or "discounting" the problems in the Middle East, or Japan, or Libya, and that they won't impact the global economy.  The stock market is not an all-knowing crystal ball.  Consider that the housing market peaked in late 2005/early 2006.  The stock market, however, soldiered on for nearly 2 more years amid assurances that the housing market issues were "contained".  Until they weren't.  And then "kaboom".

Look, policymakers in Washington know that the greater public views the stock market as THE thermometer for the health of the economy.  Therefore many policies put in place over the past year have the goal of manipulating the stock market higher.  The liquidity and firepower thrown at the markets and economy over the past few years is astounding, and it is encouraging speculation in all financial assets and commodities.  But keep this in mind: The stock market is not the economy.  CNBC and other stock market infomercials are notorious for making simplistic linkages between the stock market and gross domestic product (GDP). They tell us that any event that stimulates GDP growth inevitably drives stock prices up, and any event that hurts GDP growth pushes stocks down (what matters is valuation, regardless of what the economy does, as shown HERE).

Believe it or not, during the Great Depression investors saw some of the greatest annual returns in history.  It didn't mean the Depression was over.  And ponder this: what was the single best performing stock market in 2007?  It was Zimbabwe.  Here's a chart:

What a utopian place that must be, eh?  But the odd thing about Zimbabwe was that it's economic output had been cut in half over the preceding 5 years, tourism and farming had been destroyed, production collapsed, and the unemployment rate was estimated in the 80% range.  Store shelves were empty.  The country was suffering through a horrific hyperinflation.  But CNBC-Zimbabwe* was euphoric, and noted that the stock market was predicting good times and that current policies must be working.  The central bank chief was hailed as a savior.  "More, more, more money printing" the financial elite demanded.  And they got it...to the eventual destruction of everything.

My point is absolutely, positively, not to say we are going into a hyperinflationary spiral or that we are like Zimbabwe.  My point is that looking at the stock market to gauge the health of the economy is a dangerous road to follow.  Think about it: If the stock market told the whole economic story, there would be no need for any further economic analysis of any kind.

*there is no CNBC-Zimbabwe, but I have no doubt about what it's propaganda would have been.

Playing with Bubbles

In one of his great Monday morning missives, John Hussman discusses "The Anatomy of a Bubble".  The bottom line is that regardless of what the economy does, when stock valuations are reasonable, investors can expect reasonably satisfactory investment returns.  Yes, regardless of what the economy does.  On the other hand, stocks that reflect high valuations will greet investors with very disappointing returns over the subsequent 5-10 years. If there is one cardinal rule to investing, it's that your future returns will depend upon the valuation of what you purchase.  One would think that two massive stock market bubbles in the past 12 years would have taught investors that, but one would be wrong. Here's the key chart from Hussman:

Presently, the Shiller P/E stands at 24. Be careful how you interpret the data in the table for Shiller P/E's above 24, since these levels were almost never observed in data prior to the late-1990's market bubble...

Indeed, outside of the bubble period since the late 1990's, the only historical instance of Shiller P/Es materially above 24 was between August and early-October of 1929. The closest we got to 24 in post-war data was in mid-1965. While prices went on to achieve moderately higher levels (lagging earnings growth, so that the Shiller multiple fell), the mid-1965 valuation peak is widely viewed as the starting point for a 17-year "secular" bear market during which the S&P 500 achieved total returns of less than 5% annually through 1982, despite severe inflation. That's a good reminder that stocks are not a very good inflation hedge during periods when inflation is rising, particularly when stock valuations are already elevated and are priced to achieve poor returns. Stocks only "benefit" from inflation during hyperinflations and during sustained and anticipated inflations. In other cases, the eventual adjustments in economic activity and valuations overwhelm the "beneficial" effect of inflation on earnings.

As Hussman further emphasizes, these returns are for the next 5 & 10 year periods and says nothing of what can happen in the short-term.  We have a madman at the monetary wheel and a bunch of drunk Congressmen in the back seat.  Who knows how long this ride can go before someone "jerks the wheel into a god*&m bridge abutment" (what movie, anyone?).

To further emphasize how poorly stocks perform over the long-term when P/E's are as high as they are now, Mike Shedlock provides the following chart:

So here we sit, with a Shiller P/E of 24.  Stocks are priced for absolute perfection.  History says returns going forward will be very disappointing.  I don't know about you, but a world with massive budget deficits, exploding debt, money-printing central banks, revolutions in the Middle East and North Africa, and nuclear issues in Japan doesn't strike me as one I'd like to take a chance on that "perfect" outcome.

In addition, remember that pension plans in the U.S. are underfunded by multiple trillions, and most of them assume annual returns in the 8% range just to even have that funding deficit.  With the 10-year Treasuries at mid-3% range, the expectation is that stocks need a 12.5% annual return to make up the difference.  The odds of that are slim to none, IMHO.

Broken Window Fallacy

"He's mad, that trusts in the tameness of a wolf, a horse's health, a boy's love, or a whor's oath." -The Fool, King Lear

Or the moron's on financial TV.  

At first I dismissed the guest on CNBC as a crackpot idiot.  But after hearing it a few dozen times in the financial media, including from PIMCO's Mohamed El-Erian and former Treasury Secretary (and former Obama advisor and large contributor to the financial and economic woes of the past few years) Larry Summers, my patience has been pushed too far.  Their argument is that the silver-lining of the Japanese earthquake and tsunami disaster is that eventually the country will rebuild and will be a net positive for the resurgence of the global economy.  It is total and complete rubbish and is a great example of the bankrupt theories of the Keynesian clowns that inhabit Wall Street, Washington, and most prominently in academia.

French economist Frederic Bastiat coined this economic ineptitude "The Broken Window Fallacy".  He noted that a broken window in a bakers shop is not economic progress, contrary to what Paul Krugman might believe.  Yes, the baker will have to pay someone to fix the window, and that person will have money to spend, but it will be at the expense of whatever more productive spending or investment the baker would have done.  On a larger scale, if a company losses an entire plant in a hurricane, the company and the overall economy are poorer as scarce resources, valuable capital, and productive labor are used to create what was already in place.  The company will have similar infrastructure in place as before, but now have less savings and/or more debt and lost opportunity costs and potentially fewer customers (people will buy a GM, Ford, Hyundai, etc. instead of buying a Toyota or Honda if they aren't able to produce as many as they want).

Think about it this way: If the destruction and rebuilding of valuable infrastructure can be a positive economic catalyst, why not have a major national program to destroy and rebuild buildings?  If Katrina destroying New Orleans can be good for GDP, by all means let's give a major American city a months notice to get out and let's nuke that puppy.  Think of all demand we could create for all the hotels, airfare, fast food, etc. that would be needed.  And the construction jobs!  Hell, why not just declare war on ourselves???

See where I am going with this?  Natural disasters and their destruction are a net negative, period.  Japan will rebuild, and yes, some of that activity will feed into economic figures.  But make absolutely no mistake about it -- Japan will be much poorer for it.  In the end, Japan will have similar infrastructure in place (and if it's nicer than before, then it will cost more and it will come at the even greater expense of other, more productive uses) yet have hundreds of billions in debt more than before with no more ability to service that debt.  Perhaps instead of rebuilding, that same capital could have produced a cure for cancer.  Or a new, efficient automobile.  We will never know.

Only in the theoretical world of ivory tower economists can shattered buildings, twisted bodies, wasted farmland, and potential nuclear fallout somehow be an economic positive.  It is ridiculous on its face.  Yet this theory persists from the halls of Princeton and Harvard to PIMCO's headquarters in Newport Beach.  And we wonder how we've been led astray?  The commentary I have witnesses this week about Japan's rebuilding confirms to me why we are in such dire straights regarding our own budget and deficits.

 

Destination HyperInflation?

"With the exception only of the period of the gold standard, practically all governments of history have used their exclusive power to issue money to defraud and plunder the people."  -Fredrich August von Hayek

"Money, when considered as the fruit of many years' industry, as the reward of labor, sweat and toil, as the widow's dowry and children's portion, and as the means of procuring the necessaries and alleviating the afflictions of life, and making old age a scene of rest, has something in it sacred that is not to be sported with, or trusted to the airy bubble of paper currency."  -Thomas Paine

There are very important debates going on about inflation vs. deflation vs. hyperinflation and what role policymakers at the world's major central banks should play.  I suggest you follow this development at least to some degree, as the potential to impact you and your finances is enormous.  In a world of fiat currencies with countries drowning in debt where central bankers can print hundreds of billions of dollars in mere seconds, the consequences can be staggering.  The always must-read John Mauldin had commentary out this week dealing with just that:

After looking at inflation across all countries and analyzing all hyperinflationary episodes, the lessons are the following:

*Metallic standards like gold or silver show no or a much smaller inflationary tendency than discretionary paper money standards.

*Paper money standards with central banks independent of political authorities are less inflation-based than those with dependent central banks.

*Currencies based on discretionary paper standards and bound by a regime of a fixed exchange rate to currencies, which either enjoy a metallic standard or, with a discretionary paper money standard, an independent central bank, show also a smaller tendency toward inflation, whether their central banks are independent or not...

It is extremely important to note Bernholz’s conclusion. Hyperinflations are not caused by aggressive central banks. They are caused by irresponsible and profligate legislatures that spend far beyond their means and by accommodative central banks that lend a helping hand to governments.

Our Congress and occupiers of the White House for the past few decades, and particularly for the past 10 years (regardless of party) clearly qualify under the "irresponsible and profligate legislatures that spend far beyond their means".  But only in recent years has the Federal Reserve begun to monetize that spending with its "quantitative easing" programs (they have blown multiple massive bubbles, but that is not the point of this post).  The most recent round of $600 billion of quantitative easing, also called "QE-2", started in November and is scheduled to end in June.

At this point, I think high inflation starting within the next few years is "baked in the cake".  If you look at energy and food only, one could argue it's already started (this is being offset by the continued deleveraging by U.S. households).  While $600 billion seems like a lot -- and it is -- I don't think that is a level that brings hyperinflation into play.  But, but, but.  Starting in June the federal government is going to have to sell over $1.5 trillion a year of debt to fund our massive deficits, plus roll over a few trillion a year in looming maturities, without the Federal Reserve as a buyer.  The question is what happens if the Treasury has difficulty selling bonds at favorable rates and/or we hit another economic rough patch (inevitable) and there is pressure on the Fed to act?  Is our Federal Reserve independent and responsible enough to pull in the reigns of monetizing?  I have serious doubts, as it seems like Tim Geithner and the Treasury and Ben Bernanke and the Fed have been working hand-in-hand for years now.  There is no reason to think they won't going forward.  And events like the riots in the Middle East, the European debt problems, and now the tsunami in Japan will certainly give the Fed cover to do QE-3 if they feel like it.

Two anecdotal stories jumped out at me this week that highlights what makes me nervous about this potentially dangerous relationship.  First, William Dudley, President of the Federal Reserve Bank of New York (and former chief economist at none other than Goldman Sachs!) ran into a "let them eat cake" moment during a speech in Queens.  Reuters reports:

The president of the New York Federal Reserve Bank doesn't normally face a raucous crowd.

But in Queens, New York, on Friday, William Dudley was bombarded with questions about food inflation, and his attempt to put rising commodity prices into a broader economic context only made things worse.

"When was the last time, sir, that you went grocery shopping?" one audience member asked.

Dudley tried to explain how the Fed sees things: Yes, food prices may be rising, but at the same time, other prices are declining. The Fed looks at core inflation, which strips out volatile food and energy costs, to get a better sense of where inflation may actually be heading.

So, Dudley sought an everyday example of a price that is falling.

"Today you can buy an iPad 2 that costs the same as an iPad 1 that is twice as powerful," he said referring to Apple Inc's latest handheld tablet computer hitting stories on Friday.

"You have to look at the prices of all things," he said.

This prompted guffaws and widespread murmuring from the audience, with one audience member calling the comment "tone deaf."

"I can't eat an iPad," another quipped.

See, who cares if you can't feed your family because food and energy prices are skyrocketing due largely to Fed policies, go to the mall and buy a fu&%$ng iPad to offset it!  What a world these clowns live in!  If inflation is higher than they want or would thwart inflation-generating policies they want to enact, well then, just change the definition of inflation to exclude food and energy.  Full steam ahead.  Nevermind that food and energy hits people harder the further down the socio-economic chain you go.  And seniors on fixed incomes and savers getting horrible investment returns?  Necessary casualties of the Fed's inflation war.  The ivory tower must be higher than I thought.

It is widely believed by many (including me) that the Fed's current monetizing has been a catalyst for higher oil and fool prices, both directly with a depreciating dollar and indirectly as speculators try to anticipate the inflationary effects of money-printing and as individuals horde goods in anticipation of an inflationary future.  Besides hurting the average American consumer, some of the other knock-on effects include riots and overthrown governments in the Middle East and Africa ("Other than that, Mrs. Lincoln, how was the play?").  The Fed's cluelessness continued with Atlanta Fed President Dennis Lockhart noting the following:

Fed's Lockhart: Oil shock could lead to QE3

If oil prices continue to climb, it could force the Federal Reserve to make a new round of asset purchases, according to Atlanta Fed President Dennis Lockhart.

Appearing at the National Association of Business Economics in Arlington, Va., Lockhart said that while he doesn't think additional purchases are currently warranted, more stimulus could be needed if oil prices continue to climb.

"If [the rising price of oil] plays through to the broad economy in a way that portends a recession, I would take a position we would respond with more accommodation," Lockhart said at the conference.

This is the circle of doom.  The Fed prints money, which causes prices to rise (or really, the dollar to depreciate in value vs. real goods), which negatively impacts the economy as consumers spend more on food and energy and less on other goods, and so the Fed tries to further stimulate with easy-money policies.  Wash, rinse, and repeat.

While it will go in fits and starts, there is no question that we have started down the slippery slope of monetizing government debt that is leading to inflation.  QE-2 ends in June.  What will the Fed do then if the economy isn't self-sustaining (which, as noted most recently HERE, I believe it is not)?

I don't know what will happen.  But there is one question you need to ask yourself:  Do you trust your government and Ben Bernanke and the Federal Reserve to do the right thing?  I, personally, have grave doubts.