Mark Skousen

Lawrence Roulston

Gary Alexander

Chris Powell

Pamela Aden

Ty Andros

David Skarica

Panel Discussion:

Robert Prechter

Steve Hochberg

Frank Trotter

Frank Holmes

Dennis Gartman

David Walker

Stephen Leeb

Adrian Day

Peter Schiff

Eric Sprott

Ian McAvity

Charles Krauthammer

Sunday, November 07, 2010 PM:

QE2 is a mess from all angles. By claiming that the Fed needs to create more inflation is simply recognition of the fact that without it, the country would likely be mired in severe deflation. In fact if you look around, the housing market is in a severe deflation, and that affects nearly all homeowners. It also affects renters because their rents are less likely to rise, and shopping around should lead to comparable apartments for less rent.

The banking industry itself is in complete deflation. The Fed refuses to allow this fact to be any more visible than it is. The weekly FDIC bank failures is one indication of this deflation. The other is the fact that 829 banks are currently on the FDIC watch list and many more are having signifanct asset valuation problems. The Fed allows banks to value their assets as mark-to-model, which basically means the banks can say their assets are worth whatever they want it to be. For mortgages and commericalloans, that currently equates to 100% of face value of those loans.

However, we know from examining post mortem FDIC failed bank financial statements that their asset values were often as much as 45% overvalued. (Last weeks failed bank list ranged from 10% to 36% overvalued assets.)

The FIDC failed bank list is only a small reflection of the banking problems. According to the FDIC quarterly report, 1000 banks have been closed, merged, or dropped out since 2005. In 2005 there were 8833 FDIC banks, now there are only 7830.

The Dodd-Frank Wall Street Reform and Consumer Protection Act now permanently insures bank deposits up to $250,000. When the FDIC was created the insurance was limited to only $2,500. Member FDIC banks will have to make up for the higher coverage by paying a higher insurance premium... well, of course, they will simply pass that on in the form of bank service fees.

Here's a little math problem that you can solve yourself. If the FDIC claims the total assets of all FDIC banks is $13.2T, and if the worst banks have overstated their assets value by 40% and the best at 0%, then how much under that triangle is possibly vapor assets? While this is a very broad brush assessment of the problem, the solution is ($13.2 * 40%)/2 = $2.6T. Or another way of looking at it, if we assume a range of 40% to 0% overvalued then this really means an overall overvaluation of 40%/2=20%. The following chart illustrates:

What this means is that $2.6 trillion what the FDIC claims is asset value is really unrecognized losses. We have this because banks are not required to value their assets at mark-to-market (MTM). But when the FDIC takes over a failed bank and reports how much it had to pay for that failure, the losses become immediately realized. This means on a mark-to-market basis, 20% of all FDIC bank assets immediately goes poof.

As foreclosuregate worsens and home prices drop further the amount of these unrealized losses grows even higher. For example, if my forecast for residential real estate prices plays out, then the total of unrealized losses could exceed $4 trillion.

The FDIC is currently operating in the red -- it does not have enough cash in its reserves to process the current load of bank failures. One could argue that the FDIC could tap its $600 billion line of credit with the US Treasury, but a lot of good that will do if it can only handle 25% of the total unrealized losses ($2.6 trillion). Ignore the hype that the bank failure rate is slowing -- the reason why we are seeing so few failures over the past several months: the FDIC simply does not have the cash!

QE2 won't be able to help FDIC... that will have wait until QE3, QE4, or maybe QE5!

Bernanke has already lowered short-term interest rates to 0%, yet deflation is still here. Interest rates further out, say 5 to 10 year range, are still higher. Bernanke's QE2 goal is to buy long-dated bonds to lower interest rates that far out. If he is successful, then we will have 0% interest rates anywhere from 0 to 10 years. Maybe the 30 year bond might still be able to offer a minscule yield.

While Bernanke has told us his basic plan, he didn't say from whom he was going to be buying those bonds. Despite all of the political posturing - which is all a charade - Bernanke is going to be quietly buying the bonds from the Chinese. As such, QE2 is going to do zero good to the US economy. The only benefit to US will be that China will agree to not wage an all out financial war. By buying back the US bonds held by China, it effectively converts them from non-negotiable instruments into cash that the Chinese can spend on more productive assets -- most likely industrial and agriculture commodities, strategic real estate, and new industry development.

As for the bond bears saying the bonds Bernanke is buying will eventually have to be sold back to the market, not so fast. These are bonds that already exist. Bernanke buying them back effectively retires them or perhaps exchanges them for another central bank's desires to buy more US bonds.

China's growth has been spectacular. An argument can be made that they may be due for a retracement, or at least a pause to consolidate for awhile. But the facts are what they are - China has been systematically redirecting its trading activity away from US and more toward Brazil, India, Eastern Europe, and Russia. Its reliance upon US demand is slowly waning. This is a major paridigm shift. Another major fact to consider is that domestically, China is growing within. The greatest areas of growth had been in the free-trade zones along its coast. But that too is changing - China is slowly bulding and migrating its infrastructure further and further inland. This has helped sustain the growth of China's middle class. The retracement I mentioned above is going to happen, but primarily in trade with the US and Western countries. The rest of China's trading partners, along with its growing domestic demand, will probably more than take up the slack.

According to AFL-CIO website the US has lost 3.2 million jobs overseas since 2000, of which 2.5 million were in manufacturing. It is likely these jobs are permanantly lost.

That represents a loss rate of 25,000 jobs per month. The US domestic growth in new entry job seekers is about 150,000 per month. Unemployment is officially at 9.6%, unofficially about 22.5% (ShadowStats.com, SGS). This means that the US must create new jobs at a rate ot 200,000 per month just to hold steady at current unemployment levels. It will take a sustained rate of 250,000 to 300,000 new jobs per month before any meaningful job recovery can be noted. Despite the media hype and spin, any employment report that is less than these levels simply means the US job market is continuing to get worse, not better.

Think about that for a moment - a rate of 250,000 newly created jobs per month means full recovery could take at least 10 years; 300,000 jobs per month perhaps 5 years. Last weeks news that 151,000 new jobs were created, which is the highest in many months, is not good news as it shows that we continue to slip further and further behind.

I began todays article talking about deflation. Please note that we are not experiencing classic deflation like what happened during the Great Depression. This is because the current deflation is localized in isolated but key sectors: banking like I discussed above, employment, residential and commerical real estate, and confidence. The jist of it all is about confidence. If Bernanke's QE2 is primarily to apease China's US bond holdings, then it does absolutely nothing to address any of these key sectors already caught in the grip of deflation. As such, not addressing a worsening in confidence could drive other sectors into deflation as well. Once Main Street USA realizes that QE2 does nothing to solve domestic problems, confidence dives while fear and anger grow.

The other sectors of the economy such as energy, food, precious metals, and certain commodities are likely to simultaneously experience inflation. We are already seeing it. Of course gold and silver have been excellent barometers. But lately food and energy prices have also been rising. These are commodities that we cannot live without. Of course the official CPI excludes food and energy from its calculation so inflation does not show up as well as it should. ShadowStats.com suggests real inflation is about 4% compared to official CPI at a tad above 1%. The inflation numbers have swung in a wide range since 2008 where ShadowStats showed 2008 Q1 at 9% followed by a drop to just under 2% by 2009 Q3. At the same time official CPI went from a peak of 6% to a low of -2%. Since then the inflation rate rose again into 2010 Q1 to 6% SGS and 3% CPI. The inflation has slowly fallen to now 4% SGS and 1.5% CPI.

By the way, with agricultural grain prices rising, you don't want to see corn rise. Of course it affect tortilla prices in Mexico and ethanol here in US, it's much more than that. Americans are addicted to high fructose corn syrup (HFCS) and it can be found in many, many food products. If corn prices rise high enough, all of these HFCS products are also likely to rise. And any other product that uses those HFCS-containing products might also rise. Can you see how, once started, the inflation spiral eventually wraps around the entire food industry?

Bernanke wants QE2 to essentially buy his way out of a depression. But if his efforts are focused on buying back China's held US bonds, then deflation in the key sectors is unlikely to subside. The foreclosuregate mess pretty much assures that the housing sector will see further deflation in home prices. What little inflation he will be able to generate will be isolated to the money that China receives for its bonds and then spends on productive assets. If those dollars repatriate back to the US then it will increase the money supply. But if those dollars are used to buy assets offshore and the dollars stay offshore (ie: as additional central bank reserves in other countries) then the effect on domestic inflation may be negligible. In this way, it open the door for Bernanke to pursue QE3, QE4, and QE5, until inflation actually shows a wide and sustained resurgence.

For Main Street USA this is the worst of all scenarios: banks in tatters, home prices falling, stock market anticipating QE2 inflation will be disappointed when it does not happen as expected, and food and energy prices are likely to stay elevated or rise even more.

Western economies are acustomed to making their money earn a return. However, right now that means chasing a diminishing yield. Bernanke artifically holds down interest rates, both short- and long-term, so savers and fixed-income holders are screwed. Retirees on fixed incomes have no choice but to eat into their principle base. Unfortunately for recipients on Social Security, there will be no COLA (cost of living adjustment) for 2011. I guess the Social Security Administration believes once you reach a certain age you no longer eat or consume energy. The Bureau of Labor Statistics uses hedonics when computing CPI. Hedonics basically means that the BLS believes when the price of beef steak increases, people will automatically resort to eating more hamburger. But I guess that also means when the price of hamburger rises, people will automatically resort to cat food. All I can say is, given the current outlook for retiree finances, if granny invites you over for hors d'oeuvres, stay away from the pate.

As westerners chase yield they naturally gravitate toward riskier investments. With US interest rates at 0%, including long-term rates, the Dollar carry trade takes on a whole new angle. Brazil got wise to this prospect this week when it announced a 4% tax on foreign buying of their bonds. Brazil bonds are currently yielding about 8%, subtract 4% for the tax, and another 4% for SGS inflation, the real return for US investors becomes zero again.

Traditionally, carry trades have been implemented using a low short-term interest rate to buy higher yielding long-term bonds. Certainly short and short or long and long makes more sense, but the last several global carry trades where short and long. When they unwound it caused severe disruption to FX and bond markets. Now we have an environment where traders can buy all they want from US for near 0%, short- and long-term, and then buy higher yielding instruments (and assumed higher risk) for a locked-in yield differential. Since Bernanke is attempting to flatten the US yield curve, the impact on subsequent carry trades means we are in a much different scenario. My gut instinct tells me that traders will be able to better match maturities, which means the eventual unwinding might actually be less disruptive as when mixed maturities are involved. But it also means the mountain of carry trades may grow quite huge (and unstable).

But it also means that enough carry trade could undermine central bank desires to manage their respective currencies. For example, if enough investors use low interest US loans to buy New Zealand bonds, then this has the effect of raising the FX echange rate for NZ Dollar while simultaneously lowering it for US Dollar. Some countries are already on to this scheme. S. Korea is likely to install processes to curb similar fund inflows right after the G20 meets there next week - others are sure to follow.

I'm running out of time for this round so I need to limit to just a few more very brief topics.

US Elections: The elections last week were, in my opinion, a shot across the bow to warn everyone in 2012 that as either a long-term politician or anyone percieved as an "Elite" should be worried about losing their office. After spending $120 million of her own money former eBay officer Meg Whitman couldn't buy her office. Republicans believe the sea change in blue to red was a mandate for their platform - if they believe this they are wrong. But 2012 is very likely to follow through with what started this election. Despite what people think about the Tea Party, they made a huge impact in this election. I think they will be a major force to be reconned with in 2012 and thereafter. Americans are feed up. I don't think they fully understand what is really going on, but I think they know enough to be angry. On the surface, the Democrats had an excellent opportunity to actually make a change in 2008, but they blew it big time. The Bush administration may have taken a disfunctional economy and made it significantly worse (ie: repeal of Glass-Stegal, artificially low interest rates for too long, and yada yada), and Obama may have inherited these problems that were likely unsolvable in two short years, but the fact is that he tried so little, too ineffective, and spent valuable time and resources on cronyist bailouts and national health insurance. Before Bear Stearns collapsed, Americans may have wanted and desired better health protection as a priority, but after the economy cratered, that mandate changed toward major concerns about their employment and financial security. Obama didn't seem to notice -- but voters did. I think 2012 will see a major, major paradigm shift that will permanently change American politics.

Bull Market Experts: I want to warn everyone that in a bull market (such as the current precious metals), everyone is a freakin' expert. Please be cautious about which commentators and analysts you listen to - deversify what you read. The reason is quite simple, many gold bulls jumped aboard after the bull market was well underway. Many of these bulls have a lot of subscribers, readers, followers. But most of them have nary a clue. They are pied pipers that will not recognize when the time is right to reduce exposure or outright sell. Instead they may lead you over the cliff into financial disappointment or ruin. I urge everyone to do your own homework and due diligence so you can recognize good advice from bad. As an example, hark back to the year immediately following the NaSDAQ peak of 2000 when 99% of TV "personalities" remained bullish, advising people to "buy the dips"... all the way to the bottom! Gold is no where near a bubble peak - that is several years away. But it will eventually have its own spectacular blowoff top, the price of which is likely to be far higher than most of us can fathom. All I am trying to say is please be careful and understand that many so called "experts" really aren't.

New World Order: This is not about conspiracies, necessarily, but it is about how I think the global economy might eventually evolve to find a solution to the current international financial mess. Along with the demise of the US Dollar as the worlds reserve currency (which I think is a near certainty), the major economies are likely to create a new world currency. No, not the Amero or anything like that. What I am talking about is a two-tiered currency system where the central banks create and maintain a world currency that used used solely as reserves in their respective national accounts. We little guys continue to use our domestic currencies that we have now. The world currency would be used to back each national currency in varying amounts that change as national economies grow (or shrink). This world currency will act like gold did for the US Dollar up until 1971. The backing for the world currency will not be any of the individual national currencies, instead it will be backed by a basket of commodites - some held physically, but many will be indexed. This scheme will enforce sound fiscal responsibility and provide more FX stability for each country.

The problem with central banks holding reserves in other national currencies is cascading counterparty risk. For example, let's says for illustration purposes the EU holds 80% of its reserves in US Dollars, and India holds 50% in US Dollars and 25% in Euros. Then let's say the US has severe financial difficulty (like now), India's exposure to the US currency is not limited to the 50% it holds directly. Instead, the Euro it holds is also 80% backed by US Dollars, so essentially, India's real exposure is actually 70% (which is 50% + 80% of 25%). Think about the complicated current CB reserve situation, who holds what currencies and what is their real exposure to US Dollar debasement? I think you will find that if you drill down through the layers, you will see that everyone holds currencies on everyone else. And everyone directly or indirectly holds exposure to the US Dollar. For countries that peg their currency to the US Dollar, they will get hit with a double whammy. As Bernanke attempts to officially debase the Dollar, nearly every country in the world may be affected.

Sunday, June 20, 2010 PM: First up tonight I want to dispell the rumor of what currency traders have referred to as the "Frowning Franklin" bill of 2015.

Apparently the Fed had not only entertained the idea that the USD should be fixed to a fraction of an ounce of gold, but that it should be at the conversion rate of $1000 per 1/4 ounce. The image above was allegedly leaked from Fed planners as a mock up of what this new bill might look like when it is to be issued in the year 2015. I want to stress that I could not find any credible evidence to suggest that the Fed is planning to allow the price of gold to float up to $4000 per ounce and then cap it off to enforce a fixed exchange rate of $1000 per 1/4 ounce.

Just prior to the FDR confiscation of citizen gold in 1934, the US Dollar was convertable to gold at the rate of $20.67 per ounce. FDR then devalued the Dollar to $35.00 per ounce. Over a long history of continuous Fed currency debasement, the Dollar is currently worth about $1250 per ounce, which in terms of gold is a loss in value of -98%! If there was any credibility to this rumor, it would suggest that the Fed plans to further debase the Dollar between now and 2015 by another -30% and then try to lock it at $4000 per ounce.

Quite frankly, I don't believe it.

First of all, the Fed cannot enforce a price limit on an internationally traded commodity, such as gold. Second, by allowing the Dollar to be backed by gold, would limit their ability to further debase the Dollar as they desire. Of course this would be good for Americans. However the Fed has never implemented policy for the betterment of Americans, so why should they want to give up their power now?

Well, that provides a good segue to my next subject: the role of gold in resolving the debate between deflation and inflation.

There are many analysts that claim we are in the early midst of a hyperinflationary environment as evidenced by the rising market price of gold. If this were true, then gold stocks would also be rising. Instead, XAU, HUI, and most major gold mining stocks are lagging way behind. Gold seems to be off on its own. Last week gold made a new all-time high while XAU and HUI have not -- not even close.

This is exactly what is happening. Not the hyperinflationary part, the decoupling of gold to gold stocks.

Why?

Because gold is being recognized throughout the entire non-Western world as currency. Not just another everyday currency, but the ultimate currency -- one backed by 5000 years of recognition and acceptance as a currency. If that were not true then why would Russia, China, Phillipines, Saudi Arabia, and other countries be actively building their gold reserves if they did not think it held "reserve status" value? Just because Western countries view gold as a barbarous relic does not make it so. The rest of the world is much larger and that part of the world respects gold and its historical role as the safest and most stable of currencies.

We are in the midst of a major economic event. But this one is deflationary, not inflationary, but I guess it all depends how you chose to view it. As I said a few postings ago, we are already in a depression and the second wave down will begin soon, if not already. This is a Kondratief Winter, and these events are always deflationary.

In the 1920's the US Dollar was backed by gold and freely convertible. The first Great Depression was deflationary in Dollar terms because of this backing in gold. The current Dollar is not backed by gold. Yet, it is still gold taking on the role as the ultimate currency. As such, the Dollar's role in this deflationary environment is mitigated. The once mighty Dollar will be reduced to the analogy of the tick riding on the dogs back -- the dog being gold.

If you look over the past year you should recognize several events that support this outlook. Historically the US Dollar and gold held an inverse relationship, ie: as the value of the Dollar rose, the price of gold (in terms of Dollars) would fall. But over the past year this link has decoupled. This is mostly because of the result of the weakening Euro. Escaping the Euro, the alternatives for safe-haven status were both gold and US Dollar. That is why they both rallied and fell together, in-step. The inverse relationship between them has been temporarily muted. This relationship should continue as long as the US economy appears to be in better shape than in Europe. Right now Europe is falling apart. The US economy has its own severe problems and they will eventually come to light. But until that happens, the US Dollar will be held as a reserve currency and a safe-haven storage of wealth, along side with gold.

The marvel of a global economy is a double-edged sword. On one hand market efficiency has been greatly enhanced. Just in time inventory has been very successful as nearly all businesses have embraced and relied upon this efficency for their day to day commerce. But this efficiency comes at a cost when the inter-relationships of global trade begins to sour. So the other hand is what happens when business livelihood relies upon this efficient delivery of goods at a time when its inventory can no longer be delivered as efficiently.

For example, take the strawberry. Before we had an efficient global trade system, you could only get decent fresh commerically-raised strawberries in May-June from California or Florida. The rest of the year you could not find good strawberries or they would be extremely expensive. Now with the efficient global economy, when strawberries are not in a growing season in the US, they are grown in S. America, or other parts of the world. We can enjoy strawberries all year long. Further, because other countries can grow quality strawberries for less than in the US, fewer US farmers raise strawberries. This is one of the great benefits of the efficient global market -- as long as it continues. And that is the key to our problem.

...as long as it continues.

The global benchmark for value is gold. Within the US the currency is the Dollar. In a deflationary environment, gold will take on the role as the ultimate currency as recognized throughout the world. As the US economy begins to sputter (as viewed outside the US) the value of the Dollar will lose pace relative to other currencies, but certainly against gold. Strawberries, as priced in gold are not likely to change very much or may become cheaper. But in terms of Dollars, the price of strawberries is likely to rise. Farmers in other countries will prefer to get paid in a currency that they recognize as having value and stability. Any other currency will only be accepted in a higher rate of exchange, in other words, strawberries will cost more in Dollars.

This is the dark side of the global economy.

The rising price of our euphomistic strawberries is what analysts are seeing as inflationary. And in terms of the Dollar, they are correct. In a Kondratief Winter like we have now, all participants that guage commerce in terms of a valued and stable currency will experience deflation. In terms of gold, the entire global economy will deflate, because all countries will view gold as the ultimate currency.

The efficiency of the global economy has taken two decades to evolve into what we have today. As a result, much of the domestic manufacturing, farming, and remote services have been moved off-shore to countries that offer cheaper labor. Not having this business within the US will cost us greatly as this Kondratief Winter plays out. In the same way our strawberry farmers will prefer to be paid in what they percieve as a stable currency, so too will the businessmen that provide the other off-shore manufacturing, farming, and remote services. In Dollars, all of these will soon cost more. If domestic salaries do not also rise, then this is going to get very painful.

Pay me my salary in ounces of gold then I won't need a raise.

The reason the price of gold and gold stocks have recently decoupled is related to this growing global recognition of golds role as the safest of safe haven currencies. The current percentage of bullish investors for gold stocks is well into the 90% area. As such, investors that want to own gold stocks already own them. In order for mining stock prices to rise, new investors must enter the market for these stocks. Globally, the price of gold is rising because of how gold is viewed by other countries. But these investors are not interested in buying US stocks, they want the real thing. US mining stocks do not have a global presence, but physical gold does.

Try it out for yourself. Travel around the world and stop people on the city streets and ask them if they would rather own stock in Newmont, GoldCorp, or Barrick, or in physical gold metal. Go to Bogata, Manilla, Bejing, Tai-pei, Hong Kong, or Moscow. I think you will find it unanimous as they will all prefer physical gold.

Only in Western cultures do we put so much trust into paper promises.

Ok time to confess, the opening bit about the "Frowning Frankin" is a spoof. I hope you enjoyed it because it is not true and never will be. LOL.

Sunday, May 16, 2010 PM: Correction to my May 4 posting: I said that Gresham's Law was "Good money drives out Bad". I actually misquoted, it should have said "Bad money drives out Good". My explanation was correct, only the quote was incorrect. (Thanks JC for pointing that out to me.)

Once again, Gresham's Law goes like this: when people are confronted with two different currencies, one deemed a "good" currency and the other a "bad" one, people will tend to hoard the good currency and spend or try to get rid of the bad one as soon as they can. Thus, the good currency is driven out of circulation as people hoard it. What remains is the bad currency in a game like hot potato where no one wants to hold it for very long and as a result must be willing to give up a little more to get rid of it -- and receivers of bad currency will demand more of it... which all leads to price inflation in that currency. Thus, the good currency remains stable (a store of wealth) or even deflates (buys more with less currency) while the bad currency inflates.

Gresham's Law always applies in relative terms. For example you can have two currencies in which people have lost confidence, it's just that one of these currencies is deemed worse than the other. An example of this is what is happening right now: the US Dollar, with all of its own bruises and warts, is considered stronger over the Euro. The FX exhange between the two shows the Euro falling to a new crisis low this week, indicative of its role as the, relatively speaking, "bad" currency.

The only currency that is still held in the highest esteem is gold.

I hope that sufficiently clarifies my discussion of Gresham's Law.

As long as I am writing here today I want to cover one more topic - the stock "flash crash" on May 6, 2010. By now I am sure you have all read articles explaining why it happened, all the way from a fat-fingered Procter & Gamble stock sale, to recognition of the EU's crisis effect on exports, to a massive purchase of put options, to market-makers stepping aside which strangled liquidity.

The only story I believe is the one about the put options. Everything else happened but were only contributing factors, but none could have caused the sharpness of the plunge. Apparenly Universa Investments purchased a ton of put options on the SP500 index. They paid $1.50 each (total $7.5M) for 50,000 June, 2010 SP500 800 put options at a time when the SP500 index was about 1165. These puts were so deep out of the money they would only pay off during a severe disaster. The market was already down about 25 points on the SP500 index. The sellers of those puts hedged their risk by shorting stocks.

This is where is gets interesting -- during normal bull markets, traders systematically place protective stop losses at various levels under the market as it moves higher. Many of these stops are placed well in advance. If one could see these stop levels graphically, it would look like clusters spotting all along the price path.

A stop is an order placed by the trader at a level below the current market (during a bull market, a bear works in the opposite direction) such that it will only be triggered if the market sells down to the level set by the trader. Once that occurs, the stop becomes a market order and will get executed at whatever the best available bid is. If the volume of the order is larger than the best posted bid, then sells move into the next best bid, and so on lower and lower until all shares are sold. By causing the price to move lower, it is quite possible that other trader stop levels are also hit... and those stops become market orders too. This chain reation of events is called a stop run.

The Universa order to buy those put options started this chain reaction because the option sellers (Barclay's) had to sell stocks to hedge their risk exposure. Stops rolled down to lower stops which rolled down to even lower stops. You may have seen the chart of a $40 stock that traded as low as $0.01 because its entire structure of stops was wiped out.

My point of highlighting this event is this: putting stops on your trades is normally considered a conservative and prudent money management strategy. In this case, it showed the fatal flaw of that logic during a severe market shock. Traders have been rattled. As a result I am going to guess that many traders may decide not to use automatic stops any more. After all, if you did not have a stop on your stock when the flash-crash occured, several hours later the market was back up, almost as if the event never occured. Stops are an important part of the dynamic of the marketplace. Without them the market becomes less efficient. What I think this means is traders will begin to use "mental stops" and only initiate their sell when they are panicked enough.

And that is the crux of this discussion. If/when the market gets into another panic or near-panic situation, traders will rely upon their emotion to trigger the trade rather than automation. Before stops became widely used, it was the dreaded margin call that sometimes initiated a forced market sell of a traders stocks. I think we are about to see a resurgence in margin-related selling. What makes this more ominous to me is that the decision to make a margin call by a broker is made the day the traders portfolio margin turns negative. The actual "call" is made for the next trading day. While automatic stops sell immediately when triggered, margin calls can cascade across many days in sequence. Selling of stocks triggered by margin calls is almost exactly the same as a triggered stop except in slow-motion and over many days. We last witnessed this in action during the 2000 tech wreck when both stops and margin calls worked against each other as the market ratcheted lower and lower.

In the short-term I think a lack of stops will provide support and keep the market from a severe plunge -- I think a repeat of the flash-crash is impossible without well clusterd stops. Longer-term, however, I think trader emotion will work against them now that they have access to instantaneous trading and can dump their stocks in a panic on a whim or whatever their definition of panic is, and reluctance to selling in a falling market will increase the likelihood of margin-related selling.

Tuesday, May 4, 2010 PM: Although it has been awhile since my last update, a lot has happened in the news, but not enough to materially affect the original forecast. Almost all of my long-term forecasts appear to be still on-track. I think stocks are topping out in what I believe has been an wild bear market rally fuelled by a near-unlimited source of free money (Fed 0% loans) for Wall Street firms that have the privilege of tapping Fed resources. One might think by looking at the DJIA in isolation that the economy is well on its way to recovery, but that would be foolish. First of all, the DJIA is not the economy, and many other indicators are suggesting a 2nd dip is much more likely. So the question is, will the DJIA crash like it did in 1929 -- after its initial plunge it rallied hard but then stepped its way lower and lower until reaching the all-time low in summer 1932?

The DJIA is looking toppy. The retracement off of the March, 2009 lows has reached an important Fibonacci level of 0.618. Bullish sentiment and the lack of bears is at par with levels only seen during market peaks. Put/call option premium ratios show that speculative investors are willing to pay substantially higher premiums for calls while shunning put options of a similar level of moneyness.

DJIA 400, 4000, or 40,000?

The answer is both yes and no, so let’s elaborate. Robert Prechter's call for DJIA to reach 400 is shocking, but not realistic. Perhaps it helps sells subscriptions, but it is not at all likely, at least not in nominal terms. However, after adjusting for US Dollar currency distortions, perhaps an effective DJIA 400 may not be so wild. The DJIA/Gold ratio has reached 3:1 or less on 3 separate occasions this past century: 1.6 in 1933, 2.7 in 1942, and 1.2 in 1980. As we will see later I am expecting this ratio to reach 1.5:1. If this comes to pass, then we need to look at where the DJIA and Gold prices will have to be to make this ratio work out. Right now the ratio is 9.3:1 after reaching a recent low of 6.9:1 last year. To go from 9.3 to 1.5 from current levels either the DJIA must drop to 2000 or gold must rally to $7300, or some compromise in between. I suspect the later, and in doing so I hope to dispel the notion that DJIA might reach Prechter's target. My long-term 200-year inflation-adjusted DJIA chart continues to suggest a drop to 5600 just to reach the middle of the channel lines as early as 2012, but 3600 is the most likely target which is the lower channel line to be reached by 2016-2018. These targets are inflation-adjusted, not nominal price targets. Last year I determined that this lowest-low should occur on Monday, August 21, 2017 (LOL, like anyone could actually be so accurate.)

Depressing Thoughts

We are in a technical depression and have been for many months. When I think of economic depressions one of the first thoughts that comes to mind is the television series, "The Waltons". But we're not like that now, so how can this be a depression? The 1930's depression did not occur overnight, like someone flipped a switch and all of a sudden gloom and despair swept the nation. No, it was a very slow process. It was a combination of slowly increasing unemployment, the perception of an uncertain future, and the resulting desire to hunker down and weather the financial storm rather than recklessly spend money like a madman. The later represents the booming era of the late-1920s -- much like the US just a few years ago.

People spend money when they are happy and care-free and cut back and hunker down when they are uncertain about the future or fearful of losing their jobs. So one might say that a lot of what drives a depression is psychological. If you believe that your employment is secure, or more accurately that your income stream is assured, then even during an economic downturn you will simply view it as someone else's problem, and continue to spend. But once enough people begin to fear for their own financial security, they tend to reduce questionable spending habits and cut back, and that shows up as reduced merchant and service sales, which eventually leads to more layoffs, and then it circles around and around in a downward spiral..

The Spin Doctor is In

The government and media spin tries to project a ever-brightening future. The "recovery is in progress", "the crisis is behind us", "home sales are rebounding"... all massively inaccurate statements in an attempt to control the psychology of the crowd. All the while, unemployment is still rising (except for 1m temporary Census hires), banks still are reluctant to make new loans, and local governments are struggling to continue functioning while their tax base dwindles.

Several years ago I wrote that one of the effects of the downturn would be that local governments would resort to an increase in traffic citations as a way to generate revenue. We are seeing that happening all over. Last month, Houston PD wrote a record number of citations. The Chief of Police denied the increase was for revenue generation. But what do you get when redeploy officers to patrol rather than having them sit behind a desk? Each individual officer will tell you "they are only doing their job" by writing citations when they witness a violation. Come one… it's revenue generation, it's deliberate, and it's happening all over.

It's a sign of the times and it is an indication that local governments still have not made much attempt to reduce spending. The breaking point is inching closer. For some communities it will be reduced police or fire protection. For others it might be rescheduling school to meet 4 days a week rather than 5 or cutting back on extra-curricular school activities. How long will communities go without garbage collection services before people raise a stink?

The news is abuzz about problems in Europe regarding how to handle Greece's debts. If it was merely isolated to Greece, a solution could probably be worked out. But it is a contagion, many countries are being exposed, one by one, that they also have massive debt problems. The desire to deceive investors by withholding material information about their respective debt situations is wide-spread. In the US we thought that no longer happened after Enron. Wrong. GAAP regulations allow off balance sheet transactions, and banks are allowed to value those transactions using a mark-to-model, which is just a fancy way of saying, the banks can say it is worth whatever they want it to be worth. And that strategy works until it doesn't. Greece has found out what happens when it doesn't. There are many more countries in similar straits, it's just that they have not yet been exposed. Are Spain, Portugal, Italy next?

US banks are using mark-to-model to buy time. It won't work because eventually actual liabilities catch up with, and often times exceed, their assets. Just ask any of the 200+ banks that have already been failed by the FDIC. There are currently 722 other banks on the FDIC watch list.

I am confident in saying that all 722 banks, and probably many more, are technically insolvent right now. To explain, let's take a look at some of the recent bank failures and dissect their balance sheets. What I am about to show you is common and wide-spread, not merely isolated to a few bad banks.

Bank Fraud is as Common as Dirt

When the FDIC steps in to close a member bank, it revalues all of the banks assets based upon current market conditions. This is represented by what the FDIC refers to as a loss-share agreement they make between themselves and a new bank that comes into to take over the failed banks assets. A loss-share is where, in the event of a continued down-trend in the economy, the takeover bank and the FDIC share in any new losses that occur. Because of their own involvement in this process, the FDIC is motivated to value the failed banks assets as realistic as possible. Not only do the banks share losses, they also share in profits.

At the top of the list in last weeks list of failed banks is Frontier Bank in Everett, WA. As of December, 2009, this bank had assets of $3.5B and total deposits of $3.13B. Union Bank of San Francisco, CA stepped in to take over Frontier. Union and FDIC have a loss-share agreement for $3.04B of Frontier's assets. The FDIC withdrew $1.37B from its Deposit Insurance Fund to pay for all of the recognized losses above the loss-share amount (3.50-3.13=1.37). If my math is right, it says that Frontier defrauded its investors by saying they had $3.5B in assets just 4 months ago, yet the actual value was -39% below that. I seriously doubt the markets that Frontier was involved in dropped in value by -39% in only 4 months.

The 2nd bank on Friday’s FDIC hitlist was a small bank, BC National of Butler, Missouri. It claimed $67.2M in assets and $54.9 of deposits. The FDIC loss-share was $37.9M and a cost to FDIC insurance fund of $11.4M, (67.2-37.9=29.3). Hey, that does not add up... that's because the assets BC National claimed as of December were overstated by much more than the settled amount. The loss-share amount suggests BC overstated their assets by almost 44%.

You can do the math details for friday's bank #3, it revalued by -39%.

Bank #4 is a little trickier because the acquiring bank did not take all of the failed bank's assets, the FDIC had to take the remaining assets. Nonetheless, taking into account what the FDIC had to pay out of the insurance fund, assets were overstated by 37%. Furthermore, FDIC got saddled with $165M in assets that they will have to sell. Anything less than $165M and it further inflates how much the assets had been overstated.

These 4 banks had overstated their assets by 39%, 44%, 39%, and 37%, respectively. An average of 37.5%. You can consistently go back to previous bank failures and come up with similar overstatement ratios.

How wide-spread this is, is anyone's guess. But what we know is that the FDIC has 722 active entries in their watchlist. All of the 7922 FDIC banks collectively have stated assets of $13.1T. If all banks have assets overstated by 37%, then we're talking about almost $5T. That's probably not the case, but as long as GAAP allows banks to continue to mark-to-model, no one knows for sure. Even the FDIC does not know until they come in and perform a detailed audit/analysis when closing a failed bank. However, if only the 722 watchlist bank assets are overstated by 37%, which is likely, and if these banks represent a cross-section of the banking community, then they account for stated assets of $1.2T of which $450B may be collectively overstated.

I think the truth is somewhere in between. If we were to line up all 7922 banks ranked by how much their assets are currently overstated and drew a diagonal line across their balance sheets from -44% on one end to 0% on the other, mathematically this comes up to $2.9T of potentially overstated assets. (Calculated as the area under the diagonal divided by the area of the whole times total stated assets = $2.882B)

The Loss-Share That Bites

This would be a potentially massive loss if this were all we had to worry about. Like the late-night infomercials say "...but wait, there's more." In the example I described above, I mentioned that the FDIC entered into a "loss-share" agreement with the acquiring banks. Here is how the FDIC describes loss-share:

• For commercial assets, the agreements typically cover an eight-year period with the first five years for losses and recoveries and the final 3 years for recoveries only. FDIC will reimburse 80 percent of losses incurred by acquirer on covered assets up to a stated threshold amount (generally FDIC's dollar estimate of the total projected losses on loss share assets), with the assuming bank picking up 20 percent. Any losses above the stated threshold amount will be reimbursed at 95 percent of the losses booked by the acquirer.
• For single family mortgages, the length of the agreements tend to run for 10 years and have the same 80/20 and 95/5 split as the commercial assets. The FDIC provides coverage for four basic loss events: modification, short sale, foreclosure, and charge-off for some second liens. Loss coverage is also provided for loan sales but such sales require prior approval by the FDIC. Recoveries on loans which experience loss events are shared in the same proportion as the original loss.

If the housing industry recovers, then the FDIC actually benefits and receives a portion of the gains on the covered assets. However, if real estate values deteriorate, FDIC is exposed to even more losses.

Hypothetically speaking, let's zip ahead to the end of 2010 assuming the rate of bank failures remains constant, and the total value of all loss-share agreements reaches $300B. From there, for every 1% additional drop in the housing index, the FDIC stands to lose from $2.4B to $2.85B depending upon whether FDIC pays 80% or 80% plus 95% as described above.

As I will try to show in charts below, I think real estate could lose heavily over the next several years. In states like Florida I expect residential r/e to lose an additional 30-50% from current prices -- Florida is already down -48% from its peak.

If that happens, then many more banks will fail. The FDIC will have to take on even more loss-share's in their portfolio, and existing loss-share's will begin to generate losses that further drain the FDIC insurance fund. At this rate the FDIC will soon be tapped out and they will have to find an alternative to loss-share to help dissolve failed banks.

A Bubble in Rate Resets, Another in Foreclosures

The next 2 charts show the residential mortgage rate reset and recast schedule. The top chart is combination of all mortgage loan types. The gray bars in the background are what the forward reset schedule looked like as of last September. The blue bars are what the schedule looks like now. The bottom chart is the combined Alt-A and Option ARM loans.

Click to enlarge

What I find quite incredible is that the loan modification program has done nothing to change the outlook of defaults caused by rates resetting higher. All it has done is push the damage out further to another timeframe. The new reset peak has moved out by several months to around December, 2011. The end of the reset bubble really does not end until about September, 2012. If the normal foreclosure process takes about 6 months, then expect the foreclosure bubble to push out to at least Q1'2013.

The Alt-A, Option ARM chart shows that the value height of these loan types have reduced slightly, but their reset schedules were pushed further out. The combination chart shows that the value of all loans has actually increased. The area under the bars adds up to $1.13T which is an increase of $261B versus the same timeframe from the 2009 report.

We had been told that hundreds of thousands of residential mortgage had been renegotiated to terms that help keep the home buyer in their home. But what these charts are telling me is that effort has been little more than smoke and mirrors. The likely damage caused by reset-induced defaults has not only been pushed further out in time, the size of that bubble has grown larger.

The most vulnerable of mortgage types are the Alt-A and Option ARM's. The area under the bars for the 3 years charted represents $435B for these two loan types.

My biggest mortgage fear is that this reset bubble will continue to be pushed further out. So any forecasting we try to do from these charts is likely to shift as well. The reason I fear this scenario is because at some point this bubble must burst. And when it does, it could cause vastly more damage than if it were eased out now.

DJIA/Gold Ratio

In March, 2002 I posted the chart on the left showing the ratio of DJIA divided by gold price. At that time the ratio was around 38:1 after having reached 41.2:1 the prior year. My forecast at that time was to see the ratio reach 1.5:1 sometime between 2013 and 2018. The chart above is the same chart with updated price information. Last year when the DJIA bottomed out in March 2009, the DJIA/Gold ratio hit a low of 6.9:1. I believe this ratio will eventually reach my target for both price and time.

Click to enlarge

DJIA/Gold is currently about 9.3.

From the previous low of 1.2:1 in January, 1980, the next low is expected to be 451 months, which is approximately August, 2017. Peak-to-peak the time is about 430 months, but the ratio for the time it takes to reach the next low to the time it takes to reach the next peak again, is a Fibonacci relationship of 0.38 down and .62 up. So starting with the previous peak in May, 2001 we add 430*.38=163.4 months which takes us to December, 2014. But with rounding up and because the previous low was also in January, I am selecting January, 2015.

Why is this ratio important? Maybe not to you but it is important to me. This ratio will help me determine the best time to switch out of gold and into stocks. Personally, I do not plan on waiting until it gets to 1.5. I plan to hedge a bit and start converting at around 2.0, maybe even a trickle by 3.0, I dunno yet. If you look closely at the charts you will note that the ultimate low of each cycle occurs for a very brief period. In the big picture being early by a month or two is of little consequence. Compare that to trying to time the exact bottom and risk end up missing it completely while the market takes off without you.

Deflationary Depression

As I said earlier, we are already in a depression. We are like the frog in a pot of slowly warming water. The depth of this depression is not going to happen immediately, it will be several more years in the making. One thing that must be understood is that this depression is not going to be like the 1930's. Back then no one feared the currency because it was backed and convertible on demand to gold. After FDR confiscated citizen gold, gold stocks, as a proxy for physical bullion, soared because people needed to hold something with tangible value. Once gold was confiscated, FDR devalued the Dollar. Before FDR, the Dollar was as good as gold.

I don't recall which year it was but I'd guess about 20 years ago I travelled to Mexico at a time when the US Dollar was quite strong and the Peso was very weak. In fact, inflation in Mexico was extremely high. As such, all of the Mexican merchants (restaurants, hotels, retail shops, and even trinket hawkers) gladly accepted US Dollars. But much to my dismay and frustration, any change to be made was always returned in Pesos. I discovered a vibrant black market amongst merchants at all levels that, with Dollars in hand, you could "negotiate" much better terms. At the time I did not clearly understand why they wanted Dollars so bad while so freely returning Pesos. But it is simple, it is called Gresham's Law: "good money drives out bad."

The US Dollar is no longer backed by gold, or any other commodity. It is backed entirely by perception and faith in the strength of the country. If our financial system deteriorates far enough, Americans might begin to lose their faith in the strength of the country to honor Dollar-based obligations. The US could someday be in a position like Mexico was in my illustration. Towns along the border of Canada may resort to commerce using Canadian Dollars, southern border towns might chose to use the Peso. This is not a wild imagination, things like this could actually happen. The interior of the country does not have alternate currencies to resort to.

If the Canadian Dollar (CDN) becomes much stronger than the US Dollar (USD), Gresham's Law begins to take hold. As such, people will gravitate toward preferring to acquire the CDN while ridding themselves of their USD -- good money drives out bad. A black market will develop and most merchants will participate. This will create a 2-tiered commerce system: if you want to buy something with CDN you will pay one price, but if you want to use USD you will be quoted another, likely higher, price (relative to the “official” conversion rate.)

I picked up a magazine at the airport last week which still showed an older exchange rate: $4.95 USD, $6 CDN. Incidentally, last week, the CDN was briefly worth more than the USD. I expect we will see a similar segregation for prices, except in reverse.

The problem with Gresham's Law is that it automatically injects inflation for the "bad" currency. No one freely wants it, so in order to use it in commerce the receiver must be willing to take on additional risk. Risk comes at a price, and that is reflected in a higher cost for purchases. If you currently hold the bad currency and want to get rid of it, you must be willing to pay extra to do so. The good currency experiences deflation while at the same time the bad currency experiences inflation.

It's All in the Perspective

If all you hold or have access to is the bad currency then you should experience classic inflation. If you have only the good currency (and are savvy enough to stay away from the bad currency) then you should experience classic deflation.

Once this 2-tiered system is entrenched, arbitrage keeps it working. Let's hypothetically say the US economy get much worse and the USD takes on the role as the "bad" currency and CDN the "good" currency. A northern town businessman places an order for widgets using CDN while a mid-western town businessman places an identical order using USD. The northern guy could have used USD but got a better deal with CDN. The mid-western guy has no alternate currency, only USD. The CDN order gets the preference. The mid-western guy has to raise his offer in USD in order to compete. This is how inflation in the bad currency eventually permeates through the community, state, and even the entire country.

If this were to ever occur, I have no doubt that the US Treasury would declare that using anything except USD is illegal and punishable with severe penalties. Regardless of what the Treasury does, there will still be a black market and it will be very difficult to stop.

Gold is the ultimate currency. Silver follows suit.

As this depression plays itself out. We will experience a deflationary depression similar to 1930, but only in terms of gold (or any other "strong" currency). At the exact same time, it will be an inflationary depression in terms of USD. What drives the way gold behaves is the impact of a worsening of credit quality. Whether the USD is backed or not backed by gold (or any other commodity) is irrelevant, it's all about credit quality. A currency fully backed and redeemable with gold will behave similar to gold, this is what we saw in the 1930's before FDR. In fact, gold was hoarded over the Dollar at the time and even though it had an "official" convertible rate, people still preferred to hoard it and actually pay a black market premium to get it. Because people could convert paper into gold and then hoard gold is one of the key reasons why FDR decided to confiscate gold – the treasury was running out of gold!

Since the USD is not backed by gold we must look at the two separately.

We are already seeing deteriorating credit quality in Europe, the Euro and other currencies will take on the characteristics of a "bad" currency. If the USD is also a "bad" currency, then what alternatives exist for "good" currencies? Gold is just one.

If the current depression were entirely limited to US, the Euro would be a viable "good" currency, also the CDN, and countless others. In that environment, gold would not be nearly as desirable -- it would be in competition with these other currencies. Any country affected by the contagion sweeping Europe will eventually be treated as a "bad" currency. All of these bad currencies should experience some varying level of inflation compared to gold. Gold will, however, experience deflation, probably universally around the globe. As such, demand for gold should only increase over time. It is in limited supply and only price can fluctuate to manage the demand for it. Silver will be gold's baby brother and tag along as "poor man's gold."

A universally despised currency will only be accepted for commerce in progressively higher denominations for the same goods because the retailer or service provider will want extra compensation to pay for their risk of holding it until they can get rid of it. Therefore, in terms of that particular currency, this is classic inflation.

A universally desired currency (particularly in competition with a despised currency) will be offered more opportunities and bargains because retailers and service providers actively want to accumulate this desired currency. Holders of this currency will experience price reductions, special sales, and more lucrative terms. In terms of this particular currency, this is classic deflation.

Within the US there are no other freely traded alternate currencies (other than the fringe communities along the borders with CDN and Pesos).

Asian countries (and I also include India, Indonesia, Philippines, and even Russia) have long historical relationships with gold, it is a cultural respect that is absent from surviving generations in the US and many western countries. A such, Asian countries have been slowly adding gold to their foreign reserves. Asian individuals have been buyers of gold for many years. Americans still don't recognize gold as money or as a store of wealth. The 1930's Depression-era generation respected gold's place in the scheme of wealth preservation, but they're all gone. As the depression deepens, this lack of respect for gold will be an American downfall and any late-to-the-party individuals will be exposed to significantly higher prices (gold: deflation, USD: inflation).

Americans are still too wound up in a desire for profits. What they are missing is that this depression is one where hoarding for the sake of capital preservation far outweighs taking high risks for illusory capital appreciation.

Although in this expected environment gold will be the premier vehicle for hoarding and wealth preservation, in the end it is just an asset. Other assets may also benefit. Stocks and real estate, on a nominal basis, will probably rise (but I suspect it will be more evident once they rally up from a deeper hole rather than where they are now).

As for my expected rise in gold prices, I want to make it very clear that this is not a capital gain in the sense that you are getting more back from your investment than what you put into it. While there may be short periods of bubble-like speculation going on, for the most part and with everything else being unchanged, any price rise in gold (as a “good” currency that is priced using a “bad” currency) is merely reflecting a static value while the “bad” currency debases and inflates. Gold is a store of wealth. Except for very nimble and savvy traders who are able time it well enough, you will not make much profit while holding gold. What you will get out of it is storage of wealth, your wealth. Whatever you can buy with one oz of gold today, you are very likely to be able to buy the same thing any time in the future for that same one oz of gold.

Bargain Hunting with a Pocket Full of Gold

You have all seen the Case-Shiller Home Price Index charts as priced in USD. The chart below is the same index, except priced in ounces of gold. This shows that because real estate was in a bubble at about the same time gold was in a bear market, the real estate bubble in gold terms started in 1996 and peaked in 2005. The value of the Case-Shiller 10-city index today is 140 oz of gold. Incredibly, the same value as in 1987. The ultimate low occurred in 1980 when this same index would have been valued at only 75 oz. I think we could see this index test the 100 oz level sometime before 2014.

Click to enlarge

CyclePro Archives:

Prior CyclePro Outlook comments may be found at the following links. However, I needed to conserve space, so some of the charts may no longer be accessible.
CyclePro Nov 2003 - April 2010
CyclePro Jan 2002 - Oct 2003