By Axel Merk
on Tuesday, October 20, 2009 · 2 Comments
The government has splattered lots of money onto the economy, working hard to reflate the bubble that got us into trouble in the first place. The Dow is back at 10,000. What are you to do? If you are a wealth sustainer, you should not be drawn into the market simply because it has gone up. Instead, take a step back, look at the market dynamics and see what risks you can afford to take. I am not preaching to hide in a hole awaiting armageddon "“ there are always opportunities, but they may be very different from what the pundits may want you to believe.
My book, Sustainable Wealth: Achieve Financial Security in a Volatile World of Debt and Consumption will start shipping in a few days (pre-order now). In the meantime, the buzz is heating up: I tell Fox Business TV that you don't go broke holding cash; except that U.S. dollar cash isn't what it used to be "“ click to watch the clip.
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When the credit bubble burst, the risks in the market changed. There are those who will perpetually pound "buy and hold!" – stay the course during a crash, but unless your personal ability to bear risk becomes supercharged just as the risks in the markets explode, you should seriously consider adjusting your portfolio's risk profile to the new market environment. Similarly, investors should only put money at risk they can afford to lose; when the markets are down sharply, odds are you can afford to lose less. Only when you are focused on your priorities can you afford to take prudent risks; otherwise, you become a trend chaser "“ something that can be hazardous to your wealth.
Obviously, if you are able to predict a market decline, you can take steps ahead of time. One of the most obvious signs of a bubble is when all asset classes inflate in tandem "“if everything goes up simultaneously, especially without fundamental reason, odds are that everything comes crashing down together. Many learned this the hard way in the fall of 2008. It didn't need to be that way: in the run-up to the credit crisis, the private sector created money by increasing leverage "“homeowners extracted money from their homes, banks used off-balance sheet vehicles, or hedge funds that used up to 100:1 leverage. I warned in early 2007 that a surge in volatility would trigger a global credit contraction. At the time, few paid attention as market volatility was mostly ignored as a market barometer. But if uncertainty is infused into a goldilocks economy, volatility increases and investors pare down their leverage to adjust to the new environment. More colloquially, the boom leads to the bust as investors become more risk averse.
This time around, it's not the private sector, but the Fed pushing to expand credit, to have investors gear up yet again. Because it is the government rather than the private sector inducing the boom, the dynamics are likely to play out differently and investors better pay attention and try to understand what policy makers are up to. While I disagree with many of the policies being pursued, the one good thing about our policy makers is that they appear predictable.
The present reflation is fostered by a Fed printing money as if there were no tomorrow. However, there will be a tomorrow, and in our opinion, when tomorrow comes the Fed is likely to print even more money, not less. Here's why: while the government can try to boost this economy, it has been extremely "inefficient" at doing so, meaning that a lot more stimulus than many think "“ both fiscal and monetary "“ is likely to be necessary. The stimuli will go somewhere, though likely not where the government wants it to go; a possible worse side effect is that they may be creating a highly unstable environment dependent on continued stimulus. Let's look at this in more detail:
The ill-design of the fiscal stimulus has been widely reported. Rather than encouraging investment that could lead to long-term growth, government handouts such as the cash-for-clunkers program have a very short-term impact. The government's balance sheet deteriorates as more debt is taken on, but the economic stimulus is rather limited.
The monetary side (the Fed) isn't doing a much better job: when the Fed provides funding to a specific sector of the economy, say it offers cheap commercial paper to General Electric (this particular program has been phased out), GE will be happy, but the Fed substitutes rather than encourages private sector activity. Warren Buffett, for example, has said his insurance business (which didn't accept any government handouts) finds it extremely difficult to compete with other insurance firms who enjoy government subsidies because his insurance firm is subject to higher funding costs, despite being much more prudent leading up to the credit crisis. Last time I checked rewarding bad business models at the expense of good ones is a bad idea.
Similar unintended consequences apply to the mortgage purchase and government bond purchase programs. Everyone is excited about the low interest rates this creates, but looking at it another way: rational investors are likely to look elsewhere for more fair, market based returns, as government securities are now intentionally over-priced. In plain English, a key reason why the dollar has been under pressure is because, in our assessment, the Fed has actively worked on devaluing the dollar through its mortgage and MBS purchase programs; at some point, the Fed may be getting more than it is bargaining for. But again: the Fed is substituting rather than encouraging private sector activity. This means that more money is likely to be printed than many anticipate, as the inefficient spending programs don't jump-start the economy as many are hoping.
Now consider that consumers have not been encouraged to de-leverage "“ the mortgage debt burden for the nation is way too high.
The Fed engages in all this tough talk about an exit strategy. But even if the Fed were able to mop up all the liquidity it has injected (this is a separate discussion; suffice it to say we believe it is a lot harder than the Fed thinks given the types of securities the Fed has been purchasing "“ selling or "neutralizing" them may pose a challenge), if they truly were to raise rates or otherwise tighten credit, the economy may crash right back down as consumers continue to be interest rate sensitive. With it would come a renewed downturn in the housing market, the last thing the Fed may want.
So what does the Fed want? Think about it – what are the options when you are faced with millions of homeowners under water with their mortgages?
Before we get too theoretical, let's take a reality check. In the latest FOMC Minutes, the Fed wrote, "The level of debt of private domestic nonfinancial sector declined again in the second quarter, as both household and nonfinancial business debt fell." Translated: despite all the fiscal and monetary efforts, credit in the economy continues to contract. Indeed, all this money printing has not been enough.
Whereas Bernanke has been very keen on "credit easing" "“ subsidizing specific sectors in the credit markets and with it the economy -, we believe the odds are high that the Fed may step up good old fashioned "quantitative easing", that is, printing of money.
Don't take me wrong: in my assessment, the folks at the Fed truly believe they are doing the right thing. It's my understanding that they conclude the way Japan got out of its perennial recession was through massive printing of money. When I discussed this very point with a former Fed official the other day, I paused and wondered: Japan? Japan is not out of the woods despite all the money printing.
If I read the Fed correctly, they hope that their money printing will trickle through to the real economy. If inflation shows up in the indicators they care about, they will have an internal fight and may or may not tighten. If they do, expect a rather volatile monetary policy as the nascent recovery may well collapse yet again as consumers are still too leveraged. I believe it was Fed Vice Chairman Don Kohn, who said monetary policy in the future might look more like white water kayaking, adjusting swiftly with the currents. With due respect, as someone who used to be an avid whitewater kayaking enthusiast many years ago, this is not a sport suitable for any Fed official; Fed officials operate supertankers with fragile and explosive freight, not kayaks.
In reality, what we see is that all this money printing does not reach the intended place. Much of it simply ends up in bank's reserves. Overall, we have seen money flow to areas most sensitive to monetary stimulus, i.e. gold and currencies that benefit from reflationary efforts, such as the Australian dollar.
When it comes to the real economy, the money is only flowing to those who are creditworthy. If you have good credit, be that as an individual or as a corporation, you can get all the money you want. This hasn't escaped the Fed; in their latest FOMC minutes, they write: "Reports continued to suggest that lending institutions were unusually selective about their counterparties in funding markets."
This is a key reason why I am not a believer in the stock market rally: the business model of many corporations depends on cheap financing for their activities and continued outsourcing. This model is fundamentally broken. Not all companies are in this predicament, indeed there are some very well managed organizations out there, but it still doesn't justify the Dow at 10,000. Dow 10,000 may be more a reflection of investors desperately seeking returns above the breadcrumbs T-Bills are yielding. Similarly, why are investors racing to buy California's bonds? The absence of reasonable returns available elsewhere pushes investors into the same sort of imprudent decisions that got us into trouble the first time around. Indeed, I just learned that the CDO (collateralized debt obligations) market is back on fire "“ congrats, we made it! We have reflated an inherently unstable system, except this time, the government has more debt.
For individuals, the situation is not so different: those who are well off are able to access all the credit they desire; but if you have been squeezed by the credit crunch, odds are that your access to credit continues to be tight. Personally, I deleveraged substantially in the years leading up to the credit crunch. It is impossible to time the bursting of a bubble, but when things feel too good to be true, it may be time to start becoming more conservative. Now, the situation is different: credit is available now, I can afford to take it, so I have been and continue to lock in credit "“ in the process increasing the duration of any debt, arguing that a) who knows whether credit will be available in a few years should this new bubble burst yet again and b) market forces may ultimately overwhelm the Fed, causing the cost of borrowing to soar. I take it a step further by hedging just about all of my U.S. dollar exposure. This is certainly not a one-size fits all approach and anyone considering it must be able to afford to. If you do take on any debt, you must be able to afford the consequences should your collateral lose its value "“ be that buying a stock or real estate.
Where will the money flow if this bubble bursts again "“ or even for those periods when the prevailing market perception is that the Fed's reflationary efforts are not succeeding? While U.S. Treasuries may be considered a safe haven for some time, they won't be the only place people flee to; the U.S. balance sheet is in worse shape than most international counterparts, and secondly, other countries around the world have introduced safeguards, making their regions appear safer. Importantly, all rescue plans are on standby, thus governments around the world are able to simply push a few buttons to flush the markets with even more liquidity should they deem it appropriate.
In my assessment, we see a pendulum swinging back and forth "“ each time the pendulum swings towards the U.S. dollar and Treasuries, it won't swing as far. By all means, volatility is likely to persist as the natural market force (which continues to warrant a major credit contraction) battles with reflationary efforts by policy makers. As you might be able to gauge, as a result, aside from a substantial core holding in precious metals, I focus my personal investments on currencies "“ that's where I am comfortable with the dynamics; and more importantly, that's where one can find returns that may have a low correlation to other asset classes "“ in a period when monetary inflation pushes up most asset classes in tandem such diversification may be more valuable than ever. Just as important as diversification is that one understands what one invests in; the Dow reaching 10,000 is not a good reason; similarly, it's not a good reason to sell the U.S. dollar simply because it has been going down. If you agree to the underlying forces why the Dow is going up or the dollar going down, it's a different story.
In my book, SustainableWealth: Achieve Financial Security in a Volatile World of Debt and Consumption, to be released this month (and available for pre-order now), I dive into the dynamics that drive this world before discussing how you can invest in a boom, in a bust, in a personal or economic crisis. Make sure you sign up for the newsletter and follow the blog.
Axel
Axel Merk Author of Sustainable Wealth – order now. President and Chief Investment Officer, Merk Investments
Filed under Investing
We can see that the Federal Reserve Bank is creating the next bubble by issuing huge amounts US treasury notes and short term bonds.
Gold is going to replace the dollar. From the point of view of a citizen living in a country that has first begun to devalue its currency, the people hoard the “good” currency and then spend the bad currency by giving it to anyone who will still accept it. As the government of the country continues to devalue the currency, the citizens will finally stop accepting the “bad” currency and demand that all money transactions be made with “good” currency. This is exactly what happened in Zimbabwe. The Zimbabwe government devalued its paper currency. When that lost too much value, it then replaced old paper currency with new paper currency. The government then continued to devalue its new paper currency just as it did the old. As long as the people accepted the currency, the Zimbabwe government could pay its troops and get the troops to force the will of the government upon the people. However, after a while, the people got tired of using the monopoly money from the government. They were tired of seeing the fruits of their labor devalued. So they went to gold. Every transaction that took place…whether it was buying a loaf of bread or buying gasoline (what little there was of it) …had to be paid in gold. The government could not print gold. It could only print worthless paper. The government could no longer pay its army with money that could buy things. That forced the government to change.
From a foreign creditor point of view, most central banks around the world have dollars as part of their reserve currency. Some of these countries have loaned the US billions in the form of T bills and other securities. They do not want to paid back with dollars that are worth less than half the value of their initial investment. That is why Russia, China and many others are buying gold. Gold is hard currency. It can’t be printed. The OPEC nations are going to have to start selling their oil in some currency other than the dollar. If they do not, then they will face what we Americans are going to face…rising prices for their imported goods from Europe and elsewhere. They will want to preserve their wealth and stop selling oil in US dollars. When that happens….and it will happen soon…the US will face staggering inflation rates. Already the Russians are selling oil to the Chinese in non-dollar currency. They are moving toward creating an international currency that is more than 50% weighted in gold. It is easy to understand why. They do not trust any central bank that controls fiat currencies to NOT devalue the currency. But you can’t print gold.
China is getting ready to move toward a gold-backed currency. The Chinese government has sold gold and silver to its populous. When the Chinese are ready, they will go onto the market and buy as much gold as they can. The size of the global gold market is only $80 Billion currently. It will be easy for China to drive the price of gold up to $10,000 or $25,000 per oz. They have over $2 Trillion in reserves in their bank already. It would only take a fraction of that to drive the gold price up to $25,000 or higher. When that happens, the value of the US dollars that remain in their bank will drop….but their gold reserve will increase in value enormously. So, they will effectively replace the dollar as the world’s reserve currency with gold. Not only that, China will ensure that its population is enormously wealthy. Those Chinese people who have been buying gold and silver at the current price will become wealthy. That is what is going to happen.
The American people need to preserve their wealth now by doing what the Chinese people are doing…buying gold, silver and any other hard currency assets that are available. Those that do not are going to become impoverished. All of this was made possible because the American people stopped walking with God and decided instead to NOT treat their neighbors as they would treat themselves. Instead, they elected politicians who, for the sake of gaining and holding onto political power, were willing to kill the unborn and the infirmed (e.g. Terri Shiavo). The politicians that they elected promised them that only the top 5% of the income tax bracket would be taxed…only 1 in 20 Americans. That pleased the other 19 of 20 Americans. They thought that it would be just fine to take (…steal through government ‘redistribution of wealth”…) the assets of other Americans to give to themselves. That is why they elected Obama. It was due to their own selfishness and greed. But Obama and the liberals in Congress are now taking the wealth of the people and giving it to themselves and their banker friends from Wall Street. After all, when you are willing to kill the most innocent amongst us for the sake of gaining political power, what’s a little thing like lying to the American people? What’s a little thing like stealing?
In some ways, the American people who voted for Obama and the liberals in Congress are getting exactly what they deserve. They elected Obama to steal the wealth of their fellow Americans to give to themselves. Little did they realize that what they intended to do to their fellow Americans was, instead, going to happen to them. It is, in some sense, poetic justice. It is like the Bible says…what you sow, you will reap. Those who are wise will buy gold while they still can.
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