An Embarassment of Riches, Part II
In the conclusion of this two-part essay, Dr. Marc Faber explains that our country’s balance sheet is worse than advertised and what investors can do to protect themselves from the monetary instability.
The Goldilocks protagonists will say, "Yes, consumption is a symptom of economic strength." Personally, I think it depends on how consumption came about. If it was achieved by the household sector selling assets and going deeper into debt, then consumption is eroding the production capacity of a country and will lead to impoverishment, as is indicated by the dollar’s loss of value.
The point is simply this: in the current expansion phase, which began six years ago, the performance of the US economy and US asset markets in dollar terms looks better than is the case in reality. What kind of an adjustment we should make is debatable. It might perhaps be unfair to measure US GDP and asset markets in gold, using as a starting point a very depressed price level of gold as was the case in 2001. But even if we took a gold price of, say, US$400 or US$450 (in the 1980s and 1990s, it seldom traded above US$450), the recent performance of GDP and asset markets would be dismal.
Therefore, while the Fed can lower interest rates further and see to it that asset markets stabilize – or even appreciate – in dollar terms, it is far from certain they would increase in hard currency terms. So far, strong MZM growth in the third quarter would rather seem to have boosted the performance of emerging markets and of commodities. Also, whereas major indexes have made new highs in the US, it should be noted that the majority of shares have failed to make new highs. (Among brokerage shares, only
Goldman Sachs has made a new high.) As mentioned above, the strong rise in the Nasdaq 100 Index (up 20% from the August low) was driven by a handful of shares whose performance begins to resemble the performance of Chinese stocks (see Figures 30 and 31)! In my opinion, there is much to lose from buying these over-extended momentum stocks (including AAPL (NASDAQ:AAPL), GOOG (NASDAQ:GOOG), AMZN (NASDAQ:AMZN), RIMM (NASDAQ:RIMM), WYNN (NASDAQ:WYNN), etc.).
From my earlier reports and my thoughts above, one could reason that I am very negative about the US dollar. This is certainly the case from a longer-term perspective. However, we should also recognize that current sentiment towards the dollar is very negative and that the Fed has some power to force the European Central Bank (ECB) also to cut rates. Let us assume that, because of additional rate cuts in the US, the Euro strengthens further. At some point, the political pressure on the ECB will surely increase and demand rate cuts in order to weaken the currency. The situation in Asia is more complex. So far, Asian central banks have resisted their currencies appreciating strongly against the US dollar. But with money supply growing at around 20% in China and 24% in India, and with inflation accelerating in Asia (in particular, food inflation), Asian central banks may have no other option but to tighten meaningfully and let their currencies appreciate against the US dollar.
However, as soon as their economies weakened or their over-extended stock markets collapsed, monetary conditions would be eased very quickly. If this were to occur, I suppose that the world would be left with only one currency of total integrity: gold and other precious metals.
Consequently, if one were to bet on a continuous loss of purchasing power of the US dollar and other currencies – a safe bet with respect to the US dollar in the long term – my recommendation would be to own physical gold as cash currency, which could also be bought in the form of an ETF (GLD).
I am asked constantly how gold would perform in a deflationary collapse. With the propensity of the Fed and the ECB to flood the system with liquidity and to take "extraordinary measures" whenever problems arise, deflation is a remote possibility for the foreseeable future.
So, before worrying about deflation, I would worry about inflation accelerating strongly in the years to come – especially if the US economy stagnates. But let us assume that at some point in the future deflation follows. What then? In my opinion, deflation could only be triggered by one event: a total collapse of the existing global credit bubble. And the only event I can think of that would trigger such a debt collapse would be a third world war. The failure of a large bank – say, Citigroup – wouldn’t do the trick, because the Fed would immediately bail it out (unless Ron Paul is US President).
Now, in a debt collapse, where would you rather have your money? In bank deposits, in CDs, in dubious commercial paper, in bonds, in money market funds – all of which would experience soaring default rates – or in physical gold, ideally in a safe deposit box? I think that, particularly in a debt collapse, physical gold would shine, as people the world over would become extremely concerned about, not the return on their money (interest), but the return of their money. This would be particularly true of Asian central banks, which now have less than 2% of their reserves in gold but hold massive quantities of all kinds of debt securities.
Consequently, while I find the gold price to be currently somewhat overbought, I still think that gold will be one of the best investments over the next couple of years. In particular, I would expect demand for gold from individuals around the world to increase meaningfully – especially in Asia – at a time when production is unlikely to increase. I wish to add that I am not a "gold bug". I would much prefer to live in a world in which central banks’ top priority was to safeguard paper money’s purchasing power and its function as a "store of value". I would also much rather live in a world in which the US dollar was a strong currency, and where America was as free as it was in the 1960s, and the economic and financial imbalances weren’t as extreme as they are today. As Steven Roach recently remarked, "no nation has ever devalued its way into prosperity". But the fact is, the time has come when we can no longer trust central banks.
Therefore, each individual must be his own central bank and maintain adequate reserves for himself in the form of physical gold. The supply of paper money is potentially endless, whereas the supply of gold is very limited. In fact, gold production from mines is declining.
Dr. Marc Faber
for The Daily Reckoning
November 21, 2007
Poor Freddie (NYSE:FRE). The federally-chartered lender announced a loss of nearly $5 billion. You’d think it had lit up a cigarette in a sushi joint. Suddenly, everyone was jumping all over it. Investors spanked the company…the shares fell 30% after the firm announced a cut of as much as 50% in the dividend. Sister Fannie (NYSE:FNM) didn’t get away either. Her shares went down 22%.
Meanwhile, the U.S. dollar went down again – hitting another record low against the euro (EUR). Years ago, we guessed it would drop to $1.50 per euro. Today, it is at $1.48. Yesterday, a rumor made the rounds…that the Fed was getting ready for an emergency cut. "The Fed will keep its options open," said Neil Mellor of the Bank of New York Mellon. But an emergency cut seems unlikely. Instead, the futures market is giving a 90% probability of another cut at the Fed’s regular meeting on December 11th.
And what happened to that correction? Gold added $15 yesterday. We were hoping for more of a downturn. We don’t like to buy when the price needs to correct.
Oil, too, headed up – it’s at $96 a barrel, a new record high. Here comes the explanation: the winter is going to be cold.
But back to Freddie, Fannie et al. What had they done wrong?
Nothing, according to Richard Styron, Freddie’s CEO.
"We aren’t happy about this," he told a conference call. Then, he went on to describe what it was he wasn’t happy about. As the Financial Times put it:
"Mr. Styron blamed the meltdown in the U.S. mortgage market and the attendant decline in the value of mortgage-related shares."
Who could have seen that coming, he seemed to ask?
It is always a source of great amazement and entertainment to us here at the dour headquarters of The Daily Reckoning on the banks of the River Thames (in the building with the golden balls) – how the smartest and best informed investors can walk into the most obvious traps.
Freddie buys mortgages. It has an instruction to do so from the United States Congress – based on the ostensible grounds that a little more money in the mortgage market might be good for homeowners…and the hidden motivation that it might help get some undeserving politicians re-elected. Freddie borrows money at low rates…in order to lend it at higher rates. A pretty simple business, it has two risks: 1. That interest rates will move in an adverse direction…and 2. That the mortgages it holds will turn out to be worth less than it thought (when homeowners stop making payments…for example…or housing prices fall). Fannie’s executives must have to look at these risks more often than they shave. They are so much a core part of the business that the company cannot deny them; instead, it has to manage them – for which it has access to a huge army of hedgers, quants, intermediaries and speculators with very sharp pencils and very rich imaginations.
But wouldn’t you know it, just when things were going so well – with mortgage brokers lending money coast to coast like a house o’ fire – then along comes this totally unanticipated event, like a meteor striking the earth! And wham…all those sharp pencils break at once.
Seriously, this subprime housing meltdown… who could have seen that coming?
Not the rating agencies. Last month, Fitch said it was caught off guard by "the unprecedented reversal in home prices." What’s the matter with these people? What’s unprecedented about house prices going down? Funny how no one took these guys aside and whispered in their ear:
"Pssst…markets go up AND down. And by the way, when you lend out money recklessly…you gotta expect trouble."
Apparently, no one said a thing. It is as if these guys had come to Wall Street on the back of a turnip truck…and signed up for work the next day.
Now, they find the work is not as easy as they had thought. This week, the cost of protecting against credit whammies rose to an 18-year high – based on two year interest rate swap prices. "More black clouds on the credit horizon," the Financial Times reports. Countrywide (NYSE:CFC) is trading at less than $10 a share. And Citigroup (NYSE:C) shares have been almost cut in half.
"’The widening of swap spreads is a function of tight lending and a de-leveraging in the financial system…’ said one bond strategist. ‘The last two times we saw these meteor-like spikes in swap spreads in the U.S., they were followed by a recession. Liquidity is absolutely horrible.’"
And so papers are all talking about the credit crisis beginning to crunch down on the middle classes. Building permits are at a 14-year low. Foreclosures are still rising. House prices are still going down. More and more economists are forecasting recession.
"The Coming Consumer Crunch," Business Week calls it.
And this from our old friend Jim Rogers:
"This is worse than the S&L crisis. This is the first time – this is the worst credit bubble we’ve ever had in American history. No – never in American history have people been able to buy a house with no money down…never. That’s never happened anytime in the world. So, we have the worst credit bubble. It’s going to take a long time to work its way out. You don’t cure a bubble in five or six months… It takes five or six years."
In today’s Financial Times, our old friend Grover Norquist complains about the "dynastic disease" in American politics.
"We are about to hold a presidential election," he writes, "that may extend a sequence that gives the land of the free four years of George H.W. Bush, eight years of William Clinton, eight years of George W. Bush, son of, and the start of eight years of Hillary Clinton, wife of."
Grover notes that America was set up as a country without an aristocracy. No inherited titles. No king. No purple robes.
But now there is a "creeping tendency to see elected office as a family heirloom." Not just in the White House, but in Congress too. Grover cites dozens of examples. Some are very familiar. Certain families have national brand names that prove useful to gullible voters – Kennedys, Bushes, Gores. Most are just local brands like the Dingells of Michigan. And sometimes the desire to keep a political post in the family reaches comic levels. When Senator Mel Carnahan died just before an election, somehow his widow won the race – and she wasn’t even on the ballot.
But Grover is no medical man. He is wrong about the ‘disease.’ It’s not a disease at all. It’s merely politics in its natural, unhealthy condition. If the idea of democracy is that voters put their heads together and select the most worthy candidate, the whole thing is a fraud. Just look at Congress. What voters really do is select the fellow with the best haircut, the best line of guff, or the smoothest fundraising machinery. And it helps to have name recognition. That’s how popular actors – such as Ronald Reagan and Arnold Schwarzenegger – were able to break into the business. People do not really select the best man for the job; they have no way of knowing what the job is or who would be best for it. Instead, they buy their candidates like bath soap…based on the jingle that most appeals to them. And that’s why a hereditary monarch is actually better than an elected president. Monarchs are born to rule, rather than elected to it; that is, they are chosen by chance rather than by fraud.
The Daily Reckoning