Sowing The Seeds

Hong Kong- The current economic conditions certainly do not provide any comfort for investors. So, if the economic news remains poor for the foreseeable future, should investors rule out the potential for a significant recovery in asset prices?

The bearish camp is pointing towards Japan and claiming that asset prices will not rebound for many years. According to these folks, corporate earnings will continue to decline and unemployment will rise to much higher levels. So, the bears have concluded that global financial markets will stay depressed for the foreseeable future. It is my observation however that in post-war history (with the exception of the previous recession when stocks were grossly overvalued) stock markets have always commenced a new bull-market prior to the end of each recession.

The current U.S. recession commenced late last year, so it has already lasted for more than a year. The average post-war US recession lasted 10 months making this downturn more severe. With the exception of the Great Depression, the worst post-war recessions occurred in 1974 and 1982. Both of these lasted for 16 months, making them the worst recessions since World War II. Now, if we were to assume that the current recession continues well into 2009, this would imply that stock markets will probably bottom out over the coming months.

We must remember that the financial markets are a discounting mechanism and with prices down significantly from their highs, most of the negative news seems to be already factored in today’s prices. In the past few months, some nations have been brought to their knees, the entire investment banking industry has been decimated, homebuilders have taken huge losses and now auto-makers are facing bankruptcy! For sure, such circumstances are not signs of a major top; rather they are usually associated with the bottom of the business cycle. So, liquidating positions and taking losses during such a pessimistic environment would be a big mistake. On the contrary, the ongoing liquidation of all assets is providing long-term investors with a fantastic buying opportunity. Accordingly, over the past couple of months, I have deployed all of my personal surplus cash reserves into the markets. Now, I concede that it is possible that prices may continue to drift lower in the short-term, but the recent market action suggests that we may have reached an important low. Unfortunately, I cannot state with certainty as to whether or not last quarter’s low will turn out to be the ultimate low for this bear-market. However, I do know that investors who deploy capital in commodity stocks and bullion today, will probably be sitting on huge profits in 5 years from now.

At present, the markets are extremely oversold relative to their moving averages and investor sentiment is awful. In this environment, I anticipate a multi-month rally in commodities, related stocks and precious metals. Conversely, at the same time, I expect a decline in the U.S. dollar, Japanese yen and U.S. Treasuries. All of these assets appreciated considerably during the liquidation phase and they will come under pressure when the tide changes.

The main reason why I do not foresee deflation (decrease in the supply of money) is due to the fact that the contraction in credit arising from deleveraging is being more than compensated by the money-pumping actions of the various governments. In the past year alone, the Federal Reserve has expanded its balance-sheet by a whopping US$1.2 trillion! Moreover, thanks to Mr. Bernanke’s cash injections (quantitative easing), reserve balances have sky-rocketed from roughly US$5 billion to almost US$600 billion in roughly 3 months (Figure 1)!

Figure: Lift off in bank reserves – helicopters being primed?

Source: Federal Reserve Bank of St. Louis

Furthermore, it is interesting to note that the Federal Reserve (money-printer extraordinaire) has now started to inflate the supply of money. Over the past few weeks, the Federal Reserve has injected roughly US$300 billion into the banking system without a proportionate increase in its non-banking liabilities via deposits by the US Treasury. In simple terms, what this means is that the Federal Reserve is now increasing bank reserves without the US Treasury removing an equivalent amount of money from the system. Usually, when the Federal Reserves provides surplus reserves to its member banks, the US Treasury borrows this money from the market by issuing bonds; thereby offsetting the inflationary impact of the Federal Reserve’s monetary injections. However, this is not what is happening now and this has inflationary implications. Essentially, the Federal Reserve is now creating money ‘out of thin air’, debasing its currency and sowing the seeds for sky-high inflation.

At present, commercial banks are hoarding this cash, but I expect this newly created money to seep through the economy over the following months. When that occurs and credit starts flowing again, business activity will pick up and prices will start appreciating.

In the past few weeks, we have received numerous queries from anxious investors who want to know if we are heading into deflation. Obviously, we don’t know what will happen in the future, but for now, data shows that all the deflation hype is absurd. If you have any doubt whatsoever as to whether we are facing inflation (expansion in the supply of money) or deflation (contraction in the supply of money), you need to look no further than Figure 2 which highlights the rate at which various nations are inflating the money supply. There is no doubt in this writer’s mind that deflation is out of the question when the money supply is expanding at such a frantic pace. For the sake of clarification, I must state that what we have witnessed over the past year is not deflation but a contraction in asset prices due to forced liquidation (non-availability of credit).

Figure 2: Inflation is the problem

Source: The Economist

Now, you may be wondering why there is so much talk about deflation these days when inflation (expansion in the money-supply) is the real issue at hand. There are two reasons for this:

First and foremost, you must remember that banks are in the business of lending and the central banks’ prime objective is to manage inflationary expectations. So, Mr. Bernanke and his comrades are paid to keep a lid on the public’s inflationary fears. Accordingly, a ‘deflation scare’ is engineered ever so often, so that they can continue with their long-term stealth inflation agenda without raising too many eyebrows. Secondly, the establishment needs to advertise a ‘deflation scare’ so that the central banks can slash interest rates. If inflation rather than deflation was perceived as the legitimate threat, then the Federal Reserve would not get away with near zero interest-rates.

In summary, I am of the view that the set-backs in our preferred areas (energy, miners, agriculture and bullion) will prove to be temporary and these assets should outperform the broad market once the recovery commences. Finally, it is worth noting that silver and platinum are now unbelievably oversold and they should rally hard and outperform gold over the following months. Accordingly, I would recommend buying some silver and platinum bullion at these levels.


Puru Saxena
for The Daily Reckoning

January 21, 2009

Puru Saxena is the founder of Puru Saxena Wealth Management, his Hong Kong based firm which manages investment portfolios for individuals and corporate clients. He is a highly showcased investment manager and a regular guest on CNN, BBC World, CNBC, Bloomberg, NDTV and various radio programs.

Puru Saxena publishes Money Matters, a monthly economic report, which highlights extraordinary investment opportunities in all major markets. In addition to the monthly report, subscribers also receive “Weekly Updates” covering the recent market action.

Euphoria was almost universal yesterday…except on Wall Street.

“Dad, don’t pick on Obama,” said Maria, calling from California. “I watched the inauguration yesterday. It was moving. Really moving. They seem like such nice people…and they really want to do what’s right. At least, that’s the way it seems to me…”

We watched the TV news. The British press focused on the race issue. Blacks interviewed by the BBC spoke of the ‘historic moment’…of the dreams of Martin Luther King finally realized…of a new era of race relations. There were hoorahs and tears…

We were never fond of racism, so we weren’t especially tearful upon reading the obituaries for it. Besides, we’re a little suspicious of the coroner’s report. We’d like to see the toe tag, just to be sure.

Still, everyone wants Obama to succeed. His mother and grandmother, looking down from heaven. His relatives in Kenya. His party. His country. The entire world. Even we hardened cynics here at The Daily Reckoning wish him well.

But we weren’t born yesterday.

And neither was the stock market. The man who got the warmest welcome ever from the press and the public got the rudest brush off from Wall Street. It was the worst sell-off for an Inauguration Day in history. The Dow fell 332 points. Oil traded around $40. The dollar strengthened…to $1.28 per euro.

O! Bama! Where is thy bounce? Perhaps it is already over. From their low in November, to their high a couple weeks ago, stocks worldwide recovered about a quarter of what they had lost. Now, they seem to be going down again.

We don’t know what the stock market sees, but we see a lot more trouble coming.

Houses in Southern California are down 35% from their peak.

Japan says its economy is “worsening rapidly.”

“Air France warns loss is likely” is one headline in Europe this morning; “German retailer to cut as many as 15,000 jobs,” is another.

But the big news is in the banking sector.

U.S. banks are “effectively insolvent,” says Nouriel Roubini. He figures losses in the United States might rise to $3.6 trillion – most of it in banks and broker-dealers. Which leaves the sector a little short. The banking system in the United States only has $1.4 trillion in capital.

Last week, Bank of America posted a quarterly loss of $1.79 billion…the first loss it’s taken in 18 years. Citigroup out-did it, with a loss of $8.29 billion for the last quarter of ’08.

As in Japan in the ’90s, the economic boat cannot right itself until this bilge is dumped overboard. But the feds are against it – fighting the correction with every tool they’ve got.

Obama says his team with be “bold and swift” in its efforts to deal with the problem. But the action they take will be timid and slow. That is, they will try to hold on…to protect what we have…to prevent change at all costs. “Yes we can!” they will say. But they can’t make the mistakes of an entire generation disappear – especially if they try to prevent a correction.

The truly bold and swift solution, on the other hand, would probably get him impeached. It would be to simply announce that the Obama government was letting nature take her course. No more bailouts. No more stimulus packages. No more federal guarantees or ‘refund checks.’

“Keynes is dead,” Obama should say; “the bankers will get what they deserve.”

In a matter of days, the whole banking sector would go bust…along with GM (more about that, below)…and thousands of businesses all over the country. Millions of people would lose their jobs. Stocks would crash down to 3,000 on the Dow…maybe lower. There would be keening by widows, whose husbands had jumped in front of trains or slit their wrists…there would be gnashing of teeth by millions, whose hopes of getting something for nothing were suddenly dashed…there would be mobs in the street and revolution in the air.

A few days later, banks that were still solvent would pick up the pieces of those that had gone bust. And gradually, the economy would pick up…building on a much more solid base.

But don’t trouble yourself about it, dear reader. That won’t happen. Instead, Mr. Obama will take the more cautious route… More below.

*** What can the Obama team really do? He plans a rescue for banks – above and beyond the $825 billion fiscal stimulus. He will “reform” health care – our guess is that he will want to make a system of European-style national health care his legacy contribution. He will offer more guarantees, more bailouts, more stimulus. He will probably turn the banks into quasi-public utilities…heavily regulated, with little appetite for risk and little taste for capitalism.

“Creeping nationalization,” is how Bloomberg describes the process. In Britain, the Royal Bank of Scotland will serve as a ‘guinea pig.’ It’s lost 3/4 of its share value in the last two days. The government will keep it alive…but it will become a ‘zombie’ – more dead than alive…more ward of the state than independent financial institution.

Of course, these fixes will do more harm than good. They will retard, delay, and detour the inevitable correction. Which will cause the Obama Administration to turn to other, more desperate measures. Here’s the real story…

Yesterday’s front page headline from the Financial Times:

“Treasury gives go-ahead to ‘print money.'”

We felt like saving the paper. Like the Times edition that announced the German invasion of Poland in 1940, it is probably the start of something big. Something catastrophic.

*** GM announced yesterday that it would probably run out of money in March. As to a bailout, we turn to a letter that appeared last week in the Manufacturing and Technology Journal. It is from a man who seems to have grease under his nails and a brain under his hat. Greg Knox, president of Knox Machinery in Franklin, Ohio, explains why he is not in favor of a bail out for Detroit.

“Politicians and Management of the Big 3 are both infected with the same entitlement mentality that has spread like cancerous germs in UAW halls for the last countless decades, and whose plague is now sweeping this nation, awaiting our new ‘messiah’, Pres-elect Obama, to wave his magic wand and make all our problems go away, while at the same time allowing our once great nation to keep ‘living the dream’… Believe me folks, The dream is over!

“This dream where we can ignore the consumer for years while management myopically focuses on its personal rewards packages at the same time that our factories have been filled with the worlds most overpaid, arrogant, ignorant and laziest entitlement minded ‘laborers’ without paying the price for these atrocities…this dream where you still think the masses will line up to buy our products for ever and ever.

“Don’t even think about telling me I’m wrong. Don’t accuse me of not knowing of what I speak. I have called on Ford, GM, Chrysler, TRW, Delphi, Kelsey Hayes, American Axle and countless other automotive OEM’s throughout the Midwest during the past 30 years and what I’ve seen over those years in these union shops can only be described as disgusting. Troy Clarke, President of General Motors North America, states: ‘There is widespread sentiment throughout this country, and our government, and especially via the news media, that the current crisis is completely the result of bad management which it certainly is not.’

“You’re right Mr. Clarke, it’s not JUST management…how about the electricians who walk around the plants like lords in feudal times, making people wait on them for countless hours while they drag ass…so they can come in on the weekend and make double and triple time…for a job they easily could have done within their normal 40 hour work week. How about the line workers who threaten newbies with all kinds of scare tactics…for putting out too many parts on a shift…and for being too productive (We certainly must not expose those lazy bums who have been getting overpaid for decades for their horrific underproduction, must we?!?)

“Do you folks really not know about this stuff?!? How about this great sentiment abridged from Mr. Clarke’s sad plea: ‘over the last few years …we have closed the quality and efficiency gaps with our competitors.’ What the hell has Detroit been doing for the last 40 years?!? Did we really JUST wake up to the gaps in quality and efficiency between us and them? The K car vs. the Accord? The Pinto vs. the Civic?!? Do I need to go on? What a joke!

“We are living through the inevitable outcome of the actions of the United States auto industry for decades. It’s time to pay for your sins, Detroit.

“I attended an economic summit last week where brilliant economist, Alan Beaulieu, from the Institute of Trend Research, surprised the crowd when he said he would not have given the banks a penny of ‘bailout money’. ‘Yes,’ he said, ‘this would cause short term problems,’ but despite what people like politicians and corporate magnates would have us believe, the sun would in fact rise the next day… and the following very important thing would happen…where there had been greedy and sloppy banks, new efficient ones would pop up…that is how a free market system works…it does work…if we would only let it work…”

“But for some nondescript reason we are now deciding that the rest of the world is right and that capitalism doesn’t work – that we need the government to step in and ‘save us”‘…Save us my ass. Hell – we’re nationalizing…and unfortunately too many of our once fine nation’s citizens don’t even have a clue that this is what is really happening…But, they sure can tell you the stats on their favorite sports teams…yeah – THAT’S really important, isn’t it…

“Does it ever occur to ANYONE that the “competition” has been producing vehicles, EXTREMELY PROFITABLY, for decades in this country?… How can that be??? Let’s see… Fuel efficient… Listening to customers… Investing in the proper tooling and automation for the long haul…

“Not being too complacent or arrogant to listen to Dr. W. Edwards Deming four decades ago when he taught that by adopting appropriate principles of management, organizations could increase quality and simultaneously reduce costs. Ever increased productivity through quality and intelligent planning… Treating vendors like strategic partners, rather than like ‘the enemy’… Efficient front and back offices… Non union environment…

“Again, I could go on and on, but I really wouldn’t be telling anyone anything they really don’t already know down deep in their hearts. I have six children, so I am not unfamiliar with the concept of wanting someone to bail you out of a mess that you have gotten yourself into – my children do this on a weekly, if not daily basis, as I did when I was their age. I do for them what my parents did for me (one of their greatest gifts, by the way) – I make them stand on their own two feet and accept the consequences of their actions and work through it. Radical concept, huh… Am I there for them in the wings? Of course – but only until such time as they need to be fully on their own as adults.

“I don’t want to oversimplify a complex situation, but there certainly are unmistakable parallels here between the proper role of parenting and government. Detroit and the United States need to pay for their sins. Bad news people – it’s coming whether we like it or not. The newly elected Messiah really doesn’t have a magic wand big enough to ‘make it all go away.’ I laughed as I heard Obama ‘reeling it back in’ almost immediately after the final vote count was tallied…’we really might not do it in a year…or in four…’ Where the Hell was that kind of talk when he was RUNNING for office.

“Stop trying to put off the inevitable folks … That house in Florida really isn’t worth $750,000… People who jump across a border really don’t deserve free health care benefits… That job driving that forklift for the Big 3 really isn’t worth $85,000 a year… We really shouldn’t allow Wal-Mart to stock their shelves with products acquired from a country that unfairly manipulates their currency and has the most atrocious human rights infractions on the face of the globe…

“That couple whose combined income is less than $50,000 really shouldn’t be living in that $485,000 home… Let the market correct itself folks – it will. Yes it will be painful, but it’s gonna’ be painful either way, and the bright side of my proposal is that on the other side of it all, is a nation that appreciates what it has…and doesn’t live beyond its means…and gets back to basics…and redevelops the patriotic work ethic that made it the greatest nation in the history of the world…and probably turns back to God.

“Sorry – don’t cut my head off, I’m just the messenger sharing with you the ‘bad news’. I hope you take it to heart.

“Gregory J. Knox, President, Knox Machinery, Inc. Franklin, Ohio”

Until tomorrow,

Bill Bonner
The Daily Reckoning