Extraordinary Monetary Measures

The Daily Reckoning PRESENTS: Illiquidity among the U.S. household sector, along with the reluctance of the Fed to cut rates right away, combined with the requirements for enormous capital investments for infrastructure in emerging and developed economies, could lead to some tightening of liquidity around the world. Marc Faber explains…


If any longish marriage is an exercise in irritation management, so is listening to the hype by media commentators about the soundness and superiority of the US economy and about how well US stocks are performing. I suppose that if Larry Kudlow were living in Zimbabwe, where the economy has been contracting for eight straight years and has shrunk by 50% since 1999, and where hunger is spreading and life expectancy is down to 35 years, he would also be enthusiastic about the prospects of Zimbabwe’s stock market, which is currently soaring as inflation is likely to reach 5,000% this year. (Michael Lewitt of Harch Capital Management recently commented on the Zimbabwe stock market and noted that on March 20, the Zimbabwe stock exchange rose in that one single day by as much as in the previous 40 years to December 2006 combined.)

As in the case of the US, but in a more extreme way, while stocks are soaring in Zimbabwe, the currency is collapsing. (In fact, it is an exact replica of what happened during the Weimar hyperinflation of 1919-1923, in local currency terms, the stock market index soared into the trillions but collapsed in gold terms.) John Paul Koning, an analyst at Pollitt & Co in Toronto and writing for the Mises Institute, has made the following pertinent observation about the Zimbabwe Stock Exchange:

“The ZSE is growing some three times faster than consumer prices. This relative outperformance versus general prices is a result of stocks being a chief entry point for the flood of newly created money. Keep Zimbabwean dollars in your pocket, and they’ve already lost a chunk of their value by the next day. Putting money in the bank, where rates are pithy, is not much better. Investing in government bonds is the equivalent of financial suicide.

“Converting wealth into foreign currency is difficult; hard currency is scarce, and strict rules limit exchangeability. As for capital improvements, there is little incentive on the part of companies to invest in their already-losing enterprises since economic prospects look so bleak. Very few havens exist for people to hide their wealth from the evils created by Mugabe’s policies. Like compressed air looking for an exit, money is pouring into shares of ZSE-listed firms like banker Old Mutual, hotel group Meikles Africa, and mobile phone firm Econet Wireless. It is the only place to go. Thus the 12,000% year over year increase in the Zimbabwe Industrials.

“Our Zimbabwe example, though extreme, demonstrates how changes in stock prices can be driven by monetary conditions, and not changes in GDP. New money gets spent or invested. In Zimbabwe’s case, because there are no alternatives, it is stocks that are benefiting. This sort of thinking can be applied to the stock markets in the Western world too. Though western central banks have not been printing nearly as fast as their Zimbabwe counterpart, they do have a long history of increasing the money supply. It forces one to ask how much of the growth in Western stock markets over the preceding twenty-five years has been created by a vastly increasing money supply, and how much is due to actual wealth creation.

“Perhaps stock prices have increased faster than goods prices for the last twenty-five years because, as in Zimbabwe, Western stock markets have become one of the principal entry points for newly printed currency.”

Now, I don’t anticipate that a Zimbabwe-like scenario will unfold in the United States soon, but the phenomenon of investors realizing that cash deposits don’t give them adequate protection from the loss of their paper money’s purchasing power and therefore rushing into any kind of asset is the same everywhere in the world. Also similar is the increase in asset prices in local currency in Zimbabwe and the United States, and the collapse of the Zimbabwe dollar and, to a far lesser extent, the decline in value of the US dollar.

Still, for now, there is some hope for the US dollar. As explained in last month’s report, it is not the Fed that has tightened monetary conditions, but the marketplace through the collapse of the sub-prime lending industry. Since the housing market is more likely to deteriorate further than to recover, credit problems could get much worse. In any event, Robert Toll, CEO of Toll Brothers, just sold another US$8.3 million worth of shares. Since his company’s shares are down from almost US$60 in 2005 to US$27, his selling would indicate that he doesn’t see any immediate turnaround in the housing industry.

Moreover, there are several reasons why the Fed is unlikely to cut interest rates in the near future. Food and energy prices as well as import prices are rising, which could further increase inflationary pressures. The dollar is also in a very precarious position, and bond yields have so far failed to decline despite evidence of an economic slowdown.

Finally, I suppose Mr. Bernanke understands very well the difficult position he finds himself in as the chairman of the Fed. Should inflation under his chairmanship at the Fed become a problem, he knows that he will be blamed for it. Conversely, he is also well aware that if some sort of recession occurred due to a currently somewhat more hawkish monetary stance, financial observers will be quick to blame Mr. Greenspan for it,

since the former Fed chairman addressed any financial crisis or any potential problem (Y2K, for example) by printing money and can thus be considered directly responsible for the housing bubble.

So, from a career and reputation risk point of view, Mr. Bernanke will likely move very slowly in cutting rates and rather take the risk of some mild form of recession occurring. He could then blame a recession, which would have come from the housing sector, on Mr. Greenspan. After that, he could take some “extraordinary monetary measures” in order to engineer an economic recovery for which he would take credit. And should at that time inflationary pressures have failed to abate or have even increased – as I would expect them to do – he could always argue that the Fed’s policy priorities have temporary shifted to emphasize “economic growth” over “targeting inflation”, and that the Fed will deal with inflation once the economy has fully recovered. The stance of emphasizing “economic growth” over “inflation targeting” would by then also be perfectly acceptable politically and thus would be welcomed by the “establishment”,

which would have taken advantage of a bear market in housing and hardship among sub-prime borrowers to acquire some assets at bargain prices…

I am mentioning this because as my friend Bill King, author of The King Report reported, Ben Bernanke recently gave a speech at Stanford in which he said that “increased trade with China has reduced U.S. inflation, now running at about 2%, by only about 0.1 percentage point”. He also noted that while emerging economies have added to the global supply of manufactured goods, they are also adding to the demand for oil and other commodities. And according to Mr. Bernanke, “There seems to be little basis for concluding that globalization overall has significantly reduced inflation in the

U.S. in recent years; indeed, the opposite may be true.”

And this is where I think the Goldilocks prophets with tunnel vision, who argue for continuous economic growth amid low inflation, will be as wrong as they have been for the past few years. The super-bulls on the US have simply overlooked the fact that if economic growth in China, India, Vietnam, and other emerging regions of the world remains strong and the US economy continues to expand, this synchronised global boom will be supportive of commodity prices whose price gains have significantly outstripped the performance of US financial asset prices since 2001. So, in the event, as the entire Goldilocks sect argues, that the global economy remains strong, inflationary pressures should increase. Commodity prices, especially for agricultural products, are in real terms still extremely depressed and, contrary to expectations, could rise far more than many would think possible.

However, illiquidity among the US household sector, along with the reluctance of the Fed to cut rates right away, combined with the requirements for enormous capital investments for infrastructure in emerging and developed economies, could lead to some tightening of liquidity around the world.

Therefore, I expect a more meaningful setback in asset prices and would certainly defer the purchase of financial assets. In particular, I am concerned by the inability of financial stocks to rally convincingly from their March 2007 lows, since financials are usually

leading the market up and down. In my opinion, there is an ongoing deterioration in the US stock market. In the summer of 2005, the homebuilders peaked out. Last year, it was the turn of the sub-prime lenders to top out. And early this year, financial shares, including brokers, made their highs. The economy is likely to follow this slow stock market erosion and gradually deteriorate, with disappointing corporate profits to follow.

Investors who must own US shares may find some relative outperformance among pharmaceutical companies, and oil and coal stocks.  For the reasons outlined above (a relative tightening of liquidity in the world), I don’t expect the US dollar to collapse immediately. However, it should be clear that in the long run the purchasing power of the US dollar will continue to decline against sound currencies such as precious metals. Therefore, I continue recommending the accumulation of gold and silver.

But it is increasingly likely that something will give soon: either asset prices will decline in a tighter liquidity environment, or the US dollar will fall sharply if the Fed continues to pursue expansionary monetary policies. For the US financial market, this means either weak equities and a strong dollar or strong equities and a weak dollar.

Not a particularly appealing scenario!


Marc Faber
for The Daily Reckoning
May 3, 2007

Editor’s note: Dr. Marc Faber is the editor of The Gloom, Boom and Doom Report and author of Tomorrow’s Gold, one of the best investment books on the market.

Tomorrow’s Gold

Headquartered in Hong Kong for 20 years and now based in northern Thailand, Dr. Faber has long specialized in Asian markets and advised major clients seeking bargains with hidden value, unknown to the average investing public.

aily Reckoning sufferers, listen up. We now have word – directly from the horse’s mouth – that all’s well in the world economy. Stocks are going up. Thus sprach Abby Joseph “Zarathustra” Cohen at the Financial Times.

Yes, the optimistic, albeit delusional economist from Goldman Sachs (NYSE:GS) says the economy is slowing down. But, “critically,” she adds (they pay her big money for these neat insights), “it is also rotating.” Like tires.

And if the economy now seems to be spinning against the people who buy, finance, build and sell houses, don’t worry your head about that.

“Weak housing is unlikely to derail the economy,” says Miss Eternal Sunshine of the Stock-tout Mind.

You see, over there, commercial property is picking up. And over here, so are exports, thanks to the flailing dollar. And how do you like those consumers? They’re still spending what they don’t have on what they don’t need. Personal consumption is supposed to go up by 3% this year.

And, you want more good news? U.S. corporations are flush with cash. They’re making money…and probably will make even more – which means, stock prices are going up too. Abby’s model says the S&P 500 should hit 1,550 and the Dow should make it to 13,500 by the end of the year.

And who knows? Maybe she’ll be right; she usually is. She’s got a nice gig over there at Goldman. Every year they pay her a lot of money. Every year she says stocks will go up. And most years stocks do go up.

But readers are reminded that it is not by successfully foretelling the future alone that a gambler makes his money. Instead, it is by correctly toting up the odds…and figuring out how much he’ll lose if he is wrong. Even if Abby is right, from here to 13,500 in the Dow is only about a 4% gain – and more than half that gain reflects nothing more than the effect of inflation. So, you would be putting your money at risk in the hope of making 2% net…less after taxes. If the dollar goes down, or inflation goes up, your gain is wiped out completely. And there is always the chance that Abby is wrong. Suppose instead that the Dow goes down 10%…or 20%…or 50%. Is it worth taking the risk for the hope of a 2% gain?

And here is money manager Jeremy Grantham with more details on the risks investors face:

“From Indian antiquities to modern Chinese art; from land in Panama to Mayfair; from forestry, infrastructure and the junkiest bonds to mundane blue chips – it’s bubble time,” he writes in his latest quarterly letter entitled “The First Truly Global Bubble.”

“Most bubbles, like Internet stocks and Japanese land, go through an exponential phase before breaking, usually short in time, but dramatic in extent,” Grantham continues.

“Sustained strong fundamentals and sustained easy credit…allow for continued reinforcement. The more leverage you take, the better you do. The better you do, the more leverage you take.”

The Dow goes up, up, up – it’s been up in 20 of the last 22 sessions, something that hasn’t happened since just before the Great Crash of ’29. But the gains in the Dow are peanuts compared to what you could get overseas.

In China, the major indices have gone up almost three times in the last two years. So far this year, the CSI 300 Index, which tracks yuan-denominated A shares listed on the Shanghai and Shenzhen stock exchanges, rose 75%.

And in Europe, Germany is also booming…though at a much more modest pace.

“This time, everyone, everywhere is reinforcing one another,” Grantham argues. “Wherever you travel, you hear it confirmed that ‘they don’t make any more land,’ and that ‘with these growth rates and low interest rates, equity markets can keep rising,’ and ‘private equity will continue to drive the markets.’ To say the least, there has never been anything like the uniformity of this reinforcement.”

And when it pops, says Grantham, it “will be across all countries and all assets, with the probable exception of high-grade bonds. Risk premiums in particular will widen. Since no similar global event has occurred before, the stresses to the system are likely to be unexpected.”

A lot of risk for a measly 2% return.

More news:


Addison Wiggin, reporting from Baltimore…

“We’re so quick to judge, aren’t we?

“‘The indictment of E-gold principals is not part of any attempt by the US government to dissuade gold’s use as currency in legitimate ways,’ James Turk told us yesterday. ‘These indictments relate solely to E-Gold’s business practices.’ James, as you may know, is the managing director of goldmoney.com, a competitor to e-gold.

“‘In fact, the indictments come as no surprise,’ says Turk. Major allegations of e-gold’s practices have been publicized in the past.

“‘These schemes coupled with e-gold’s anonymous-user policies were the real source of the indictments,’ says Turk.”

For more details on this classic “Ponzi” scheme that the e-gold execs have allowed on their watch, and for more insights into the markets, see today’s issue of The 5 Min. Forecast


And more views…

*** There’s bad risk – and then there’s good risk. And if you conquer your fear of the latter, there is much money to be made. To help get yourself over this fear, here is some advice (and daily affirmations) from Options Hotline’s Steve Sarnoff:

“Every investment involves some level of risk. Even ‘safe’ investments like savings accounts, money market funds, even IRAs and 401(k)s can go bust. It’s rare…but it does happen.

“In other words, if you’re investing in anything, you have already overcome some of your fear of risk. So all you need to do is push that tolerance to the next level.

“Start by saying to yourself:

“I will have losses – but my wins will overpower them
“I will make mistakes – but I will learn from them and won’t repeat them
“I will make money – but only if I don’t give up.

“Of course, reading this is one thing…believing them is something completely different. Don’t expect it to happen overnight. But the more you trade, the more confident you’ll become. And soon fear won’t be a factor in your investment decisions.

“Now all you need discipline to follow-through on your decisions.”

Steve knows a lot about risk – he runs a service that recommends buying one specific option a week for the last seven years. While options have gotten a reputation for being
“too risky” for the average investor, Steve’s service, Options Hotline, is proof that’s not necessarily the case. In fact, every recommendation he’s made since August 2004 has gone up – giving his readers a chance to gain six figures every year.

For a limited time, you can get in on the action…for half the price.

*** Meanwhile, last night we had dinner with a group of fund managers. The message we took away was the same one we’ve been hearing for months:

“What is really amazing is that there is so much money around. We don’t know what to make of it. People have money. A lot of money. And they’re ready to invest it in places that they never would have done a few years ago.”

While Abby Joseph Cohen lures the lumpen to the NYSE with her Panglossian schtick, the big money goes after bigger returns…in hedge funds, private equity, and managed accounts. Every boom has an element of folderol in it, but this boom is bigger than most…with a gigantic dollop of humbug balanced like whip-cream on the top.

The stock market run-up of the 1990s was based on the fraud that investors could all get rich – big investment pros from Manhattan as well as Mom & Pops from Duluth – just by all being ‘in the market’ together. The Efficient Market Hypothesis – endorsed by the U.S. Supreme Court – claimed that everyone had an equal shot at making money in stocks.

Now along come all these opportunities for rich investors to make MORE than the lumps…by bidding against them! The hedge funds are playing options, futures, leveraged derivatives and other sophisticated investments considered too risky and too complicated for small investors. Private equity players are buying public companies right out from under the patsies’ noses…’restructuring’ them (generally, borrowing money against their assets in order to pay themselves special dividends and fees)…and then selling them back to the small investors at a bigger price. And, of course, fund managers argue that they can beat the market – which is to say, beat the average investor; and they’ve got the numbers to prove it.

Now, both propositions couldn’t possibly be true at the same time. Average investors couldn’t be doing as well as the pros…whilst the pros are supposed to be doing better than them. On the other hand, they can both be costly humbugs.

*** “America frets about executive pay,” says an editorial by Clive Crook, in the Financial Times.

Mr. Crook noticed that the House of Representatives passed a bill to “strengthen shareholder oversight of top executive pay.”

What follows is a Daily Reckoning cogitation, of the sort that pleases no one.

On the one hand, we are clearly in the camp of those who think the top echelon of American business spends far too long swilling at the trough. We say that based on no evidence whatsoever; it is just a matter of taste. Between one biped and another, in our opinion, there is not enough difference as to justify earnings of $5.29 per hour for the one…and nearly $500,000 an hour for another. And from our observation, there are thousands, or even millions of people wandering around with about the same level of competence…any one of whom could perfectly well do what the best-paid corporate bipeds do.

In short, we think the people who own these businesses are making a mistake; they’re over-paying their employees. But that does not mean we see anything wrong with it or want to do anything about it. Mistakes are made all the time. Without error, there is no truth. Without stupid investors there are no smart ones. And without mis-priced shares, there are no bargains.

Envy takes over occasionally, as it did recently in the U.S. House of Representatives. But, generally, Americans are relaxed about differences in wealth. They will put up with extravagant personal earnings…as long as they think they – or maybe their children – might have a shot at them, too.

But modern America is so full of world-improvers, you can barely toss a beer can out of a car window without hitting one in the head.

Some want to limit executive pay…some want regime change in foreign countries…some want to try to alter the planet’s weather! A pox on them all.

*** And here is an interesting letter from a dear reader:

“Don’t you think that it would be interesting to tell your readers who owns the Federal Reserve? Or don’t you know? The Federal Reserve is not a government institution, but a bank.

“At the turn of the century, our government used to print its own money…but then this very astute group of bankers came along and said, ‘Why don’t we lend your our money?’ And they did.

“And our ‘income tax’ (levied illegally in 1913) pays the interest on the money our government borrows from the Fed. Our income tax does not pay for the infrastructure of our country…it only pays the ‘bankers/fed’ their interest! It’s in the billions!

“Why would a government borrow and pay interest when it can print its own money? Why does no one do some basic homework and find out that the Fed is NOT a government institution, but a bank?

“Why does everyone say that our form of government is a Democracy, when it’s actually a Constitutional Republic? Don’t believe it? Go to Wikipedia.org, do a search on Constitutional Republic, and you’ll see that the U.S. is the oldest Constitutional Republic in the world.

“Of course, now that the North American Union is under way, we won’t have that form of government anymore: one that protects even 1% of the population’s rights against the other 99%.

“Considering that all these issues have HUGE financial and social ramifications, I keep waiting for you to tell your readers about it…as the media is compliantly silent. Afraid of exercising your rights of free speech? If you wait much longer and you won’t have any.”

The Daily Reckoning