Fighting the Little Devils in Front of Us
“There is no means of avoiding the final collapse of a boom brought about by credit (debt) expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt) expansion, or later as a final and total catastrophe of the currency system involved.”
– Ludwig von Mises
Read it and weep.
Von Mises was saying that there is no escape. There is no magic elixir…no panacea…no free lunch. When you borrow money, you have to pay it back. End of story.
The borrowing phase – a credit expansion – is pleasant enough. You feel rich…and smart. You have money to spend. Your assets go up in price. Your stock rises. You even think you’ve discovered some miracle formula – some way to get rich without working or saving. It’s as simple as buying a house. Then, it goes up in price. So buy another one…or two or three of them.
And then, alas, along comes the day when you have to pay back the money you’ve borrowed – the credit contraction. Now, you don’t feel so smart. Because, when everyone is trying to pay down debt, no one has money to bid up asset prices. Your house actually falls in price…and you desperately try to get rid of those extra houses, hoping to get back what you have in them.
Yesterday, the Dow fell 277 points. It is a bear market, dear reader. That’s what stock markets do in a credit contraction. Assets, generally, become cheaper.
“Home sales dive” in South California, comes another report. Sales are off 42% from a year ago. Prices are down more than 10%. And it won’t end there…
Even the slicks on Wall Street are having trouble. The expansion stage of the credit cycle was pure molasses to them. But the contraction stage is bitter medicine. Today’s International Herald Tribune tells us that Citigroup (NYSE:C) has turned to the moneybags in Singapore for a $22 billion bailout. Over at Merrill Lynch (NYSE:MER), they already hit up the Singaporeans for $6.2 billion in December. They’re writing down some $8.4 billion in subprime debt, creating the biggest loss in the firm’s 93-year history. This month, they turned to Korea and Japan to fill a $6.6 billion hole.
Why go to Asia to raise money? Because that’s where the money is.
“Asians have trillions in dollar reserves,” Lord Rees Mogg explained over lunch yesterday. “They probably think they have enough of our money. Over the next few years, it looks as though the Western currencies…and Western economies…are going to be in trouble.”
As reported here yesterday, retail sector is showing signs of slower consumer buying. Even the luxury outlets – such as Tiffany and Ralph Lauren – have seen their stocks cut 20% to 50%.
What can be done about it?
As von Mises describes, above, the only alternatives are to stop the process of credit creation voluntarily…or to continue to a “final and total catastrophe of the currency system.”
In the late ’70s, the Fed chose to abandon further credit creation. It was obvious that more money and credit was making consumer prices rise without causing genuine economic growth.
Now, three decades later, consumer inflation rates are still tolerable. It’s the threat of recession that seems insupportable. And so, between sooner or later, the choice is clearly – later. Better to try to fight the little devil in front of us, they say; let someone else worry about that big devil Beelzebub.
Word on the street is that the Fed may act before its regularly-scheduled meeting later this month…and it may cut rates by a whopping 0.75%. Whether or not it will actually be able to stop the correction now in progress, we don’t know. But our Trade of the Decade just looks better and better. Buy gold on dips; sell stocks on rallies.
The feds can control only the quantity of paper money or the quality of it. If they lean down hard on the quantity side, pushing trillions of dollars worth of new cash and credit into the system in order to try to avoid a serious recession, the quality of the money will suffer. The Asians will be more eager than ever to dump the dollar; the greenback will fall…and gold will soar.
If, in the unlikely event that they were to voluntarily give up on credit expansion, reducing the quantity of dollars in order to protect the quality, they may be able to stop gold’s rise. In that case, a sharp recession would mean falling share prices. This is the trick that Paul Volcker pulled off in the early ’80s. The price of gold collapsed…and stocks took off. But not before he had pushed up short-term lending rates to 20%…and drove the economy into its worst recession since the ’30s…and knocked down stocks so low you could buy the entire Dow for the price of one ounce of gold.
No matter what happens, we’ve got a long way to go before we reach that kind of turnaround point. And most likely – given the situation – it won’t come at all until we’ve been through Von Mises’ “crack-up” – the final and total catastrophe of the currency system.
*** The European Central Bank is being cagey. Recently, Jean-Claude Trichet tried to explain himself. We do not have the same mandate as the U.S. Fed, he put forth. The Fed is meant to do two things at once – protect the value of the dollar…and maintain a healthy, prosperous economy. Our mission at the ECB, he went on, is merely to protect the value of the currency.
Accordingly, the ECB has been reluctant to cut rates in order to help the economy. And consequently, the euro (EUR) has gone up against the dollar…and the pound.
In today’s news, the ECB warns that the U.S. Fed may not be able to continue cutting rates: “crashing dollar may stop Fed cuts,” says the headline.
Against gold and oil, the dollar has already crashed. You could buy an ounce of gold for just over $260 when George W. Bush first began using the White House toilet on a regular basis. That was not quite seven years ago. As of yesterday, you’d pay $902 for an ounce. Against gold, the buck has lost 60% of its value in less than two presidential terms. Against oil, it has taken a similar shellacking. Even against the euro – Europe’s Esperanto money – the greenback has been cut in half, more or less, over the same period of time.
And now the whole world is wise to America’s game. When the voters feel pinched, the feds give them more money. But the money they give them competes for value directly with the dollars the foreigners have saved. The Asians, for example, sweat and save…and stick the dollars in their vaults. Now, they have trillions of them. But they wake up every morning and find their dollars are losing value. One day, a dollar buys one 800th of an ounce of gold. A few days later, it will only bring one 900th. One week, a dollar will buy one 90th of a barrel of oil. The next week, a barrel of oil costs $100.
So the ECB feels it is only fair to give warning. ‘Don’t expect us to keep protecting the quality of your money. If you keep putting it out, we’re going to sell it.’
Trichet is right about the theory. But he is probably wrong about the practice. Property prices on the fringe of Europe – in Ireland and Spain, notably – are falling faster than those in the United States. It won’t be long before the squeals of pain – in various foreign languages – reach the ECB too.
Spain and Ireland benefited hugely from the European Union. Suddenly, the Irish and the Spanish were able to borrow money at rates set by the Germans. They were low rates – the kind of rates the Germans, with the financial discipline and economic rigor, deserved. When such rates were on tap in Ireland, it set the whole country into major boom. Everyone wanted to buy property. And after a decade, Irish property was the most expensive in Europe…and the Irish, improbably, were Europe’s richest people. In Spain, the circumstances were different. But the effect was the same – Spain enjoyed a boom of the sort not seen in Iberia since the galleons came back from the New World with Inca gold.
But now what? Irish houses fell about 10% last year. We don’t have figures on Spanish property prices, but word on the Costa del Sol is that they are falling…and so are the shares of the large builders who have been putting up apartments at a furious pace for the last 10 years. And the editors of International Living magazine tell me that they’re preparing a special feature article on Spanish real estate prices in the next issue. “If you’re looking for bargains,” they say, “that’s the place to look.”
What will Trichet do in the face of such America-like problems? Will he hold fast to his principles and refuse to cut rates? Or will he take a page of the Alan Greenspan Manual of Successful Central Banking and fall into line with his counterparts in Washington and London? Like them, will he favor the quantity side of the balance…and let the quality go to Hell?
We don’t know. And we’d still rather hold euros than dollars…but the rate of increase in the European money supply is not much different from that of the dollar – about three or four times GDP increases. We prefer the yen to the euro…and the euro to the dollar…and the dollar to the pound…but we’d rather hold gold than any of them.
The Daily Reckoning
Wednesday, January 16, 2008
P.S. And while we realize that the price of gold is higher than we usually recommend you buy at, there is a way that you can get the yellow metal for just one penny per ounce – no joke.
The Daily Reckoning PRESENTS: We all know about the credit crisis, the Treasury’s bailout plan, and the Fed’s determination to cut interest rates in order to support asset markets and the economy, but it is extremely difficult – if not impossible – to quantify the problem and the effectiveness of the government’s intervention in the market economy. Dr. Marc Faber explores…
UNCHARTED ECONOMIC WATERS
by Dr. Marc Faber
I must confess that I have no idea whether the US stock market will be higher or lower in a year’s time. I sometimes recall these words of Lao Tzu, the sixth-century Chinese poet:
“Those who have knowledge, don’t predict. Those who predict, don’t have knowledge.”
The problem that confronts investors was best summarized by Albert Einstein, who said: “Not everything that counts can be counted, and not everything that can be counted counts.” We all know about the credit crisis, the Treasury’s bailout plan, and the Fed’s determination to cut interest rates in order to support asset markets and the economy, but it is extremely difficult – if not impossible – to quantify the problem and the effectiveness of the government’s intervention in the market economy.
At the same time, we have a number of relatively reliable statistics – such as railcar loadings, the trucking index, the number of inbound containers, etc. – which indicate, if not a recession, then little economic growth. However, although all these indicators have a weakening trend and point to considerable economic slowdown, or even to a recession, they may have little or no impact on the performance of the stock market.
Peter L. Bernstein, the wise 88-year-young economist and strategist (author of five books in the last 15 years and of the excellent, but demanding, Economics & Portfolio Strategy report), explains in a piece entitled “Uncharted Territories” that “the current scene bears no resemblance to a typical economic peak or to the conditions usually preceding a slowdown in business activity. Those kinds of conditions feature excesses in the business sector, but the business sector at the present time has a relatively clean bill of health… There are no signs of the usual boom in capital spending that leads to a cyclical top and leaves an overhang of capacity. Growth of industrial capacity over the past five years has been a meager 0.8% a year. This piddling rate of expansion is a sharp contrast to the 4.2% annual growth rate in capacity during the 1990s or to the 2.7% rate from 1949 to 1969.”
Peter further points out that there has not been an unusually strong accumulation of inventories; that there has been an absence of sharply rising interest rates, which in the past preceded recessions; and that there has been an absence of “strains in the resources of the system, such as high levels of capacity utilization and low unemployment”. (Peter Bernstein has developed a “Strain Indicator”, which indicated the problems we had in the 1970s, the over-optimism prior to the 1987 crash, and a clear peak prior to the end of the high-tech boom in 1999. However, this indicator “has been declining since mid 2006 and stands nowhere near where it has been at earlier business cycle highs”.)
But Peter Bernstein isn’t optimistic about the economy. In asking himself the questions “what is going to happen next?” and “what is the outlook?”, he explains: “[T]hese questions are never easy, but they are more difficult than usual this time around. The experience is not only inexplicable. It provides no antecedents to guide us.”
In referring to some of the unique features in the current scene – mentioned briefly above – Peter opines:
“[W]e are unable to choose which among them is most important, but we believe the key problem is not in the financial sector. Rather the basic difficulty is the impact of these financial shenanigans on households. The deflation in home prices is not only unsettling to homeowners; it has in effect removed a crucial part of the consumer’s piggy bank. Home equity is no longer a source to finance consumer spending. This development is unsettling in its own right, but it is only a reminder to homeowners that their major asset is in deep trouble and is not likely to improve any time in the foreseeable future. If we are correct in placing primary emphasis on the problem faced by households, the economic malaise will not be brief, even though its depth is uncertain. The process is going to be like water torture – drip by drip over an extended period of time until all these excesses are squeezed out of the system and new and happier horizons can open up.”
The author Dave Wilbur has said: “One of the world’s greatest problems is the impossibility of any person searching for the truth on any subject when they believe they already have it.”
Similarly, Peter Bernstein concludes his report with the observation that “there is a lesson here so obvious we hesitate to set it forth. History shows even the most knowledgeable people forget this lesson over and over again. We do not know what the future holds. Once we begin to make major and unhedged decisions on the assumption we do know what the future holds, we will have passed the inflection point on the road to disaster.”
During the Battle of Britain, in the Second World War, a saying went the rounds of the Royal Air Force: “There are old pilots and there are bold pilots, but there are no old, bold pilots.” Therefore, as we move into 2008, I would rather err on the side of caution in terms of taking large onesided and leveraged positions in any asset market, individual stock, or sector. As Peter Bernstein has argued, we are indeed in uncharted waters and economic and financial history provides us with only an incomplete and outdated set of signposts to go by.
While I generally accept that obstacles provide opportunities, at the same time I feel, at least for now, that it may be better to be prepared for a great buying or selling opportunity and not have one for some time, than to have a very unusual opportunity, such as occurred after the Asian economic and financial meltdown in 1997/98, and not to be prepared. My advice is therefore, as mentioned in recent reports, to hold an above-average cash position in US dollars and to lighten up on high, and especially leveraged, asset positions during rallies.
Nevertheless, I recognise that some investors feel they must have an exposure to financial assets, and so I should like to offer here three investment opportunities that, at least on a relative basis, would seem to have some appeal. In this letter on various occasions I have discussed agriculture as an investment theme. I believe that agricultural commodities will – albeit erratically and amidst high volatility – continue to increase in price. Larry Hatheway, an economist at UBS, believes that “a shift in relative food prices owing to rising Chinese or Indian affluence is likely to manifest itself as an increase in food prices for industrialized economies. This is because the food groups most favoured by more affluent developed economies will tend to become mainstays of food consumption in the faster growing economies of Asia.”
In addition, UBS points out that shifting demand patterns will create opportunities in global trade and production. As an example, demand for sugar from China is expected to surge in the next decade. In fact, as indicated in previous reports, I consider that sugar prices are relatively low following their correction, and currently offer a favourable entry point. My friend Mac Overton alerted me to the fact that sugar prices are down 21.5% over the past two years, whereas wheat is up 185%, corn is up 105%, soybeans are up 93%, and cotton is up 18.3%. So, at least in relative terms, sugar is very inexpensive. Mac also notes that, “while not totally inter-changeable, I suspect that many farmers, especially in the southern US and Brazil, have an option of what to plant. I’m betting that they plant more acres of wheat, corn and soybeans next year and less of cotton and sugar. If the area in which they plant allows it, they’d be crazy to do otherwise at current prices….”
Jonathan Anderson, a UBS economist with a special interest in China, pointed out in an earlier report that whereas China’s state procurement system maintains precautionary stocks for large-scale durable agricultural products such as wheat, rice, corn, coarse grains, cotton, etc., “ending stocks dropped sharply between 2003 and 2005 across all grain categories as state boards were forced to sell down to prevent overly aggressive price increases. Since then grain stocks have stabilized, but they are not rising, and remain at very low levels by Chinese historical standards”. Ritesh Menon, of DBS Bank in Singapore, also reminded me that arable land per capita in China and India is only 18% and 26% of US levels, respectively: “Environmental degradation is further reducing available land supply; soil erosion occurs in 2/3 of China’s agricultural land (largely due to heavy fertilizer use), which undermines the longterm sustainability of agricultural production. Furthermore, water scarcity will be increasingly problematic.
First, water availability is relatively scarce in China (water resources per capita are 25% of the world average). Second, water pollution is widespread, with 44% of Chinese rivers classified as polluted. Third, the demand for water increases dramatically as meat consumption increases. The net result of the above two phenomena is dangerously low inventories of agricultural products”. In his report dated September 28, 2007, Larry Hatheway said that, “rising food prices will tend to have a disproportionate impact on real purchasing power of lower income groups. This is because lower income groups spend a higher proportion of their income on food. Furthermore, lower income groups spend proportionally more on food items that have a lower fraction of labour and a higher fraction of commodity inputs in the final price.
Hence, rising commodity prices hit lower income groups hardest.” As can be seen from, more than 95% of American households spend more than 20% of their income on food – excluding alcohol, which is now also increasing in price. But then consider, which shows the CPI food weights for different countries. If you compare how much of their income (over 20%) most American families spend on food with the CPI Food Weight, it is obvious that the CPI, as calculated by the US Bureau of Labor Statistics (BLS), grossly understates the true rate of inflation by underweighting food, which has lately been rising at an annual rate of more than 10%!
This really reinforces my view that the BLS publishes totally bogus inflation figures and that, even worse, Mr. Bernanke relies on these figures for his monetary policies….
Tom McClellan, editor of The McClellan Market Report ( firstname.lastname@example.org), calls the CPI “the World Office of Obfuscation Price Index (WOOPI)”. I am certainly not an accomplished statistician, but I can’t help shaking my head in disbelief that the government gets away with this distortion of hard economic facts, which is also leading to a gross overstatement of real economic growth data (real GDP) and of real retail sales in the US.
I believe, as mentioned in earlier reports, that we are already in stagflation: no real economic growth – or recession – amidst inflation, which the Ministry of Truth understates in order not to depress the population further. My South African friend Faisal Kalla, who has previously described for this report how grocery prices in that country have increased this year (he should know, since he is a grocery wholesaler), recently sent me the following email:
“Something very strange is happening in South Africa. The Christmas season has started early for us. Our trade is mostly groceries and related items. There seems to be a shortage of products from most companies. We are battling to get supplies of food products such as sugar, baked beans and staples. Also the price increases do not stop. Yesterday, the manufacturer of body creams said the price will go up 9%. On the converse, furniture, automobiles and real estate are suffering, especially autos whose price devaluation is ferocious. Real estate is also suffering but at a slower pace. The delusion is still alive…”
Well, what is happening in South Africa is representative of what is happening everywhere in the world. Grocery sales are up because of price increases, whereas sales of discretionary items are either down or sluggish because household incomes are being squeezed by cost-of-living increases and declining home prices.
In the US, the November Producer Price Index increased by 7.2% year-on-year, which will lead to higher consumer prices and inflation, or pressure on corporate profit margins, or both.
for The Daily Reckoning
Wednesday, January 16, 2008
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.
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.