Ready to Run

Should we care that China has revalued its currency, the yuan, by approximately 2.1%?  And if we should care, in what fashion? Justice Litle explores…

"Global inflation, interest rates, bond yields, house prices, wages, profits and commodity prices are now being increasingly driven by decisions in China. This could be the most profound economic change in the world for at least half a century." – The Economist

"There is great disorder under heaven…the situation is excellent." – Mao Zedong

Is it the tip of the iceberg, or merely a tempest in a teacup? Should we be pleased and relieved by Beijing’s move – as Washington so clearly seemed to be on hearing the news – or should we be worried, fearing what may come next?

Concern is warranted, but there is little point in worrying. The purpose of worry, after all, is to spur some sort of productive action. Global currency movements are complex, but the action to take in response to the yuan revaluation is simple: If you haven’t done so already, buy gold.  Not as a knee-jerk response to a single announcement, of course, but as a calculated and farsighted response to what is coming.

China’s revaluation of the yuan is the equivalent of a hairline fracture in the Hoover Dam. On first glance it appears, to be nothing serious… and yet it is the beginning of something deadly serious. Over time, the hairline fracture will grow. A network of cracks will spread. And the dam itself will eventually burst. We don’t know when the climax will occur, but we do know the endgame has begun.

But why worry, the perma-bulls say. After all, the consumer is getting along famously, the dollar is still the world’s reserve currency and Asian exporters have no better place to stash their cash than Treasury bonds.

The Yuan and Gold: Projecting Trends to Infinity

Before answering the perma-bulls directly, it’s helpful to recall the natural human tendency of projecting trends out to infinity. For a combination of psychological and empirical reasons, it’s the easy thing to do. Thus, real estate investors currently expect house prices to rise for the next decade – and by "decade," they really mean "as far into the future as we can imagine."  Just as ’90s investors expected dot-com stocks to rise ad infinitum, ’80s investors had Japan,  ’70s investors had inflation, ’60s investors had the Nifty Fifty, and so on. The pattern of extrapolation excess appears consistent, going as far back as market history records. Good or bad, if a trend dominates the period for long enough, it is eventually assumed to have no end.  Whether the masses believe in infinite trends or not, they often act as if they do.

This is an odd thing, because market history so clearly teaches the opposite. With very few exceptions, even the longest trends tend to end, often abruptly. Bull and bear markets have life spans, just like people. As do empires.

In May of 1925, Chancellor of the Exchequer Winston Churchill made these closing remarks to Parliament: "If the English pound is not to be the standard everyone knows and can trust…the business not only of the British Empire but of Europe as well might have to be transacted in dollars instead of pound sterling. I think that would be a great misfortune."

Prophetic words. Why did the pound sterling give way to the dollar, and the British Empire to the United States? There are two ways to answer the question.

The first way is to look at 20th-century specifics. World War I devastated Europe and spurred a massive wealth transfer to the United States, with the same dynamics roughly repeated in World War II. Meanwhile, the United States drew strength from a massive influx of immigrants, the rise of industrialization on a grand scale and a powerful advantage in natural resources – with a brilliantly conceived political system and a unifying ideology to hold it all together.

The second way to consider Britain’s fall and America’s rise is within the sweeping context of history. Simply put, the sun was bound to set on the British Empire at some point, for reasons that were bound to come about. Change eventually dislodges incumbents; it was only a matter of time before the order of things shifted. In the same light, predicting an eventual sunset for United States hegemony is not necessarily pessimistic or controversial. The inevitability of change is an idea rooted in long-term historical observation, not moral pronouncement or value judgment.

The Yuan and Gold: One Superpower May Not Replace Another

For all the talk of China’s rise, it is not a given that one superpower will simply be replaced by another, either. It may be that multiple countries come to share the 21st-century world stage, with none gaining a clear and permanent advantage. No one knows exactly how things will unfold. We can say with certainty, though, that the old order of things is passing. Globalization is remaking the world in ways that few expected – and in many ways, these changes are the results of success, not failure. The creation of 2 billion new capitalists (in China and India) is an incredibly positive development in the long run. But in the short run, massive change creates turmoil and upheaval – and the more it is resisted, the more chaos is created in the transition.

This is where the role of gold comes in. But first, a bit of history.

Joseph Schumpeter, of "creative destruction" fame, noted, "Economic progress, in capitalist society, means turmoil." Looking back at the economic and monetary history of the world, or even just the considerably shorter history of the United States, we can see that Schumpeter’s observation is all too true. Historically, long periods of peaceful expansion have been the exception, and turmoil and upheaval more the rule.

Financial crises are far more common than many might expect, and the basic workings of international finance are far older than many might realize. The technology has changed, but it’s the same old game – like toddlers learning to walk, countries and capital markets mature through a series of blunders, bruises and mistakes. For example: in the 19th century, the United States Treasury nearly went broke multiple times. The fledgling superpower was bailed out more than once by bad weather in Europe, allowing U.S. farmers to export their bumper crops in exchange for precious gold reserves.

The 1860s introduced the joys of fiat money, with inflation eroding the value of the greenback more than 60% by the Civil War’s end. In 1890, an emerging market disaster unfolded in Argentina, threatening to bring down Barings Bank, cripple the Bank of England and bankrupt America for good measure (the Yanks pulled through, but it was a close call). The crisis had all the elements we are so familiar with today: speculative boom, hot money withdrawal, international bailout, global backlash. Ironically, the principal players involved – Barings Bank and Argentina – saw fit to revisit their crisis roles a century later (Barings brought down by Nick Leeson in 1995, Argentina by sovereign debt default in 2001). J.P. Morgan was the Alan Greenspan, George Soros and Robert Rubin of his day – probably with more influence than all three men rolled into one.

As for calculated currency movements and mercantilist foreign exchange policies, Europe had been playing the game for centuries by the time the 20th century rolled around. The difference today? Scores are kept with electronic blips on computer screens, rather than gold and silver reserves. And yet, just in case, the gold reserves remain.

In terms of monetary policy, the last century was a gigantic, ongoing experiment (which still continues today). Before and after World War I, belief in the gold standard reigned supreme. Peter Bernstein captures the mood in his excellent (though somewhat critical) book The Power of Gold:

"The international gold standard shimmers from the past like the memory of a lost paradise, embodying all the nostalgia of the Victorian and Edwardian eras – stability, harmony, respectability. The glow attached to this nostalgia is not based in myth but stems from vivid reality. From the end of the American Civil War to the outbreak of World War I – a brief period of only 50 years – the international gold standard acquired a mystique that radiated far beyond the simple discipline that it imposed on its members. The control of gold over the affairs of human beings has never been so absolute, nor the worship of gold by hardheaded financiers and statesmen so humble."

The Yuan and Gold: The Ideas of John Maynard Keynes

It was only with the onset of the Great Depression that the standard-bearers wavered as the ideas of John Maynard Keynes gained traction and persistent hoarding caused gold to lose its glitter. Keynes argued that the traditional gold standard policies of austerity and fiscal rigidity had only made the Depression worse. While political leaders preached of belt tightening and sacrifice for the sake of sound money, Keynes took the opposite tack, urging the government and the people to forget about gold and open their wallets. His "paradox of thrift" explained how actions that are rational for the individual can yet prove devastating to the economy: It is good for families to save rather than spend, but if all families cut back their spending at once, the economy is worse off:

"Suppose we were to stop spending our incomes altogether and were to save the lot. Why, everyone would be out of work…  Therefore, oh patriotic housewives, sally out tomorrow into the streets and go to the wonderful sales which are everywhere advertised. You will do yourselves good – for never were things so cheap…And have the added joy that you are increasing employment…"

What government must do, Keynes further argued, was to act as a counterweight to the business cycle, spending money when times were hard and saving money when times were good. Spending money in hard times, of course, requires running persistent deficits, potentially substantial ones. Such an idea was considered sacrilege at the time.

More than 15,000 banks (!) failed in the four years following the ’29 crash (with the Federal Reserve nowhere in sight). An environment like this naturally encouraged more hoarding of the yellow metal, with seemingly no safe place to put the last of one’s money. Into the breech stepped the recently elected President Roosevelt.  Public surrender of all gold and silver was required, in exchange for paper notes, as declared by the Emergency Banking Act of 1933. (It is hard, if not impossible, to imagine such a brazen act being pulled off today.) FDR then took the apostasy further by declaring the right to adjust the dollar/ gold ratio as he saw fit, prompting at least one fiscal observer to declare "the end of Western civilization."

But Western civilization kept plugging along, and after a managed creep upward, the price of gold was fixed at $35 per ounce in 1934. There it stayed for almost four decades, through the Second World War, the establishment of Bretton Woods, the challenge of De Gaulle and the rise of Keynesian policy. Indeed, around the time Nixon finally shut the gold window in 1971, he uttered frighteningly appropriate words: "We are all Keynesians now."


Justice Litle
for The Daily Reckoning

September 08, 2005

Justice Litle is an editor of Outstanding Investments. He has worked with soybean farmers, cattle ranchers, energy consultants, currency hedgers, scrap metal dealers and everything in between, including multiple hedge funds. Mr. Litle also acted as head trader for a private equity partnership, and made contributions to Trend Following: How Great Traders Make Millions in Up or Down Markets, a popular trading book by Mike Covel (FT/Prentice Hall)

Justice Litle is also a member of an elite group that meets occasionally to debate and discuss the new trends in the financial world and investment ideas – among other things. This monthly gathering includes the cream of the crop of financial minds – and for a limited time, you can attend the Agora Financial Reserve meetings.

"We are only three meals from anarchy," said Henry at the dinner table last night, fresh from his new school, and quoting a French cynic.

When a disaster has not occurred for a while, people think it will never happen. After it comes, they expect another one every day. That is why stocks tend to droop after a long bear market and often puff themselves into a bubble after a multi-year boom. When the ground has been dry for a long time, they turn up their noses at dikes and hip boots and rush to buy insurance right after a 100-year flood.

(More about the soggy delta below…)

When a country has had a few good wars, it is eager for more. After it has been on the losing side a few times, it longs for peace.

Markets make opinions, in other words.

What we do here at The Daily Reckoning is look at opinions in order to figure out the major trends in markets. Stock buyers are very bullish. Property buyers are extremely bullish. Ergo, the markets are near a top.
As an example of how bullish investors are we turn to page 65 of the Economist.

There we find a picture of Martha Stewart along with a chart of her share price. We note that the price has gone up during her stay in prison. But what is really remarkable is that it went up so high – to a level that makes Martha Stewart Living Omnimedia’s P/E ratio four times as high as Google.

The company has been losing money for the last three years. Next year, it may earn a paltry $10 million. At the current price, the company is thought to be worth 160 times those hoped-for earnings.

We are not speculators, but we have spent the last quarter of a century in the publishing business. It is not an easy business and not one that forgives mistakes. This is almost too much to resist: Sell Martha Stewart, dear reader, sell.

"All share analysis is based on a flawed concept," once explained our friend James Ferguson. The flaw is that prices are considered correct. The market is thought to know much more than any individual. So, if you take a view contrary to the market – that is, if you think the price is too high or too low – you are wrong.

When analysts try to figure out where a stock will go, they begin with the premise that the current price is now where it ought to be. The question is: How will it react to future events?

But if the share has already reacted to past events in a faulty way, such as investor’s eagerness to buy Martha Stewart just because the woman was behind bars and in the news, they have no solid point of departure. It is like trying to plot a course at sea without knowing where you are in the first place.

It is a waste of time to try to figure out where a stock will go…or even where the entire market will go. The best you can do is to try to figure out where it ought to be; sooner or later, it will be there.

Martha Stewart ought to be under $10. Sell.

More news, from our team at The Rude Awakening:


Eric Fry, reporting from Wall Street…

"All last week, while Katrina was visiting misery on hundreds of thousands of Gulf Coast residents, she was also lavishing riches on hundreds of thousands of investors."


Bill Bonner, with more views:

*** The ideal investment for Joe Blo investor – options.

In short, options are the right to buy or sell a particular commodity or stock at a certain price for a limited amount of time.

The ‘call’ option gives the holder the right to buy the underlying security, while the ‘put’ option gives the holder the right to sell it.  And the price at which the commodity or stock may be bought or sold is called the ‘strike price’.  The ‘expiration date’ refers to the date the underlying commodity or stock has to reach or exceed the strike price.

With that, the real important factor to recognize with options is the amazing leverage they offer.

*** What’s this? The median price of a house fell in July by 7.2 percent, says Steve Sjuggerud. No one has noticed, but the bubble may have popped, says the article on Houses are down 14 percent since April. Housing stocks fell 10 percent last month.

*** "End of the bubble is nigh," adds Bill Gross of PIMCO. Get rid of stocks, real estate, corporate and junk bonds, he says.

*** The more we read about the New Orleans disaster, the more curious we become. How could so many people drown when there were so many houses, office buildings, trees, over-passes, bars and brothels high and dry?

On the cover of The Economist is a photo of the city underwater. Yet, no further than 20 feet in any direction is something above water, including entire stretches of elevated highway and the entire downtown area. The French Quarter was dry, we are told. There were even bars open.

We have also read reports of the lawlessness and despair at the convention center. Some people were so fed up with it, they got in a taxi and left! One wonders why more people didn’t leave. Or why entrepreneurs did not swing into action, offering bottles of Perrier and open-heart surgery…or trips out of town?

Everyone complains about the incompetence of government officials, but where were America’s dynamic risk takers?

The answer, most likely, is that they saw no profit in it. As near as we can tell from the press reports, those who suffered most were those who had come to count on the empire’s ‘panem et circenses’ – bread and circuses – in the homeland. When the system failed, they were in trouble. They could not afford the cost of their own rescue or they were too shiftless to figure out how to save themselves. Those are the people for whom God and good people down the street usually look out. Too bad government officials had shouldered them both out of the neighborhood.

The trouble with empires, dear reader, is that both the panem et circenses and the foreign wars are expensive. Eventually, the empire runs out of money and its programs fail. And then people face a disaster – military, social, economic…or all of them combined.

And then come the regrets and recriminations. The liberal media thinks it finally has found a club with which to beat on the Bush administration. Silent when the United States entered a preposterous war against Iraq; silent as the administration turned a $300 billion surplus into a $400 billion deficit – the president has never vetoed a single spending bill, even a health care boondoggle that is estimated to cost the nation $700 billion over the next 10 years – and now the Democrat hacks yelp and howl! Yes, the president made a mess of the War on Terror overseas, now he has made a mess of the war against wave and weather at home.

Poor George. He that did ride so high doth lie so low…! He escaped blame for two of the biggest stupidities ever committed by an American president…only to be tagged for failing to react adequately to a hurricane.

The Daily Reckoning