Reverting to the Mean

The Daily Reckoning PRESENTS: Somewhere along the line, the high price of gold fell to its theoretical value, and then overshot on the downside. And that’s where we are now. And now the actual price is 300% below its theoretical value! The Mogambo explores…

REVERTING TO THE MEAN

Troy Schwensen, of The Global Speculator newsletter, has taken a look at the price of gold in Australian dollars versus inflation and interest rates during the 24 years from 1982 to 2006. “We can see that in this period where high interest rates eventually tamed core inflation, the actual price of gold fell below the theoretical value, as people regained confidence in the financial system and interest rates eventually declined. This consequently fueled unprecedented gains in financial assets.”

It’s the next part that gets our attention when he says, “We can see now in 2006 that a massive disconnect again exists between the actual and theoretical prices,” and that the difference this time is that “Actual is just 33% of Theoretical”.

So in trying to understand what is going on, it seems that somewhere along the line, the high price of gold fell to its theoretical value, and then overshot on the downside. And that’s where we are now. And now the actual price is 300% below its theoretical value!

My sensitive Mogambo Investment Opportunity Sensors (MIOS) spring to alert, and an inner voice says, “Hmmm! This reverting to the mean thing seems intriguing to me for some reason! But why? Why? Why?”

Being a real stupid kind of guy, I missed the obvious conclusion that gold will again revert to the mean by going up in price until it reaches its theoretical value. Fortunately, there was a kindergarten class taking a field trip through Mogambo Galactic Headquarters (MGH), and Larry, one of the smart-aleck little kids, saw me laboring over this an said “Hey! Stupid Mogambo Idiot (SMI)! It means gold will rise 300% and then overshoot to the upside, dork!”

My intense gratitude at learning this valuable piece of information directly offset my supreme irritation at being addressed so rudely by a little five-year-old brat that I could have easily beaten up if I wanted to (so watch it punk). Successfully throttling my rage, I ended up letting him off by sticking a “kick me” sign on his back, but he saw me and started running.

I had a big grin on my face and was just starting to take off after him when Larry’s teacher imploringly looked to Mr. Schwensen for help in controlling what appeared to be developing into another Unfortunate Mogambo Incident (UMI), who saved the day by putting it into a pithy nutshell when he went on to say, “Rising interest rates and high levels of debt are obviously not a good combination.”

Immediately spurred to action by his words, I change course, and run out of the door to get more money (probably by begging from total strangers) as my “friends” are all tapped out (so they say, the liars!), and I use the money to buy more gold. But as I am leaving, I stop in my tracks when he says that I may be making a mistake by not begging for money with which to buy platinum instead!

“Hmmm!” I say to myself! “Tell me more!” So they do, and it seems that John Ross Crooks at Money and Markets wrote, “The automotive and jewelry industries account for roughly 80% of annual demand for the metal. These days, about half of the world’s platinum goes into jewelry. Mines in South Africa and Russia account for 90% of the world’s platinum. All told, about five million ounces of the metal get hauled out of the ground annually. In case you’re wondering, that’s nothing compared to annual gold and silver production of 82 million ounces and 547 million ounces, respectively.”

I raise my hand, interrupting to ask, “Now, this is all very interesting, dude, but what is the point of it all to someone who is just interested in making a whole lot of money as fast as he possibly can so he can get out of this stupid town and away from these stupid people?”

Apparently he lives a very sheltered life, and I guess he has never seen a sociopath consumed by raw, naked greed before, but, obviously repulsed, he nonetheless graciously replies, “This year, stocks of platinum are expected to fall short of demand for the eighth year in a row”, which assumes I know how the supply/demand dynamic works. And brother, do I ever!

As if to buttress my case for somehow accumulating a stake in crude oil, Dan Denning, editor of the Australian Daily Reckoning writes, “the IEA released its World Energy Outlook 2006.”

While lengthy, at 596 pages, he says, “You don’t have to read all 596 pages to understand the Outlook’s basic proposition,” which is terrific news for me because I sure as hell wasn’t going to read no stinking 596 pages of anything that is not pornographic and with a lot of steamy pictures, too. He says the summary is simplicity itself: “Demand for energy is growing. Supply is not.”

Now, if you are familiar with the graph of the supply and demand curves and how they equilibrate at some price, then the phrase “Demand for energy is growing. Supply is not” surely caused your budding Mogambo Larval Greed Gland (MLGG) to squish some “avarice hormone” into your bloodstream, and now you are fixated, like a hungry predator upon prey, on what happens to the price of oil when “Demand for energy is growing [and] supply is not.”

And since we buy most of our oil from foreigners, paying a rising price for it is only a part of the problem. A falling dollar is, to use a Real-Life Mogambo Example (RLME), like me going into the convenience store and selecting a candy bar that costs one dollar, but then handing the clerk three quarters and just walking out with the candy.

Immediately, you know something is wrong when he starts yelling at me, and I deny the accusation vehemently, but I don’t know whether it was the peanuts caught between my teeth, or the fact that I had chocolate smeared all over my face and hands, or the fact that I politely explained to him that paying him less money now, is exactly the same as paying him with more money that loses its buying power in the future, but he was surprisingly calm and cool. He even seemed to like it when I explained that we have brilliantly smoothed, real, inflation-adjusted prices across the portals of time! We’re time travelers!

Then I politely and generously explained how this is exactly what we are doing to OPEC and everybody else who will stupidly accept dollars in exchange for something, be it candy bars or oil.

“Sooner or later that dollar is going to be worth 75 cents, you moron!” I explained. “Which I already paid you! So shut your stupid hole, you conceited, greedy jerk! Everybody’s getting screwed over!”

That was when, for some unexplained reason, he decided to get all huffy with me, and started yelling “You stupid xenophobic paranoid nutcase thieving Mogambo pig!”

With my famous rapier-like wit, I replied “Touché, dude! But that does not change the facts of the case – namely that we are paying for oil with a depreciating money, and now I am merely doing the same thing to you with a candy bar, although one is a delicious and chewy confection of caramel, nuts and milk chocolate, while the other is a much better source of energy but tastes like crap! So, what do you want from me, stupid? You want me to drink oil? Is that what you want? Punk!”

Mr. Denning is horrified at this surprising and utterly bizarre chain of events, and he quickly tries to break it up by saying that the report is clearly succinct in that “we are on course for an expensive and dirty energy system that will go from crisis to crisis. It can mean more supply disruptions, meteorological disasters or both. This energy future is not only unsustainable, but it is doomed to failure.”

And don’t embarrass yourself by asking Mr. Denning or me for an example of the price of oil going down “in a crisis.” Asking such a silly question is the sure sign of a rookie.

Until next week,

The Mogambo Guru
for The Daily Reckoning
November 26, 2006

Editor’s Note: Richard Daughty is general partner and COO for Smith Consultant Group, serving the financial and medical communities, and the editor of The Mogambo Guru economic newsletter – an avocational exercise to heap disrespect on those who desperately deserve it.

“Watch the dollar,” we warned on Friday morning. By Friday evening it had dropped to a 20-month low…trading at $1.31 per euro. In gold terms, the number of dollars it took to buy an ounce of gold rose to 640.

Just a few days ago we wondered if we would ever see $600 gold again in our lifetimes. We still wonder…but the odds are increasing that we won’t. Currencies move up and down; but over time, paper-based money goes down more often than up. And all paper money ever invented, up until now, has eventually gone the way of all forms of paper – to the trash bin.

While its money deteriorates, the U.S. economy shows more and more signs of weakness. The yield curve is still inverted, meaning the U.S. treasury can borrow for ten years or more and pay a lower interest rate than it gives to very short-term depositors. This is an unusual thing; why would anyone lend long for less than he would lend short? Risks increase with time. Just look at what has happened to the dollar. In the last hundred years, it lost about 95% of its purchasing power. In the last 20 years, it has been cut in half.

When George W. Bush took up his tasks in the White House, you could still take 270 paper dollars to your coin dealer and exchange them for a one-ounce gold coin. Now, you have to take more than twice as many. And how much did it cost to fill up your car in 2000? We don’t recall exactly, but it was probably less than half what it costs today. And housing…well, there too, your dollars barely buy half the house today that they would have bought in 2000.

And yet, lenders still lend at 5%…6% interest, knowing that they will get dollars of less value back. The longer the term of the loan, the more likely that the dollars they get back with be significantly less valuable than the ones they originally let out.

The whole thing is remarkable. At a 5% nominal interest rate, a lender earns only about 3% after ‘ordinary’ cost-of-living inflation. Plus, depending on his situation, he pays about 2% in income taxes – leaving him actual, after-tax earnings of 1% per year. And yet, each year the dollar could easily lose 1% of its value against other currencies…or against gold…without even making the back pages of a financial newspaper.

In addition to the inverted yield curve, the index of leading indicators has also turned down. And hardly a day goes by without more evidence that housing is in trouble.

“Homebuyers getting cold feet,” is a headline at Netscape news this morning. “Just a year ago they couldn’t wait to sign contracts. Now they can’t wait to get out of them.”

Unless it is some sort of mass illusion, everyone now knows that housing is weak. The homebuilding stocks are down sharply. Inventories are at records. Prices are soft; sellers are offering incentives to try to move the merchandise.

Some super-hot areas – such as Las Vegas – have gone stone cold; whole neighborhoods are said to be ‘ghost towns,’ with For Sale signs in front of empty houses up and down the block.

So far, however, few people expect the slowdown to do much damage. Householders themselves show no sign of panic. From the retail sector comes news that the lumpen continue to spend. Sales on Thanksgiving weekend rose 19% from the year before. Sales on ‘Black Friday’ alone – which marks the beginning of the holiday shopping season – rose 6% over a year ago. Only Wal-Mart bucked the trend, with a tiny decline in same-store sales from the previous year. Householders may be on board the Titanic, but they’re going to enjoy the trip!

This too is remarkable. Since ’02 one of four new jobs has been created in the housing industry. What are those people going to do now that there are fewer nails to pound and less concrete to pour? We don’t know…maybe they’re trading derivatives… more below…

More news from our currency counselor:

————–

Chuck Butler, reporting from the EverBank world currency trading desk…

“Thursday and Friday’s action was ignited by a prevailing thought in the markets that the Fed is finished with rate hikes, and their next move in 2007 will be a rate cut…in contrast to the rest of the world, where interest rates are still moving up.”

For the rest of this story, and for more insights into the currency markets, see today’s issue of The Daily Pfennig

————–

And more thoughts of little consequence…

*** More reports from the New Orleans Investment Conference…

“One of the strongest themes of the conference, reiterated by Jim Rogers, Marc Faber, Frank Holmes and others, was that Asia, and particularly China, is much stronger than some might think,” Justice Litle tells us.

“It isn’t clear that a Western slowdown would hurt Asia, and Faber thinks it might even help. All the cash on emerging market balance sheets puts it in a very strong position, and domestic activity is more robust than typically reported.

“Jim Rogers further pointed out that China could endure a real estate collapse, or even a full-blown economic collapse, and that would not necessarily put a halt to things. He reminded the audience of the Panic of 1907, almost a full century ago. The United States went completely bust back then, yet become the most prosperous country in the world not long after.

“Rogers voiced similar long-term perspective in regard to commodities. All great bull markets endure drawn-out declines from time to time, he reminded us, and should be taken in stride.”

*** Our friend and officemate, James Boric showed up at work today, saying things like “boo-yeah, baby!” and high-fiving everyone. We haven’t seen him this fired up since the last time we threatened to fire him. We asked him what had him in such a tizzy…

“The headline story on investor.com this morning is ‘Wal-Mart Sales Fall,'” James answered.

“Sales at the retail superpower fell 0.1% for the month of November – the worst performance in 10 years. As a result, the stock is down 2% in early trading.

“Big deal.

“I agree that Wal-Mart should be in the headlines, but for drastically different reasons.

“This morning Wal-Mart announced it formed an alliance with Bharti Enterprises Ltd. (India’s leading telecommunications company) to open hundreds of stores in India over the next several years. According to the article on investor.com, “Under the deal, Wal-Mart and Bharti Enterprises will set up a joint venture to manage procurement, inventories and logistics, while stores will be set up under a franchise agreement, said Sunil Bharti Mittal, the chief executive of the Indian company.”

“This is huge!

“India’s retail market is worth about $200 billion right now – and growing about 30% a year. Until recently, though, major retailers like Wal-Mart and Target have not been allowed to tap this massive money pot. India’s government opted to protect the mom and pop businesses owners that make up nearly India’s entire retail sector.

“However, as I have been saying for two years now, in order for India to compete on a global level it must open up its retail to foreign competition. And when India does that, there will be a massive influx of investment spending. Stores will have to be built. Access roads will be carved into the countryside. Pipes will be laid. Wells will be built. And on top of that, salaries and benefits will be paid to thousands and thousands of workers.

“The trickle down effect that Wal-Mart will have in India will be massive. And it’s finally happening.

“Investor.com goes on to report, ‘India’s retail industry is estimated at about $300 billion, and is forecast to grow to $427 billion in 2010 and $637 billion in 2015, according to consultancy Technopak Advisors.

“‘Organized, or branded, retail makes up only 3 percent of the market, compared to China’s 20 percent and Thailand’s 40 percent, but is forecast to rise to 15 to 18 percent by 2011/12.’

“This is only the beginning, dear reader. India’s retail boom will make a lot of investors a lot of money. Of course if you have followed my colleagues and I for the past several years, you’ve already made a fortune.”

[Ed. Note: Indian investment has really been picking up steam lately…if you are still holding onto the picks we gave in our last India Report, you are looking at some very nice returns: 52.49%…46.75%…38%…and 27.50%. Keep your eyes peeled for our next special report…

*** What comes after a trillion? A quadrillion? We may soon find out.

Housing may be the Titanic market…but derivatives could be the iceberg. Trading in these things has become the biggest bubble of all – growing to $480 trillion, face value, or 30 times the size of the U.S. economy. If growth continues at the present rate, in a couple years the derivatives market will be a quadrillion-dollar market.

Other economies put their mathematical whizzes to work on engineering problems – building newer, faster, better technology. But in the U.S. of A., during the Degenerate Empire Period, people who are good with numbers go into derivatives trading. There, they devise marvelously complex Frankensteinian trading instruments, such as the CPDO, the Constant Proportion Debt Obligation. We don’t know what it is, a type of CDS (Credit Default Swap) we guess; but it is completely invented by the mind of man…completely out of nature. Still, it is part of the same evolutionary chain that has brought us such wonders as I.O., Neg Am mortgages, congressional redistricting, and reality TV.

But of all of these monsters…derivatives must be in a special category. Whenever higher math and greater greed come together, there is bound to be entertainment. The quants at big investment firms invent these things…give them a jolt of juice…and then these abominations spring to life. The next thing you know, there are billions…trillions in CPDO and other contracts, many in the hands of buyers who didn’t quite understand the elaborate equations behind the contract; and many – and here we are just guessing – who will be surprised when they find out how the things actually work.

As we understand it, a fellow who is good with figures can devise a way to at least partially protect his own investments. A fellow who is especially sharp can also figure out how to make more money than his slower-moving peers, from time to time. But no financial wizardry…or any complex instrument…can protect a whole market. The more people that climb on board the great ship – $1 trillion might be a small party; $480 trillion must be a crowd – the more un-seaworthy the vessel becomes.

Oh, this is going to be fun, dear reader. We can’t wait to find out what happens.