June - 2009 Economic Brief

Investments soar as investors ignore the economy!

The economy sank at an annual rate of -6.1 percent in the first three months of 2009 ... after plunging -6.3 percent the previous quarter — that's the WORST back-to-back contraction in 50 YEARS.

Yale professor Robert Shiller looks at a 10-year trend in "normalized" earnings for the S&P 500 Index, after adjusting for inflation. In March, his normalized P/E ratio fell to 13, its lowest level since 1986! But wait, that still isn't dirt-cheap.
That's because, at the end of previous secular bear markets in the 1940s, 1970s, and early 1980s the normalized P/E ratio frequently fell below 10 ... sometimes even lower.

After the market's nine-week rebound rally, the normalized P/E ratio is back up to 15.6 today ... that's close to its historical average, but again it's certainly not cheap.

Don't lose sight of the severity of this economic crisis. The recession is currently in its 17th month. Already, it's the longest recession since WWII — even worse than the previous record holders — the recessions in 1973-75, and 1981-82.

GDP already fell at an annual rate of -6.1 percent last quarter alone! The previous record decline was -1.9 percent in 1982.

The consumer economy's apparent strength is misleading because it is fueled by lower taxes and transfer payments from the government. And yet the market has been on a tear with the S&P 500 climbing to old highs, and guess -- just guess -- where the bulk of those gains have come from? Why, from financial stocks, of course, go figure…

If a bank is earning a positive interest spread, it's making money. It's as simple as that.

And right now, the banking industry in general is earning interest spreads so wide, they're close to breaking all-time highs due to the government’s help!

Keep in mind that during America's first Great Depression, stocks staged rallies of +25 percent to +30 percent on four different occasions, but with each rally attempt coming from a lower level, while the overall market trend continued to spiral downward.

Our apparent willingness to prop them up into perpetuity has yet to be seriously challenged, which explains the financials rally. Rumors of profitability have been greatly exaggerated (thanks in part to mark-to-dream-on accounting), but when the U.S. taxpayer is your compulsory patron, it is, as the kids used to say, all good.

However, the rally appears to be overdone. Most of it is built on the banks beginning to rebound with the government’s help. That’s absurd.
The last I checked, the same problems that are at the core of the crisis not only still exist, but are worsening...

 Consumers have purged 20 percent of their net worth since the second quarter of 2007, in addition to the biggest decline in consumer credit ever recorded, a decline of 80 percent! This represents a massive contraction of bank loans and credit, sabotaging attempts to revive credit flows and stimulate the economy.
Reason: These banks must build capital quickly, and the only realistic way to do so is by cutting back on their lending.

 The housing market, which fueled the crisis, is still printing new lows and foreclosure rates are still rising aggressively. About 22% of homeowners carry mortgage balances that are greater than their houses are worth. Home foreclosure filings skyrocketed 32 percent to a new all-time record high in April, making the March-April period the worst two-month surge in foreclosures ever with a record 682,000 homeowners receiving notices.

The big picture: Housing starts, the best measure of the industry's health, peaked at an annual pace of 2.3 million units in early 2006.
Now, they're running at barely more than a 0.5 million units.
That's a decline of 77.6 percent — three-quarters of America's largest single industry wiped out.

Following on the heels of the subprime debacle, a huge wave of Alt-A and option-ARM resets are in the pipeline. They will soon start showing up as huge credit losses. We are not even one-third of the $3.8 trillion of total losses thought to occur across all mortgage types including commercial. So there's more than twice as much pain ahead as behind. Ouch.

 Unemployment is still rising, during April, joblessness in the U.S. likely reached its highest level in 25 years, economists said. For the fifth consecutive month, employers slashed 600,000 or more jobs, bringing the unemployment rate to 8.9%, 23 million people. Who is going to pay for social security and Medicare?

 The problem, of course, is that we have fewer people working and paying taxes while the cost of providing benefits is skyrocketing. Meanwhile, politicians keep TALKING about solving this problem somehow. Yet they aren't actually DOING anything. Republicans. Democrats. It doesn't matter. They're all complicit!

 While our trade balance has swung from a massive deficit to a smaller deficit over the past seven months, it hasn't been because of stellar exports. Rather, it's been because our imports are plunging,

 Chrysler and GM filled for bankruptcy, data released recently showed U.S. auto sales fell nearly 34 per cent in May from a year earlier and car manufacturing consumes around half the global supply of metals,

 US Treasury approves capital infusions for six insurers – (told you so),

 So far, 32 banks have failed since January 1, more than the 25 that failed in all of 2008,

 The combined monetary and fiscal stimulus to combat the recession, the banking crisis and all the other aftermaths of the burst bubble already add up to 30 percent of Gross Domestic Product.

That's a new record by a HUGE margin:

• In 1974 it was 4 percent
• In 1982 it was 2.8 percent
• And in 2001 this figure was 7.2 percent

And time is passing — which makes all of the aforementioned problems dramatically more threatening.

Here is the situation:
The facts:

• Congress cannot raise taxes without sinking the economy even faster.

• The Treasury can't borrow the money without driving interest rates through the roof for everyone.

• And the Federal Reserve can't print the money without destroying global confidence in the U.S. dollar and credit markets, gutting the economy even more.

“The explosive rise of the U.S. budget deficit and debt burden will lead to serious inflation down the road”, “A country that continuously expands its debt as a percentage of GDP and raises much of the money abroad to finance that, at some point, it’s going to inflate its way out of the burden of that debt,” and “Every country that has denominated its debt in its own currency and has found itself with uncomfortable amounts of debt relative to the rest of the world, in the end they inflate,” says billionaire and Obama supporter Warren Buffett.

• While the S&P 500 is up for the year, only three of its ten sectors are in positive territory. The Technology and Materials sectors are up the most at 19.4% and 18.5%, while Consumer Discretionary has been the third best at +11.3%...

• A strange thing happened this year, for the first time since 1983, the Treasury ran a DEFICIT in April, a huge shift from a year earlier, when Treasury recorded a SURPLUS of $159.3 billion, so, we've ALREADY dug a budget hole that's more than five times as deep as the one in 2008!.

Each of these — singly or in combination — will sabotage the same bailouts they're seeking to finance.


Let’s talk about gold and money supply:

The U.S. government has learned from experience and has taken Volcker's advice. Given the U.S. dollar's role as the world's reserve currency, the U.S. government has the most to lose if the market chooses gold over US currency and erodes the government's stranglehold on the monopolistic privilege it has awarded to itself of creating "money."

So the U.S. government intervenes in the gold market to make the dollar look worthy of being the world's reserve currency when of course it is not equal to the demands of that esteemed role. The U.S. government does this by trying to keep the gold price low, but this is an impossible task.

For example, until the end of the 19th century, approximately 40 percent of the world's money supply consisted of gold, and the remaining 60 percent was national currency. As governments began to usurp the money-issuing privilege and intentionally diminish gold's role, the US currency's role expanded by the mid-20th century to approximately 90 percent. The inflationary policies of the 1960s, particularly in the United States, further eroded gold's role to 2 percent by the time the last remnants of the gold standard were abandoned in 1971.

So how does the U.S. government manage the gold price?
They recruit Goldman Sachs, JP Morgan Chase, and Deutsche Bank to do it, by executing trades to pursue the U.S. government's aims.

How did the gold cartel come about?

There was an abrupt change in government policy around 1990. It was introduced by then-Federal Reserve Chairman Alan Greenspan to bail out the banks back then, which, as now, were insolvent. Taxpayers were already on the hook for hundreds of billions of dollars to bail out the collapsed "savings and loan" industry, so adding to this tax burden was untenable. Greenspan therefore came up with an alternative.

Banks could generate the needed profits through the Federal Reserve's steepening of the yield curve, which kept long-term interest rates relatively high while lowering short-term rates. To earn this wide spread, banks leveraged themselves to borrow short-term and use the proceeds to buy long-term paper. This mismatch of assets and liabilities became known as the carry trade.

The Japanese yen was a particular favorite to borrow. The Japanese stock market had crashed in 1990 and the Bank of Japan was pursuing a zero-interest-rate policy to try reviving the Japanese economy. A U.S. bank could borrow Japanese yen for 0.2 percent and buy U.S. T-notes yielding more than 8 percent, pocketing the spread, which did wonders for bank profits and rebuilding the bank capital base.
And right now, the banking industry in general is earning interest spreads so wide, they're close to breaking all-time highs.

Right now, the spread between the two-year note and the 10-year note is 2.32%. The spread has only been higher than this three other times in American history. In 1992, it reached 2.65% and in 2003, it set an all-time high at 2.74%. Finally, last November, it peaked at 2.61%.

In other words, right now, with the yield curve at 2.32%, the banking industry is earning record interest income. Take Bank of America as an example. It takes money in from depositors. Depositors can get their money back whenever they want. If the bank does tie their money up, it's usually for less than a year. These depositors receive the lowest interest rates in the market. I just checked at my local branch, and right now Bank of America pays 1.9% on a one-year CD.

The carry trade was a gift to the banks from the Federal Reserve, and all was well provided that the yen and gold did not rise against the dollar, because this mismatch of dollar assets and yen or gold liabilities was not hedged. Alas, both gold and the yen began to strengthen, which, if allowed to rise high enough, would force marked-to-market losses on those carry-trade positions in the banks. It was a major problem because the losses of the banks could be considerable, given the magnitude of the carry trade.

So the gold cartel was created to manage the gold price, and all went well at first, given the help it received from the Bank of England in 1999 to sell half of its gold holdings. Gold was driven to historic lows, as noted above, but this low gold price created its own problem. Gold became so unbelievably cheap that value hunters around the world recognized the exceptional opportunity it offered and demand for physical gold began to climb.

As demand rose, another more intractable and unforeseen problem arose for the gold cartel.

The gold borrowed from the central banks had been melted down and turned into coins, small bars, and monetary jewelry that were acquired by countless individuals around the world. This gold was now in "strong hands," and these gold owners would part with it only at a much higher price. So where would the gold come from to repay the central banks?

In short, the banks were in a predicament. The Federal Reserve's policies were debasing the dollar, and the "canary in the coal mine" was warning of the loss of purchasing power. So Greenspan's policy of using interventions in the market to bail out banks morphed yet again.

The gold borrowed from central banks would not be repaid after all, because obtaining the physical gold to repay the loans would cause the gold price to soar. So beginning this decade, the gold cartel would conduct the government's managed retreat, allowing the gold price to move generally higher in the hope that, basically, people wouldn't notice. Given gold's "canary in a coal mine" function, a rising gold price creates demand for gold, and a rapidly rising gold price would worsen the marked-to-market losses of the gold cartel.

So the objective is to allow the gold price to rise around 15 percent per year while enabling the gold cartel members to intervene in the gold market with implicit government backing in order to earn profits to offset the growing losses on their gold liabilities. The gold cartel's trading strategy to accomplish this task is clear. The gold cartel reverse-engineers the black-box trend-following trading models.

Just look at the losses taken by some of the major commodity trading managers on their gold trading over the last decade. It is hundreds of millions of dollars of client money lost, and the same amount gained for the gold cartel to help offset their losses from the gold carry trade -- all to make the dollar look good by keeping the gold price lower than it should be and would be if it were allowed to trade in a market unfettered by government intervention.

As I see it there are only two outcomes. Either the gold cartel will fail or the U.S. government will have destroyed what remains of the free market in America.

Total demand for gold in Q1 ’09 rose 38 percent year on year.

One measure of inflation- the Consumer Price Index (CPI) has recently turned positive. Deflation is out—Inflation is starting.

There are a lot of reasons why investors and institutions buy gold. It has no counterparty risk. It’s the premier hedge against inflation. And it’s a safe haven in a sea of financial and political turmoil.

But there is really only one reason why the price is going up… because the demand for the metal is significantly outpacing the supply.

Besides scrap gold and individuals selling their holdings into the market, the other primary source of supply are sales of bullion from the holdings of central banks. For a number of years, central bank sales and leasing have accounted for about 1,500 metric tons per year. This has bridged a serious supply gap and has helped the banking establishment keep a lid on rising gold prices.

Just now, it appears becasue there is no public accounting of central bank coffiers, that the central banks are running out of ammo (gold to sell) and it appears that the tide has turned. The central banks of Brazil, Russia, India and those in the Middle East have all stated a policy of increasing their gold reserves. Not surprisingly, China has also. The Director of China’s Central Bank recently stated:

“Reducing reliance on the dollar and maintaining greater diversification in foreign exchange reserves is the only way to reduce the risk. As a result, an increase in our country’s gold reserves is necessary.”

Russia added 90 metric tons to their reserves in December and January. Ecuador added 28 metric tons in January. Remember Ecuador, in December ’08 it defaulted on its IMF loan, now look who is coming home for dinner.

Considering that the world’s entire gold production in 2008 amounted to only 2,400 metric tons, the potential impact of central banks going from selling 1,500 metric tons to becoming net buyers can’t be overstated.

A short time ago, it was revealed China had nearly doubled its gold reserves, from a game-theory perspective, China has to buy gold and rattle its sword. Last month North Korea set off an underground nuclear device. Apparently, China’s President Hu Jintao finds North Korea’s President Kim useful in the short-term for keeping Japan and South Korea off-balance and in extracting concessions from the United States.

North Korea can continue to defy the international community as long as it has Beijing's support. So we don't have a North Korea problem. We have a China one.
Remember: The first phase was the debt disaster. The second phase was the collapse in the economy. Now, in the third phase, Treasury bonds and the U.S. dollar are getting hit hard, largely due to foreign selling.


Out of the blue:

Friedman, former president of the powerful NY Fed, (he's also a director of Goldman) buys 52,600 shares of stock in Goldman Sachs, and he's accused of a conflict of interest. Friedman quits - but where does he quit? Why I'll be damned, he quits his Fed job - and chooses to remain a Goldman director. What a surprise!

It's now obvious that the Fed and the Treasury want, above all, to save the banks. Everything else is secondary. It's also increasingly obvious that the bankers own the nation and that Goldman Sachs runs the nation and the banks. The whole thing is so flagrant that my head spins. And what Goldman doesn't control, the Pentagon controls.

Rising gold means that the dollar is being devalued - it takes more of a weak dollar to buy an ounce of gold. I expect the "dollar-bugs" to do everything they can to halt the rise in gold. The Fed does not want its massive creation of dollars to be advertised via a surging gold price, and so it goes.

Note to readers: One may wonder how it is that I accumulate such a mass of information, let alone have the time for this blog. First, it is purely self-interest as I too have to navigate these markets and since I am making the time to do the reading and discovery, why not share it with a larger audience, and so I do. Second, my sources are many and varied and what I do is take the best of the best, cut and paste, and string together a somewhat coherent thesis. In reference to my sources this month, they include in no particular order: Gregory Spear's Market Commentary, DailyWealth Reader, The Daily Crux, Money and Markets, Investorsdailyedge.com, Moody’s, Bloomberg, The New York Times, The Associated Press, Financial Times, The Globe and Mail (Toronto), Financial Week, International Herald Tribune, Reuters, The Washington Post, InvestmentNews, CBS News, The Toronto, Rick Pendergraft, Business Week, The Wall Street Journal, Martin Weiss, Sharon Daniels, , Financial Post, Mike Larson, Bryan Rich, Claus Vogt, James Turk of Freemarket Gold & Money Report, Sharon Zimmerman, Richard Russell of the Dow Theory Letters, Porter Stansberry, Dan Ferris of Extreme Value.