True to form, even the mainstream press is starting to take notice, long after the trend has been well established. Ambrose Evans Pritchard dedicated a piece yesterday to the collapse in M3 growth, something that hasn’t been seen in the US since the Great Depression. Monetarists the world around are frightened about this trend, and with good reason. US interest rates are already essentially zero. The massive monetary and fiscal stimulus has been epic in nature. And all this has still not prevented the actual textbook deflationary trend we now find ourselves in.

“It’s frightening,” said Professor Tim Congdon from International Monetary Research. “The plunge in M3 has no precedent since the Great Depression. The dominant reason for this is that regulators across the world are pressing banks to raise capital asset ratios and to shrink their risk assets. This is why the US is not recovering properly,” he said.

The major reason for this is that the banking system has severely curtailed its lending activities, which are largely (but not entirely) responsible for the growth in the money supply thanks to the money multiplier. One must ask how this is possible since essentially the banks have the Taxpayer Put in place where the US taxpayer is immediately hooked for any significant failure. For decades we have had an economy that relied on credit for its survival and now, like a drug addict in rehab, that credit is being limited. The result was fairly predictable.

Given the massive debts in our system, there are two obvious choices. First, hyperinflate away the debt. However, that ultimately ends in the destruction of the currency and the end of the current fiat age. Secondly, we could default through deflation/devaluation, and try to, in effect, reset the system much like what happened in the 1930’s. The major difference between then and now is the relative financial position of both the nation and individuals. Both are considerably weakened as we approach this next phase in America’s existence.

I’ve argued for the coordinated default/devaluation outcome for some time now. The collapse of M3 growth is one of the biggest factors on this side of the argument. The second is history. The US already has a rich experience in fiat money, dating back to before Lexington and Concord. We also have a rich history of defaults thanks to the over-issuance of fiat money. Granted, the defaults consisted of ceasing to redeem paper money for specie (Gold/Silver), but a default is a default.

We are clearly out of control in terms of our debts, both internal and external, and don’t seem the least bit concerned about real generational or fiscal reform beyond traditional Washington lip service. The Fed has been largely ineffective at doing anything but fattening bank cash flows by squeezing savers and allowing banks to collect generous margins on the performing consumer loans they do have. The bailout money sits in bank coffers, withheld from an economy that now depends on loans for its very survival.

Larry Summers, President Barack Obama’s top economic adviser, has asked Congress to “grit its teeth” and approve a fresh fiscal boost of $200bn to keep growth on track. “We are nearly 8m jobs short of normal employment. For millions of Americans the economic emergency grinds on,” he said.

I wrote many moons ago that once the parade of stimulus started that it would never end. Summers’ statement is tantamount to admission of the failure of his own Keynesian thinking. He is now acknowledging that in order to ‘grow’, we need stimulus (debt). Every once in a while the truth does come out.

Given these undisputable facts, it is really hard to conjure up a scenario where we can have any type of broad, well-grounded economic recovery. The various economic reports I dissect on a weekly basis bear this out. However, the bottom line as we solemnly observe Memorial Day weekend is M3. Where it goes, so goes America. Such is the way of things in a fiat money system.

]]> http://www.sutton-associates.net/blog/2010/05/27/the-consequences-of-m3/feed/ 1 http://www.sutton-associates.net/blog/2010/05/07/the-turmoil-continues/ http://www.sutton-associates.net/blog/2010/05/07/the-turmoil-continues/#comments Fri, 07 May 2010 23:32:31 +0000 TwoCentsEditor http://www.sutton-associates.net/blog/?p=376 The obvious pick for a topic this week would be yesterday’s fearful plunge in US Markets. However, absent a well-defined culprit for the plunge (so far), it seems pointless to speculate on what really happened. I am still sifting through my own observations of that ten-minute span as well as those sent to me by subscribers. There are reports of index ETFs with near zero volume and unfilled orders at the market. Yesterday should also serve to remind us of the possible pitfalls associated with using stops. There were countless times in 2008 when stops weren’t filled. It happened again yesterday. Truly it was an awful day well before 2:40 with the Dow already off several hundred points. Looking at the bigger picture, yesterday was the fourth 90% down day in two weeks. The market’s disposition has clearly changed for the worse. All this aside, there are a couple of other topics that need to be discussed, which have an even larger bearing on what is going on behind the scenes.

The ‘Strong Dollar’ is Back?

For the past several weeks, the proclamations of a ‘strong dollar’ have been floating around the airwaves. Commentators will point at the rising USDollar Index and mistakenly assume that everyone wants our currency because our economy is recovering so nicely. What they fail to understand and/or convey is how the index is calculated. The index is nothing more than a weighting of the value of various currencies versus the Dollar. The Euro is currently 57.1% of the index and is in freefall thanks to out of control sovereign debt. Our policymakers should be taking notes on the developments in Europe. At any rate, since currencies are traded in pairs, when one half of the pair falls, the other rises. This recent surge in the US Dollar index, while good for us in terms of the cost of European imports has nothing to do with the strength of our currency. I’ve said this time and time again. We have to hope for bad things to happen to the rest of the world to keep the Dollar afloat. The true barometer of the strength of a currency is the cost of Gold in that currency. Even as the Dollar index has risen over the past several months, Gold priced in Dollars has risen right along with it. Gold is sniffing out exactly the points made above. People are fearful of paper currencies, and while they dump the Euro in favor of the Dollar in the short run, they are also loading up on Gold, the ultimate money.

The reality shown above is not a one or two day event, but a three month trend, which is intact even in a period of extreme market distress. Many people will try to draw parallels between 2008 and the present. By that logic, they argue that Gold should be falling since we’re flirting with another period of all-out liquidation. However, 2008 was largely a liquidity crisis whereas today we are facing that plus the bankruptcy of roughly 20 nations and the possible disintegration of at least one currency along with it. Yes, the sovereign debt crisis is that bad. Granted, the emerging divergence between the equity markets and Gold (shown below) is in its infancy, but it is a very important development and needs to be pointed out now.

Will Greece Pay Up?

On the front burner and driving the current hysteria is the situation in Greece. While the EU has come together to bailout the embattled nation, there are legitimate fears that:

a) The bailout isn’t big enough and is merely a band-aid. Apparently folks have been paying attention to the bailout of the US financial system.

b) The EU won’t be willing (or able) to extend the bailout

c) The people of Greece will not accept austerity measures

d) The people of Greece will dismiss their standing government in favor of one who will continue the current welfare state.

e) Greece will not pay back its neighbors for the bailout

I would contend that all of these are legitimate concerns. Several days of intense rioting and national strike by the people of Greece are making it very clear that at this point they have no intention of being under the thumb of austerity. This is what happens when you create a welfare state. Again, our policymakers should be taking notes. The country can’t pay back what it already owes, hence the ‘need’ for a bailout. How is a reasonable person to accept the notion that somehow Greece will now be able to pay back the money already owed plus another $146 billion in bailout loans?

Yanking the carpet out from under a welfare state is going to have monumentous social implications. The people of Greece are likely to dispatch their current government in favor of one who will take a disposition similar to that of Iceland and tell the lenders of the bailout money and the country’s creditors in general to take a real long walk off a short pier.

It would be bad enough if this problem stopped at the Greek borders, but unfortunately, it is nearly systemic in Europe, and in fact extends across the Atlantic as well.

Freddie Mac Continues to Bleed

In a harsh reminder of the perpetual state of bailout that the US has entered, Freddie Mac announced earlier this week that it will need another $10.6 Billion from the Treasury by the end of June to cover first quarter losses of $6.7 Billion. This wil run Freddie’s tab to well over $50 Billion with no end in sight.

Back in 2008, the USGovernment pledged to guarantee that both Freddie and Fannie Mae maintain a positive net worth. This has led to periodic infusions of cash into what is now admitted to be a black hole at both companies. What is most concerning about these actions is that there is little or nothing being done to end the reliance on bailouts. At the root of this problem lies the reality that people, for various reasons, cannot pay their mortgages. For many it is because of job losses. If we’re going to borrow and throw money down a black hole, it would have made a lot more sense to use the $50 Billion to build some factories that would employ workers who would produce goods made in the US. That would have put people to work and at the same time would have helped us ease our reliance on foreigners. Instead, we throw the money away, choosing to perpetuate a broken system.

April Jobs Report

As of this writing, the April jobs numbers are available. The economy ‘added’ 290,000 jobs in April, with generous upward revisions to both February and March. What is disconcerting about this report is the fact that we now know that roughly 600,000 new census workers are in place, yet these folks don’t appear to be attributed to the government’s portion of the non-farm payroll. BLS is claiming that of the 573,000 jobs created so far this year that 483,000 were created in the private sector. Yet looking at the Federal Government’s workforce over the past few months there hasn’t been much of an increase at all. So either government is trimming the sails in other areas or the census workers aren’t being counted as government employees, but are instead being credited to the private sector. A recent Gallup survey seems to bear out this discrepancy in that it concluded that government hiring was outpacing private sector job creation. While we don’t yet have the birth/death adjustment to April’s numbers, it is clear that something is amiss. The headline and U-6 unemployment rates rose to 9.9% and 17.1% respectively. State and Local government workforces continued to shrink in April, outlining the dire circumstances that continue to face many geographic areas.

With the cost of insurance on European bank bonds surging to a pre-Lehman high, it is apparent that at the very least, there is again a severe ripple in the credit system, this time at a sovereign level. Given debt levels around the globe it is quite likely that damage control will take precedent over containment.

All joking aside, we’ve again reached the point of absurdity on so many fronts that instead of focusing in on a single topic, it is time to dedicate an entire issue to scanning the landscape in an attempt to make sense of the ludicrous.

Bureau of Labor Statistics – Ring #1

The monthly unemployment numbers were released last Friday by BLS and you could almost hear the clinking of the champagne glasses from the studio in the belly of the NASDAQ. Yes, the US only lost 36,000 jobs in February; good times must be just around the corner! Such a sham was this report that I actually dedicated an entire podcast to debunking it. The bottom line is that the jobs deficit for the month of February was around 350,000 jobs – nearly 10 times what BLS reported. This takes into account the 97,000 jobs mysteriously created by the birth/death model (completely unsubstantiated), the fact that our economy needs to create roughly 145,000 jobs each month just to break even in terms of population growth and new entrants to the work force, and finally the fact that most of the ‘new’ jobs created were temp jobs, a whole bunch of which were for the upcoming census.

Perhaps the most alarming part of this report was the revelation that 31,000 state and local government workers lost their jobs last month. These are the jobs most people make fun of, but would love to have because they’ve always been considered to be a job for life with a great pension. The paradigm is changing folks. Either recognize and deal with it or become cannon fodder for the new economic realities that are emerging. The days of borrow and spend are over; at least for the consumer. As you’ll see in the next section, the US Government apparently thinks it has an exemption from the laws of economics – and common sense.

The US Treasury – Ring #2

In the second ring, we have the US Treasury and its burgeoning FY2010 shortfall. So bad was FY2009’s shortfall that the report that outlines our actual financial position was delayed nearly 2 full months, FINALLY being released back on 2/26 to an absolutely comatose response from the belly of the NASDAQ. February’s outlay was massive, totally $220.9 billion. Much of it was blamed on stimulus spending, tax credits, and TARP outlays of $2.3 Billion (Yes, they’re still handing out TARP money). The media cooed about the Fed’s contribution to the US Treasury, but says nothing about the fact that every dollar in our system is loaned to us by those same loan sharks at interest. Ah, the conveniences of selective reporting. To date, the Treasury’s gap stands at a whopping $651.5 billion, which is around $65 billion ahead of last year’s record pace. If they maintain this pace for another seven months, we’ll have a cash basis shortfall for FY2010 of $1.563 trillion – around $132 billion more than FY2009.

Let’s consider for a second all the money that has been spent on stimulus and other projects. Let’s consider the trillions spent bailing out banks. Finally, let’s overlay all that spending with the grossly awful jobs report from last Friday and the months preceding it. How can anyone in their right mind call the stimulus anything but an abysmal failure? The problem is that the government cannot create jobs. Simple. Yes, the government can pay people to perform services. They can pay for a guy to fill potholes. (Send someone to Pennsylvania while you’re at it please; I’ve seen some potholes here that are bigger than these new ‘mini’ cars everyone seems to want.) Once the potholes are filled, then what? Once the bridge is built, then what? Once the census is finished, then what? It all comes down to sustainability. None of the money that is being spent in ‘stimulus’ is being spent on anything that can sustain itself. It cannot pay for itself. How is an $8000 housing tax credit going to pay for itself? The consumer will take the $8000, spend it and create a temporary boost. Then what? This is why I’ve said for many months now that additional stimulus would be needed. And it will need to continue ad infinitum unless our policymakers wise up and start implementing policies that would foster genuine growth, provide for a return of manufacturing to the US, and create sustainable economic growth. Unfortunately, that just isn’t in the ringmasters’ plan. The new tactic in Washington is to devise stimulus packages, but call them anything but, as if somehow changing the name really makes a difference.

The Commerce Department – Ring #3

Not to be outdone we have the Commerce Department, and more specifically the Census Bureau, in the third ring. This morning’s release of retail sales data will no doubt serve to thoroughly confuse anyone who pays attention to such matters. Granted, it is extremely hard to reconcile, but one must look just in the opening statement of the release to get a window into what is really going on here. Repetition notwithstanding, it must be noted (again) that retail sales are reported in nominal terms. From this morning’s release:

“The US Census Bureau announced today that advance estimates of US retail and food services sales for February, adjusted for seasonal variation and holiday and trading day difference, but not for price changes, were $355.5 billion…”

It would be much more useful, albeit challenging to accomplish, if these numbers were reported in units as opposed to dollars. But we can do some reasonable discounting on our own. The ‘headline’ retail sales number was up .3%. Ignore for a second that the media takes sales ex-autos when that shows a bigger gain or smaller loss. Basically, whichever number is better is the one they’ll focus on. While we don’t yet have February’s CPI, let’s assume the headline is .2%-.3%, which is pretty much in line with what has been reported over the past half year. That pretty much wipes out the headline gain. Our internal metric was .55% for February, which when applied to the headline number would take it to a .25% contraction.

Of course, you’ll never hear this from the belly of the NASDAQ. You’ll be lead to believe that all is well, consumers are tripping over each other to spend money, and that a return to the boom times of 2005 can only be a few short months around the corner. While that would be nice, it would be extremely irresponsible to predict such an occurrence based on the evidence that now lies before us.

Some potentially useful tidbits of information from the report are presented below. It must be noted that these useful bits of information can be gleaned from each month’s report for monitoring purposes.

- Seasonal Adjustments added $38 billion or 12.28% to February’s total.

- Removing the seasonal adjustments, retail sales fell in February from $321.8 billion to $316.7 billion; a change of $5.1 billion or 1.59%

- Gasoline station sales are up 26.4% in the last year.

- The 3.7% jump in electronic and appliance stores comes in concurrence with several states doing ‘cash for appliances’ type programs. See Iowa as an example. The state gave away nearly $200 million in funds to such a program. While that may not sound like a lot, it accounts for nearly all of February’s gain for the sector. And that is just Iowa. I realize this is highly anecdotal in nature, but these are the types of things that can skew reporting and promulgate false assumptions so I’m bringing it up.

- The data for MARTS (Monthly Retail and Food Services Survey) is gathered by sending surveys to 5000 businesses. The responding firms’ data accounts for nearly 65% of the national monthly sales estimates.

- The estimates use the 90% confidence level. If the range established by the use of this level includes zero, then the change is not statistically significant. The headline number was .3% with a range of ±.5%, meaning that zero lies in the range, and therefore this month’s retail sales change from last month is not statistically significant. The December 2009 – January 2010 change of .1% with a range of ±.3% was also not statistically significant. Put simply, retail sales are just as likely to have been flat or even negative as they were to gain .3%.

Obviously the points above are enough to cast serious doubt on the veracity of consumer spending. When one overlays the jobs situation, relatively stagnant incomes, and other factors over top of this, it would seem fairly likely that this report represents something of an outlier. It is also instructive to note the role that borrowed government spending plays in skewing the numbers as in the case of cash for clunkers last year, homebuyer tax credits, and now cash for appliances. Also not commonly known is that Medicare spending also counts as part of retail sales. So if Medicare pays for a knee replacement for your uncle, that counts as retail sales and is parlayed as consumer spending.

Sorry Ringling Brothers, but the government-media complex, which puts out and then appropriately spins the numbers and information has stolen your title of “Greatest Show on Earth”; and they’ve done it hands down.

This month’s issue of the Centsible Investor will be released on Monday, March 15th. It will contain an in-depth analysis of the recent Treasury report on the financial condition of the US, a look at current trends in gasoline production and consumption in light of predictions of $3.50/gallon gas this summer, and a comprehensive study of a rather successful petroleum transportation operation. Plus, we’ll do our usual cutting-edge analysis of the major stock indexes and plot the course for the markets over the next few weeks. For more information, Click Here

Theme #1 for 2009 – The blowout federal deficit

“In a classic journalistic transgression, the Congressional Budget Office stole most of the thunder of our first theme for 2009 – a blowout in the Federal deficit as the government, almost out of options, pulls out all the stops and piles it on taking the national debt curve parabolic.”

I’ll readily admit I should have spent some more time on this, but the CBO had in fact just released a report on the projected 2009 FY budget that was actually carried in a spirit of journalistic honesty unrivaled in recent years. The media, for a week, became deficit hawks. After that they resorted to just gawking at the monthly Treasury shortfalls and commenting how it was ‘necessary’ to get the economy going again. The ending FY 2009 deficit was indeed massive: $1.4 trillion.

This year, we’re in a similar situation; the CBO came out this week with a report identifying a $292 Billion shortfall for the first two months of FY 2010. If this trend holds out, the FY 2010 shortfall would be in the $1.75 Trillion area. I’m inclined to go even higher and predict a greater than $2 Trillion deficit for several reasons:

1) Another stimulus is in the works. Reeking of Madison Avenue marketing, this third stimulus in just two years is not even being called a stimulus, but a jobs plan. If you read the fine print, however, you’ll see that it differs very little from its most recent predecessor. While details are sketchy at this point, I’ve been asserting for the past few months that they’d propose another stimulus and it would be a whopper: probably a trillion dollars or more. I’m sticking to my guns on this one.

2) The actual ‘cost’ of the existing programs is much higher than their price tags, resulting in a dramatic and spectacular piling up of shortfalls. For example, the 2009 stimulus carried a $787 Billion price tag, but a total cost somewhere in the neighborhood of $3.25 Trillion according to the CBO.

3) Healthcare Takeover. Again, details are sketchy at this point, but the nationalization of America’s healthcare system is likely to sport a price tag of near a trillion dollars, with the actual cost likely somewhere between here and Saturn since it is not a one-time program, but one that will run essentially in perpetuity. Don’t be fooled by assertions that this measure will prevent the insolvency of Medicare and Medicaid either.

All of these factors (and many others) point to a continued increasing slope of the public debt curve. Not to mention that at this point in the debt curve, which is essentially a mathematical function, deficits beget larger deficits as compounding kicks in. Another buffalo nickel goes out to whoever accurately predicts the year when we cross the $100 Trillion mark on the national debt. In truth, the currency system we’re under may well end before we reach that point, but it is an interesting study nonetheless.

Theme #2 for 2009 – States Circle the Wagons for bailouts

“California, New York, and as many as 29 other states are already in fiscal extremis as revenues plunge due to unemployment and decreasing tax receipts. States are faced with difficult choices in 2009. They can raise taxes, cut services, beg for a bailout, or in all likelihood all of the above. And in a typical ironic twist of fate, the market for municipal bonds is drying up just when the states are going to need the money most. To make matters worse, yields on municipal bonds blew out to nearly 2.2 times the yields on corresponding Treasury issues. This is more than twice the .96 historic level normally observed. Obviously, the message here is that the perception of security is gone. We pointed out this likely eventuality when MBIA and AMBAC came under duress and saw their credit ratings cut back in June. Not only are the bonds questionable, but their insurance is as well. The bottom line here is that if bond issues can be sold, investors will command much higher yields resulting in greater debt servicing costs. Initial forecasts for 2009 indicate that there will be a 6% decrease in new bond issues sold, taking the total down to around $364 Billion.”

Again, absent Madison Avenue marketing, we’d have seen this for what it was. The 2009 stimulus was largely a de facto bailout for many states that lined up to grab the federal dollars. However, several spurned the freebies in heroic fashion, realizing that there were too many strings attached. Granted, not much has been made of the downgrades of AMBAC and MBIA since they happened and on top of that muni bond yields have fallen so much that on many points along the yield curve, they’re actually bringing in less than their Treasury counterparts. However, if you adjust for the 28% tax rate equivalent yield, muni bonds are still sporting a hefty spread at the long end of the yield curve: 1.42X the 30-year Treasury bond.

As for the issue of cutting services and raising taxes, we were spot on. The media landscape in 2009 was littered with stories of cities, states, and municipalities cutting all sorts of services, even police, fire, and EMS in many cases. New Jersey, California, and Michigan were just a few states that gave public school teachers pink slips in 2009; a nearly unprecedented move. On the revenue side, many areas have resorted to increasing and adding fees as opposed to raising funds through the more traditional taxing systems already in place. NYC led the way in this regard, raising fees on everything from parking to taxi cab rides. And the rest of us haven’t been immune either. Fees and surcharges are being raised all over the country in an effort to patch broken budgets from Omaha to Oregon without raising broader tax rates, which are much more in the public eye.

The one portion of the municipal story that we seem to have been a tad early on is the overt purchase of muni bonds by the government. However, given the fact that California virtually begged the Treasury for TARP money and the Treasury’s CPP (Capital Purchase Program) has poured over $26 Billion into California banks, it is probably not a completely unreasonable assumption that at least some of that money went towards California ES and GO bonds held by the aforementioned banks.

Theme #3 for 2009 – Creative Financing to Induce Borrowing

“Creative financing will be back in 2009. And I don’t just mean 0% interest loans. Any machination that allows payment to be put off until a later date will do. 12, 24, and 36 months interest-free. No payments for 12 months. Partial payments for 12 months. No down payment and we’ll make the first 3 monthly installments for you. We’ve already seen these before, but they’ll become commonplace in 2009. Look for new ones as well with longer payments terms, which ironically means you’ll end up paying even more for the items. However, the focus will be on the ‘low monthly payments’. Stimulus checks may not be checks at all, but may rather have a requirement for consumption attached. All indications are that the framers of the last stimulus package were unhappy because not enough of the money was spent. Apparently some people actually paid bills and/or saved the money. Maybe Wal-Mart and Home Depot Gift Cards will be the delivery method for the next economic stimulus. I’m only half joking about this.”

Cash for Clunkers. Need I say more? On other fronts, the Fed has led the charge to induce home buying through the purchase of $854 Billion (to date) worth of mortgage bonds. Not to be outdone, the feds have thrown in their own incentive in the form of tax credits for first time home buyers. These folks will do anything to raise the dead and buried notion that home ownership is the epicenter of wealth and prosperity. There have been various incentives to purchase all manner of home improvements centered on energy efficiency. This might be perhaps the most innocuous of the government’s attempts to urge people to spend money. We were spot on with regards to cash handouts; they didn’t happen because the government wants to guarantee that people actually spend the money. So instead of mailing checks, the feds will give you a kickback if you spend your own money or even better, borrow and spend someone else’s.

Retail chains have done their part by slashing prices to induce spending. Creative financing arrangements are out there, but are not quite as prevalent as we had expected at the outset of the year save for the auto sector. Consumer spending has remained tame at best, and the consumer’s willingness to take on more debt to finance large living has diminished significantly. Consumer credit outstanding – one of my favorite indicators in terms of predicting consumption patterns and GDP growth ex government spending has seen 8 consecutive months of declines; the first such occurrence of a sustained decline since the series began in 1943. The mainstream has of late picked up on this storyline mostly because the declines in recent months have been less severe which fits into the mantra of ‘not as bad’ economic reports being spun as great news.

For sure as we close out the first decade of the new century and millennium, the spin will be on the increase. Few things will be as they appear. News reporting has already taken on a frighteningly 1984-ish aura complete with glitzy marketing props and plenty of subterfuge. Economic statistics released by the government will become more and more irrelevant. Even now, press releases from BLS and the Commerce Department in particular are littered with asterisks about changes in reporting, methodologies, and data gathering. It would seem those responsible for providing us with accurate data have hired the Enron crew to cook the numbers for them.

You can have all of this spin and subterfuge decoded for you each week on ‘Spin Cycle’. I host the show and debunk economic reports and bring on guests to talk about the important issues of day as they relate to media bias and misinformation. For more information or to listen, please visit Contrary Investor’s Cafe

Not helping our prospects for avoiding another October surprise is the fact that almost nothing has been done to rectify the underlying problems facing the US economy. Plenty has been spent to bailout various enterprises, but until a healthy, unsubsidized demand for goods and services exists at the consumer level, we will continue to spin our wheels. A fantastic example is the cash for clunkers program. The massive infusion of subsidies did manage to increase auto sales, but now that the program has ended, we’re heading right back to where we were before. This is evidenced by Ford’s US auto sales immediately dropping 5.1% after C4C was terminated.

The Panic of 1819

The panic of 1819 was the first stoic example of the boom-bust cycle in the nascent United States. Oddly enough, this panic, and the crisis in which we are currently embroiled have striking similarities even though they occurred nearly 200 years apart. For starters, the panic of 1819 was a direct result of internal factors rather than external ones. Occasionally, a crisis in a nation can happen because of someone else’s doing. This one was mainly due to the rampant spread of private bank notes of varying quality and value thanks to runaway inflation caused by borrowing for the War of 1812. Oddly enough, the panic of 1819 resulted in many of the same things we are seeing today: foreclosures, unemployment, bank failures, and significant slowdowns in both agriculture and manufacturing activity. This crisis is important because it is the country’s first example of a homegrown crisis and really determined the anatomy of many subsequent events. Essentially what happened was a boom of sorts, which resulted in malinvestment, financial and economic dislocations, and the decay of underlying fundamentals followed by a severe correction of the imbalances to restore economic and financial order.

However, there was another interesting twist in many of these early panics, and it had to do with our money itself. One of the characteristics of early banks in the US was to offer paper bills that were redeemable for specie (metallic) money. Redeemability was a huge factor in the confidence in the paper bills. Unfortunately, analogous to today’s Fed, these early banks had the propensity to print and circulate bills far in excess of the amount of specie they had on deposit making them susceptible to bank runs. Many of the early panics in the new United States were caused because banks got greedy and overstepped their boundaries. Sound familiar? The more things change, the more they stay the same. Unfortunately, when these bank runs occurred, the banks would merely run to the government who made the rather foolish decision to suspend specie payments on bank notes, effectively ripping off the holders of the bank notes. Incidentally, as a result of the panic of 1819, unemployment in Philadelphia, for example, reached near 90% and almost 2000 workers were put into debtors prisons. In addition, displaced and unemployed workers lived in tents outside the city. I am sure this irony is not lost on anyone who has seen some of the tent cities around America as a result of runaway foreclosures.

The important point underlying many of the panics of the 19th century was the fact that they were rooted in the monetary system and/or the economy in general. This paradigm shifted with the advent of share markets and the panics oftentimes transitioned from monetary and economic panics to stock market crashes and then to a hybrid situation from 1929 through the start of World War II.

The Crash of 1929 – October 24-29, 1929

I am not going to rewrite the chronology and factors surrounding the Great Depression. For anyone who is interested, they can Click Here to read an article entitled ‘Anatomy of a Disaster’ from last fall. This crash was the first well-defined example of a stock market crash and a significant economic contraction happening simultaneously. Not surprisingly, this is where the history books usually get it wrong. They oftentimes assert that the market crash caused the Great Depression. Nothing could be further from the truth. The economic boom of the roaring 1920’s had run its course leaving (as in prior examples) financial and economic dislocations, overleveraged consumers, and a general feeling the boom would last forever. The mountain started shaking in the summer of 1929 and by autumn, panic gripped the markets resulting in a 2-day 23% sell-off in the DJIA. By the middle of November 1929, the DJIA had lost 40% of its value. What happened next is crucial to understanding what is happening right now. The market then made a valiant attempt to rally, bringing back many investors from the sidelines as the Dow mounted a furious charge into 1930. However, the rally didn’t stick, conditions worsened, and by the time 1932 rolled around, the venerable index had lost 89% of its value. It would take 25 years for the Dow to recover that lost value in nominal terms. If you think this cannot happen again, then you are incredibly naïve.

The Crash of 1987 – October 14th – 19th, 1987

In financial folklore, the crash of 1987 is one of those events that cannot generally be explained since there were no obvious dislocations. P/E ratios were high, but not extreme, investors were not grossly overleveraged, and the economy was comparatively healthy. There have been many theories about financial raiders cashing in on the sudden decline, and given what we’ve seen recently, the idea of someone triggering a crash for their own benefit doesn’t seem too far out of the realm of possibility. The interesting thing about the 1987 event was the recovery time. On a percentage basis, the loss was massive – 31% in 5 days for the DJIA. Yet it took just a tad under two years for the index to fully recover in nominal terms.

What was rather poignant about the ’87 crash was the response. This was the event that gave rise to the shadowy President’s Group on Working Markets, lovingly referred to as the Plunge Protection Team. In addition, various circuit breakers were placed in the markets to halt trading if certain conditions were met:

After the invocation of trading curbs and the President’s Working Group, investors seemed to be lulled into a sense that the markets could never again drop significantly. That has certainly not been the case, and in case anyone is counting, the events are becoming larger and closer together. In 1997 and 1998 we had the Asian crisis and the Russian default, followed by Long Term Capital Management. The new century was ushered in by a vicious bear market thanks largely to overvalued Internet stocks. That bear market ended in 2003 and was followed by a steep nominal recovery in share prices only to see markets fall apart once again after the late 2007 top.

In summation, given everything we know about the underlying economic fundamentals, and the nature of bear market rallies; it certainly won’t be much of a surprise if we have another horrendous October. And if the first day is any indication, it could be a long month.

The Hindenburg Omen

Once it has been established that we are in fact looking for a top, the next order of business is to try to get a handle on when that top might occur. This week we’ll take a look at once such indicator; the Hindenburg Omen. Before we even start it must be said that this indicator is not a be all end all and should only be used in conjunction with other technical indicators, a broad understanding of the macroeconomic environment, and a healthy dose of common sense. It is merely a tool. It is not a magic wand. Such things do not exist.

Essentially, the Hindenburg Omen is an indicator of underlying divergence in the movement of the issues traded on the New York Stock Exchange (NYSE). It is stock market sonar, meant to scan underneath apparently placid waters, searching out turbulence beneath the surface. Merely looking at the daily progression of the price of the major market indexes will not glean any light whatsoever on the actual internal condition of the markets. Examples of such divergence generally happen around major tops, which is what the Omen has been rather good at sniffing out. In the past 25 years there has not been a major market crash event without a confirmed Hindenburg Omen. However, to be fair, it must also be said that every Hindenburg Omen has not resulted in a market crash during this same period of time.

Hindenburg Omen Criteria

There are 5 criteria that must be observed on a particular day in order for a Hindenburg Omen to be registered. They are:

• 52-week Highs and Lows must both be greater than 2.2% of the issues traded on NYSE.

• The lower of the Highs/Lows must be greater than 75.

• The 10-Week NYSE Moving Average must be increasing

• The McClellan Oscillator must be negative.

• The 52-week Highs cannot be more than twice the number of 52-week Lows, but the number of Lows can be more than twice that of the Highs.

• An optional condition for the Hindenburg Omen, which has been found to be extremely beneficial in honing the accuracy of the indicator, is a confirmation within 36 trading days of the initial observation. So in order to have a confirmed HO, two observations need to be made within 36 trading days of each other.

Let’s take a look at the Hindenburg Omens of the past 25 years. It is important to note that the indicator is not exclusively prescient. It will sometimes trigger prior to a crash event, sometimes it is coincident with the beginning of the crash event (the market top), and sometimes it comes slightly after the crash has begun.

Historical Occurrences

In the past 25 years, there have been 27 confirmed Hindenburg Omens and 191 individual occurrences of the Omen. Thus, the rate of occurrence was around 3%. Here’s the breakdown of what happened after those 27 confirmed Hindenburg Omens:

DJIA decline of 15% or more: 8 times or 30%

DJIA decline of 10-14.9%: 3 times or 11%

DJIA decline of 5-9.9%: 10 times or 37%

DJIA decline less than 5%: 6 times or 22%

Of the last group, 2 of the declines were less than 2% and therefore considered ‘failures’ in terms of the predictive value of the signal. Looking at it a different way, there is a near 78% chance that a confirmed Hindenburg Omen will result in a 5% or greater decline in the DJIA. In the context of the current position of the DJIA, we would have a 78% chance of at least a 480 point drop if we had a confirmed HO. Fortunately, as of this time we do not, and in fact do not have even an unconfirmed observation.

Below is the chart of data for the Confirmed Hindenburg Omens shown.

Incidentally, there is no relationship at all between the number of observations and the magnitude of the resultant decline (Correlation between series: -0.01)

Where do We Stand Currently?

Based on 9/24/2009 closing numbers, this is where the various requirements for a Hindenburg Omen stand:

52-Week Highs: 157 (4.97%) – Met

52-Week Lows: 3 (.10%) – Not met

Lower Greater than 75? – Not met

52-Week Highs < 2X greater than 52-Week Lows – Not met

10-Week MA: Rising – Met

McClellan Oscillator: -112.34 – Met

The above analysis indicates that while some requirements have already been met, that the level of bearish divergence necessary to generate the required number of 52-week lows still doesn’t exist. Keep in mind that these numbers change daily and therefore, must be watched continuously.

Worth Noting

Two failures of a confirmed Hindenburg Omen to predict a more significant drop in the DJIA during the past 25 years were accompanied by significant liquidity injections by the Federal Reserve to stave off the decline. Chalk these up to either coincidence or overt market manipulation. These injections were $155 and $148 Billion and occurred in 2004 and 2005 respectively. Just three years later, multiple trillions were required and were still not enough to keep a 50% crash at bay. This alone should reinforce the notion of a hyperbolic growth in debt, leverage, and systemic risk.

Venezuela’s $16 Billion Oil Deal

On 9/17/09, Venezuela President Hugo Chavez announced in a brief statement that his country had entered into a $16 billion oil deal with the Chinese to further develop the Orinoco project and ramp up Venezuelan production by 900,000 barrels per day. This agreement is separate from a similar deal inked in October of last year that promised an unspecified amount of Venezuelan production to the Chinese. The important thing to note is that Venezuelan state-owned PDVSA not only committed to ship oil East, but will essentially operate a joint venture with Beijing for the purposes of developing further reserves. At the time, Chavez was optimistic that his country would become China’s top oil supplier.

Of important note in the oil space is the fact that the #3 supplier of oil to the US is Mexico and its production has experienced a steady decline since 2004 and is now in a full state of export destruction. While much ado has been made of the Bakken formation in the western US, some reality must be brought to bear on all the misinformation being disbursed. The US Geological Survey has stated that the formation could contain 4 billion barrels of oil. While getting every drop is impossible, let’s assume for a moment that we can. Even in the throes of the worst economic contraction since the 1930’s the US still burns up about 19 million barrels of oil each day. Using that as a basis, the Bakken contains a whopping 210.53 days of US supply – about 7 months worth. Not really a big deal is it? For comparison, the USGS estimates Alaskan oil reserves including the North Slope to contain 90 billion barrels. Again, let’s assume we can recover every drop of it. The situation here is a bit better and we’ll get about 13 years of supply at current burn rates. Note that doesn’t account for any economic growth, which carries a proportional increase in petroleum consumption under our current transportation, power, and living systems.

Keep in mind I am being purposely US centric here to frame the issue in simple terms. The recent strategic agreements the Chinese have entered into should take on a whole new significance when looking at the information through the lens of what is actually available to us domestically. Sure, they might have a large find in Brazil. Is it really safe to assume that we’ll command it? The Dollar is already looked upon with contempt thanks to decades of abuse and there is no indication that is about to change any time soon. Unfortunately, the strategic accumulations don’t stop at oil.

China’s Rare Earth Metal Monopoly

While much of the talk in the US recently has shifted to green technology, there is a glaring oversight being made. These new technologies, while solving one complex problem, create another. Much of today’s array of battery technology, fuel cells, wind turbines and solar panels requires an available supply of rare earth metals (REMs) for production. For the past decade and a half, the Chinese have been quietly accumulating large, unrivaled stockpiles as well as a near monopoly in the production of these critical metals. So successful were they that 95% of the lanthanide (periodic table) series metals are produced in China. These metals are used in everything from iPods to hybrid cars. China’s 1987 pledge to become the Saudi Arabia of REMs has come true says Jack Lifton, a REM specialist. The Japanese government sees REMs being the turf for future trade wars, especially since the island country imports almost 100% of its supply from China.

As the above chart illustrates, China has a near complete stranglehold on the supply of REMs as a group and a healthy stockpile to boot. Even more importantly, mainland demand is now eating away at exports. And unfortunately, unlike oil, large deposits of REMs are not scattered all over the globe. The only real bit of good news that can be attained from the chart is that supply is still growing. Unfortunately there are no meaningful stockpiles to speak of outside mainland China.

We used to have some domestic sources of these critical metals, but unfortunately, many of those mining operations were scuttled during the price wars of the early 1990s and expensive overhauls would be necessary to get them back in production. Many industry analysts fear that Beijing will be able to affect a serious supply crunch before any meaningful competitive supply can be brought to market. Another shining example of how supply doesn’t automatically appear to quench demand even though the textbooks suggest otherwise. This has resulted in a frantic scramble throughout Southeast Asia as Japanese car and electronic manufacturers try to lock down alternative sources.

Meanwhile the Chinese have sought to solidify their position as the REM capitol of the world. A state-owned investment company recently purchased a 25% stake in Arafura the Australian REM miner. In August, China Minmetals Rare Earth Company made an investment of $310 Million to lock in its dominant position in an already tight industry.

The REM situation has massive implications for the United States and our desire to go green. Without these metals, many green alternatives are not possible given current technology constraints. It also has implications for our consumption of electronic consumer goods, many of which end up in landfills when they no longer work.

Some possible conclusions that can be drawn from these activities don’t paint a good picture for the continuation of activities here in the US as we’re used to. If the countries that supply us with many of our products are locking in stockpiles, it would be rather foolish for us to assume that they’ve done so in order to continue exchanging these dwindling resources for green paper tickets as they have been doing. This becomes even more evident when one considers that much of this stockpiling didn’t exist just a few years ago.

Certainly another contributing factor is that the perceptions of the dollar have grown so pessimistic that many countries are diversifying into hard assets. However, rather than creating a speculative bubble, the strategy being invoked is a longer-term accumulation strategy. They buy the dips and take delivery. This is a testament of the growing disdain of paper assets, particularly currencies. The paradigm shift, which happened not too long in the recent past, is now moving into a higher gear.

Even if this activity ends up being nothing more than a global diversification strategy, which isn’t likely, then the law of unintended consequences kicks in and America will likely face nasty resource shortages as a result sooner than most are willing to admit.

Yes, we are one year removed from that column and Gold is up 25% in dollar terms at nearly $1000/ounce. Detractors will quickly point out Gold’s inability to land and stick above the $1000 level. In return, I will point at the Dollar’s failed rally to 90 as measured by the USDX. Detractors will point to a lack of interest and dividends from investing in Gold. I will point out that Gold is not an investment; it is money. However, for those who insist on comparing Gold to stocks, I will point out that in the year since the last article, Gold is up 25% while the Dow Jones Industrials are down 19%. Detractors will point out the new bull market in stocks. I’ll counter with the fact that stocks are merely in the middle of a countertrend rally within a bear market while Gold’s correction last year was a countertrend move within a bull market. Detractors will point to the save-haven status of the Dollar during times of economic distress. I’ll counter with the fact that Congress has ensured that the Dollar will die of nearly two trillion cuts – in FY 2009 alone. Must we really continue this?

So on the anniversary of the beginning of the first in extremis phase of the financial crisis, we’re going to look at two of the many developing situations that should give us pause when considering the stability of our financial structures despite all the positive rhetoric and hopefully compel us to consider how to adequately protect ourselves.

China’s stop-loss

Earlier this week, China released some rather earthshaking news that was barely reported by the diligent media here in the US. And where it was reported, the significance was completely glossed over or even ignored. The Chinese Government gave a directive to its state banks to cut their losses on commodity related derivatives, many of which are tied to NY and London banks. In doing so, the Chinese government is in essence saying it no longer respects the validity of these specific performance contracts, pointing out that without performance, there is nothing special about the contracts.

This is tantamount to a shot across the bow. The commodities portion of the total notional value of all OTC derivatives as of December 2008 is rather small at .75% of the total. Telling Wall Street to take a long walk off a short pier in this instance will probably not destroy the financial system in and of itself, but it will certainly give the bailout boys a hint of what could happen if the Chinese et al (think BRIC) start backing out of other more important areas such as interest rate swaps which were nearly 55% of the total notional value. (Data courtesy of BIS)

Even the most diehard of Keynesians, who have never seen a deficit they didn’t love, are aware of the fact that it is much more favorable to have foreign cooperation in your currency burying than to have to do it on your own with direct (or around the woodpile) monetization. In that regard, they still need the Chinese if for nothing else than maintaining the façade of vendor financing and the maintenance of the status quo.

Stock markets reacted poorly to the news on Tuesday with the DOW losing nearly 200 points on a day where there was a bevy of ‘green shoots’ economic news in the form of ISM manufacturing data, pending home sales, and motor vehicle sales. Financial stocks led the decline and we must wonder if the smart money had its eyes on the Chinese as the day progressed. On Wednesday, Gold broke out of its recent doldrums and immediately headed north. Granted the technical patterns had been predicting the breakout for the past few weeks, but it is rather coincidental and we have to ask if we are not beginning to see the first shockwave from the recent Chinese action? If so, Gold gets a big thumbs up, while paper assets get the boot.

FDIC: The paper tiger is going to need more paper

“We’ve all seen the good news that has come out on the economy in the past few weeks. While challenges remain, evidence is building that the American economy is starting to grow again. But no matter how challenging the environment … the FDIC has ample resources to continue protecting insured depositors as we have for the last 75 years. No insured depositor has ever lost a penny of insured deposits … and no one ever will.”

The above statement, made by FDIC boss Sheila Bair is overflowing with inaccuracies, but for the purposes of this article, I want to focus on the last sentence. The FDIC’s ‘trust fund’ is dry. At the beginning of 2008, the Deposit Insurance Fund (DIF) had a balance of approximately $52.8 Billion. By the end of 2008, the DIF had been drained to around $17.3 Billion on the back of just 25 bank failures. To date in 2009, there have been 81 failures, with the two largest failures of the recession coming in the last month. At the end of Q1 2009, the DIF balance had already been reduced to $13.1 Billion. In addition, the list of ‘troubled’ (read: dead) banks now stands at 416 as of the FDIC’s latest quarterly report.

Ms. Bair, in her statement alluded to the notion that the FDIC sets aside reserves for anticipated failures. The problem is that their estimates of the total impact of failures have been categorically low during the recent run of bank failures. In fact the actual losses have been nearly twice (1.94X) the estimates by FDIC. In the following graphic, used in Ms. Bair’s presentation, the FDIC has estimated the cost of failures to be $32 Billion. If recent history is any guide, the real cost is likely to be a tick over $62 Billion. Given that the balance of the DIF is now at $10.4 Billion, I’d say they have more than a small problem.

What is even more interesting is that Ms. Bair considers money borrowed from the Treasury (taxpayers) and thrown into a black hole to be an asset and her chart above fails to recognize that such a loan creates a liability as well. However, this is indicative of our new accounting paradigm. In addition, she asserts that the FDIC is entirely ‘industry-funded’. Not so when they’re tapping a Treasury credit line. While most folks are sniffing a bailout of FDIC, I wouldn’t count on it. So far, the vast majority of the bailout money has found its way to Wall Street, not Main Street.

So while the FDIC is bragging that no insured depositor has ever lost a penny and never will, it must be noted that it is incorrect to assume that Congress is under any type of mandate to bailout FDIC. When the DIF requires massive borrowing from the Treasury, bank premiums will be increased in a vain attempt cover the cost, which will mean higher borrowing costs for the real economy. And if Congress does step in and bailout FDIC, the amount will just get tacked onto the national debt. So while large banks gobble up smaller ones and consolidate on the back of TARP, TALF, TSLF and a dozen other ‘emergency’ Fed lending programs, everyday Americans will foot the bill in its entirety. How’s that for a guarantee?

The above items are just a sampling of where we stand a year later. The opportunity offered by precious metals is the opportunity rid oneself of counterparty risk. The Dollar is the ultimate example of counterparty risk as it relies on the responsible performance of government and monetary authorities to maintain its value. Since the two aforementioned entities have been absentee custodians of the Dollar for so long, its value has deteriorated dramatically. Precious metals have allowed individuals to compensate for that loss in purchasing power. Pundits will say that Gold is a lousy investment and they’re right. The problem with their thinking is that Gold is not an investment; it is sound money and should be regarded as such, not with contempt as is routinely the case in the mainstream press corps.

So as we begin another September, a time of year that seems to bring out the worst in our financial and banking system, I will say it again – Gold continues to be the opportunity of a lifetime.

This month’s Keynote article deals with the US Bond market, the future of interest rates, and potential impact that the oversupply of Treasury bonds will likely have on the equity markets. We also update our powerful proprietary indicator, which has been front-running major turns in the 10-year yield market for nearly the past 3 years.

In the Energy and Precious Metals reports, we analyze the many mixed signals in precious metals, and take a much closer look at the supply-side of the energy markets. Our contention is that mainstream economists and analysts alike are making a critical error when assessing these dynamics. You need to be aware of these misconceptions.

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