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.

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

Mandate #1 – Price Stability

When the private Federal Reserve was chartered in 1913 by the unconstitutional Act of the same name, it stated two specific mandates: maximum employment and price stability. Those were to be the Fed’s areas of activity. However, with virtually no accountability to the American people (except vis a vis the President who appoints the Chairman and the Congress who invariably rubber-stamps such appointments), the Fed was turned loose on the undefended US Dollar.

For years, the American public has been duped into thinking that inflation is necessary for economic growth. This outright lie will likely compete for the title of biggest financial fraud in history. Aided by this unawareness, we have seen a fairly standard 5% rate of annual inflation institutionalized into our economic system. For quite a while, this inflation went virtually undetected as it feasted mainly on the prosperity America had achieved, particularly after the Great Depression. As a nation, we began to spend away our surpluses and attach claims on future economic activity through the great society programs of the 1960’s and the perpetuation of New Deal programs such as Social Security.

By the 1970s, however, we’d run short of real money and dealt the global financial system the shock of accepting paper dollars in settlement of our out of control deficit spending. This resulted in a period of increased instability in the 1970s and twin severe recessions. By this time, the devalued Dollar had destroyed enough of our purchasing power that it became necessary in many cases for a second breadwinner to work to maintain the standard of living. In the 1980s and 1990s, Americans began to rely increasingly on consumer credit to bridge the gap left by the waning dollar, and for much of the first decade of this new century, the house became the ATM as another gap filler.

It is no wonder that the recent contraction in consumer credit isn’t touched by the mainstream press; it is that critical to economic growth. This contraction is one of the biggest reasons the federal government has stepped in with record deficit spending. To keep the economic charade going, it has had to.

The above bevy of charts and data should make it perfectly clear that the Fed has failed in spectacular fashion in terms of price stability. The only thing it has been successful in is ensuring that the devaluation of the Dollar occurred gradually, over time, so as not to alarm Main Street.

Mandate #2 – Maximum Employment

The second part of the dual mandate was maximum employment. In this regard, the central bank has done only a slightly better job. America in general has ranked fairly high globally in terms of low unemployment. However, one thing that must be noted is the Fed’s role in assisting with the exportation of American industry and the high paying manufacturing jobs that went with it. How did the Fed do this? Conventional wisdom would assert that it was solely government trade policies and agreements such as GATT and NAFTA that ruined our manufacturing base. That is certainly true, but these government policies had plenty of help.

A consistently weaker dollar means export advantages. However, there was (and still is, albeit a smaller one) a significant gap between labor costs in foreign countries like much of Asia and the US. So US-based companies could export their manufacturing activities abroad to take advantage of the cheap labor while having export advantages over their foreign competitors because of the weak dollar.
While the bottom line was certainly money and power, it is debatable whether the de-industrialization was done to flood America with cheap imported goods to mask the loss of the Dollar’s purchasing power or if it was done merely to consolidate global power by knocking down the standard of living of the first world. I realize this is going to be a difficult point to argue when one can walk into a store almost anywhere in the country and purchase a myriad of items at ‘Rollback’ prices. However, if you take a look around you and imagine what would be there if it weren’t for the debt load, I think you’ll get a pretty good picture of what is going on here.

What is undeniable is the transition from a goods-producing economy to a service-oriented one. The biggest problem with a country full of employees performing services is that many of these services cannot be exported to pay for the goods we now must import. Despite the technological developments of the past 10 years, a haircut still cannot be exported to China. To be honest, the Fed’s direct impact on the job market has traditionally been much less than its impact on price stability. However, the fact that there has been a covert move to de-industrialize the first world cannot be denied. The fact that much of the impetus for this move came from the policies of the IMF and World Bank with assistance from regional central banks is equally real. A good take home message from this is that central planning almost always works against personal liberty and human rights.

Ramifications

Unfortunately, what has taken place over the years is that the Fed has used these two broad mandates to create for itself a battalion of illicit activities, to the point where mere disclosure of what these activities are would cause an instant depression if you listen to Ben Bernanke, Frederic Mishkin, and others. Attempts to shine the light of day on the Fed’s activities are painted as being ‘dangerous’. I’m sure they are dangerous – to the status quo. Even more disturbing is the Fed’s ability to buy out the entire country while Congress worries about state dinner party crashers and how many subpoenas should be issued. Few commentators have bothered to mention that when the Fed buys $852 Billion in mortgage bonds, it is buying the mortgages of American homes. Maybe your mortgage is now held by an offshore banking cartel even though your mortgage contract was with Countrywide, BAC or any of a thousand originators. Does that bother you? It should.

No, this is not a problem of a single rogue Fed Chairman. It is a problem of a rogue institution, which has stretched way beyond its original charter – and an unconstitutional charter at that. Recent moves to audit the Fed, while noble, will only go so far. I had the opportunity to chat with G. Edward Griffin about this very topic and share his concern that the audit movement will act as a lightning rod for public outrage while allowing the institution itself to continue in a business as usual manner. Congress has the power to yank the Federal Reserve’s ticket; it is about time they used it to give the Fed a 100th birthday present – a pink slip.

Addendum It should come as little surprise to anyone that a truly out of nowhere jobs report comes out just as Bernanke is ‘under fire’ on Capitol Hill. It would be nearly impossible to count all the times this has happened over the past year or so when either the stock market or some political figure has needed a boost. What must be noted is that goods-producing jobs continue to disappear, and that much of the ‘good news’ in the jobs report comes from the fact that temp agencies signed on 52,000 workers in November. Much ballyhooed about this trend is the fact that temp agencies have been adding staff for the last 4 months now. What should be of concern is that there appears to be almost no conversion of those temp jobs into permanent positions at this point in time.

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.

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.

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The fact that he is asking for the increase should not be a surprise to anyone given the massive deficits already racked up over the past 18 months. What would be laughable if it weren’t so serious, however, were the comments made in his request letter to Congress.

“It is critically important that Congress act before the limit is reached so that citizens and investors here and around the world can remain confident that the United States will always meet its obligations,”

How exactly does digging your hole even deeper inspire confidence? How does borrowing nearly 50 cents of every dollar you spend inspire confidence? How can anyone with two bits of common sense to rub together take this as anything less than an overt devaluation of the Dollar?

Yet his request was taken in a ‘business as usual’ manner by the media. Of course, this could be due to the fact that in our age of borrow and spend, these requests are becoming more and more commonplace. Perhaps this is one of the reasons people are so annoyed these days?

Debt as a percentage of GDP

This is one of the ways that the overall debts of one nation can be compared to those of another. In 2009, US public debt will be approximately 90% of GDP. It will quickly approach and surpass 100% of GDP in the near future. The chart below, sourced from FY 1020 historical budget tables on pp. 127-128, outlines in dramatic detail the accumulation of debt.

But the chart, unfortunately, only tells a very small portion of the story. First of all, there are some rather interesting assumptions being made here:

1) The chart deals in gross GDP, which is actually better for the discussion since we don’t have to worry about the deflator (GDP Price Index) clouding the initial discussion.

2) The chart assumes that 2009 GDP will be $14,233.96 billion. Given that 2008 GDP was $14,441.40 billion, this constitutes a total drop in GDP of $207.44 billion or 1.44%. This seems a bit shallow considering that to date gross GDP is already 1.38% below that of Q4 2008. That puts the annual pace of the contraction at 2.76%.

3) 2014 estimates place a national public debt of $18,350 billion at 99.9 percent of GDP. This implies a GDP of $18,368.4 billion. This assumes an immediate return to 5% GDP growth per year for each of the 5 years estimated.

Let’s say for example that the rate of ‘recovery’ is more realistic at 2.5% (a rather charitable assumption given the current state of affairs). Suddenly by 2014, the public debt is a whopping 113% of GDP instead of the 99.9% assumed. If we take it a step further and set the GDP growth to 1%/year, which is probably rather close to a best-case scenario, then the $18,350 billion of public debt in 2014 becomes 127% of GDP.

So the big question is where did the assumption of a return to 5% growth come from? Let us take a look at a popular, but discontinued series – M3. Discontinued, if you remember, to save the taxpayers money.

If you do a little smoothing on the data, you will find that M3 generally rose at a rate of very close to 5% per annum. From a monetarist’s perspective, THIS is the real rate of inflation, not what is displayed in the CPI, the GDP price index or other hedonically adjusted numbers.

I think that most people are able to understand the implications of discounting annual GDP growth by 5% every single year. Just to make the point, it is included below:

If you perform the same smoothing on this data, amazingly, you’ll come up with almost the same 5% as above.

What this means is that since 1959, we have had almost no growth in real GDP over the period, but have gone into debt nearly eleven and a half trillion dollars to do it. Now many folks will nitpick about the fact that M3 growth should not be used to adjust GDP, but if you’re going to understand that inflation is an increase in the money supply, then you’d better discount your GDP by the growth in the money supply, not by some politically driven price index, which at best only measures one of the symptoms of actual inflation.

Given the fact that we have such a dismal record of turning our borrowed dollars into anything productive, it would make sense to prohibit the government from borrowing any more money on the behalf of the people. Surely Secy. Geithner is aware of this awful record.

But it gets even better.

“Congress has never failed to raise the debt limit when necessary,”

I would contend that in never failing to increase the debt ceiling that Congress has done exactly that – failed.

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“Identifying False Signals” I discussed the false signals being generated in two key areas of the economy: housing, and GDP. Don’t be fooled into making important decisions based on what you’re getting from these reports; there is much more than meets the eye. Listen Here

“IEA Whitewash” – The IEA’s Chief Economist announced that the agency had grossly underestimated the rate of supply decline. His comments survived long enough to make it into one mainstream story. Then the spin machine kicked in and tried to drop those comments down the memory hole. We’ll make the kick save and present this whitewash to you with our guest Zapata George. Listen Here

“Discussion with Chris Wilson of yourcontrarian.com” Chris and I talk about the state of the consumer, the intracacies of the major economic reports and also spend some time on the timely topic of Keynesian vs. Austrian. Listen Here

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