Saturday, September 4, 2010
There is nothing apart from political rhetoric and wishful economic thinking that contradicts this evidence. Few people truly recognize the futility of the economic "stimulus" for the sham that it was; this also includes all the policies enacted by the Federal Reserve Board. Unless a radical shift occurs in monetary and fiscal policies, the end result will be disastrous.
Saturday, August 28, 2010
That said, it is worthwhile to note that, as the data show, the stock market can increase along with declining volumes. This is because a higher value in stocks is generally expected by the market. Therefore, lower volumes theoretically represent scarcity, which buoys prices and perceived value. Of course, this is under the assumption there is such a thing as value, which at this time it is being artificially maintained.
Unfortunately, I am not able to upload the charts I created via Excel which demonstrate the evolution of stock market volumes. However the reader can independently perform my analysis. Simply go to yahoo.com and download the Dow’s and the S&P 500’s “historical prices” data in a spreadsheet, after which you can manipulate the data (by taking 10-day average volume) to obtain my figures.
There is no question that a severe stock market correction is coming. However, it is particularly difficult to predict the specific time it will come. However, we can be assured that as each day passes by we are getting closer to the day of financial reckoning.
Saturday, August 14, 2010
In relative terms, that is, taking into account the year-over-year change in absolute amounts, it is hovering close to 20%. It appears to have initially hit bottom in early 2010.
As I previously noted, when the trough in this measure is reached, we are basically in the countdown phase before a major market correction occurs.
The FED edict this week that they will reinvest the proceeds from the coupon rate and other maturing MBS to purchase US Treasuries is nothing but a drop in the bucket. The move was concocted with the intention of managing market expectations. In other words, it gives the impression to market participants that the FED is willing and able to continue to manipulate capital allocation.
However, as a former central banker and neo-Keynesian supporter, Alan Beattie, currently writing for the Financial Times put it:
One of the peculiar challenges that confront central bankers – and I used to be one – is countering the perception that they are privy to large amounts of private information. True, central banks talk to a lot of practitioners in the financial markets and the real economy and have a good insight into the short-term money markets from their own operations. But beyond that, they are usually working off the same numbers as everyone else. Yet in times of great uncertainty, investors will cling on to anything they can to form a view about the economy, including assuming the Fed knows more than they do.
Of course, like most mainstream economists, Mr. Beattie insists in more spending to cure our economic malice. Conveniently however, like most mainstream economists, he fails to mention—let alone explain—the evidence refuting his opinion: Namely, since 2008 US GDP has increased about $100 billion; total debt, on the other hand, has increased $2.5 trillion (this is not even counting all the government guarantees). In other words, every $25 dollars of additional debt has generated $1 of additional GDP. All these folks with Ivy League and other elite school degrees fail to comprehend simple arithmetic. Their solutions are always more of the same. Therefore, it doesn’t require a high level of intelligence to recognize that, as Marc Faber says, the FED will print and print until the system finally collapses. This will be sooner that you think!
Saturday, August 7, 2010
Last week, Mr. James Bullard was being both cagey and clairvoyant. The president of the St. Louis Federal Reserve Bank noticed what everyone else has seen for months; the US economic recovery is a flop. GDP growth was last measured pottering along at a 2.4% rate in the second quarter, less than half the speed of the last quarter of ’09. At this stage in the typical post-war recovery, GDP growth should be over 5% with strong employment. Instead, the “Help Wanted” pages are largely empty. Homeowners are still underwater. And shoppers are still largely missing from the malls that once knew them. Whatever is going on, it is not the “V” shaped recovery that economists had expected. Many now worry that the recovery might have a “W” shape – a “double dip recession” form, with GDP growth dropping down below zero in this quarter or the next.
Mr. Bullard told a telephone press conference he worries that the US economy may become “enmeshed in a Japanese-style deflationary outcome within the next several years.” That is exactly what is likely to happen.
But it is a little early for the Fed economists to throw in the towel. They still have some fight left in them. If they were really on the ropes, for example, they could throw their “widow maker” punch – dropping dollar bills from helicopters. This would make sure that the money supply increases, even if the normal distribution channel – bank lending – is broken.
In a celebrated speech on Nov. 21, 202, Mr. Ben Bernanke, then a recent addition to the Federal Reserve Bank’s board of governors, explained why deflation was not a problem:
Like gold, US dollars have value only to the extent that they are strictly limited in supply. But the US government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many US dollars as it wishes at essentially no cost.
It was that technology to which Mr. Bullard referred when he ceased being prescient and began being cagey. He was not advocating dropping money from helicopters, not just yet. He was hoping he wouldn’t have to. Instead, he was raising the menace of inflation, in the hopes that that would be enough.
“By increasing the number of US dollars in circulation, or even by credibly threatening to do so,” Mr. Bernanke had continued, “the US government can also reduce the value of a US dollar in terms of goods and services, which is equivalent to raising prices in dollars of those goods and services… We conclude that under a paper money system, a determined government can always generate higher spending and hence positive inflation.”
There’s the problem right there. The threat must be credible. Ben Bernanke’s speech title left no doubt about his intentions: “Deflation: Making sure it doesn’t happen here.” Back then, the reported consumer price measure stood at 1.7% – slightly below the 2% target. Perhaps it was that 0.3% undershoot that set Ben Bernanke to thinking about it. If so, we wonder what he must think now. Today, the Fed is off-target by 75%, which is to say, the measured inflation rate is just 0.5%. It is beginning to look as though Ben Bernanke’s reputation as a deflation fighter is more boast than reality.
The Fed’s Open Market Committee meets on August 10th. On the agenda will be more direct purchases of US Treasury debt – bought with money that didn’t exist previously. This is what economists call “quantitative easing.” It is a way of increasing the money supply. But quantitative easing is not the same as dropping money from helicopters. If you drop money from helicopters there is no room for ambiguity, and no doubt about what happens next. In a matter of seconds, your currency will be sold off, your loans called, and your credibility ruined for at least a generation. Quantitative easing, on the other hand, is a much more subtle proposition. It allows the central banker to maintain his credibility, at least for a while, because it doesn’t necessarily or immediately work. When the private sector is hunkering down, the money doesn’t go far. Prices don’t rise. Japan has done plenty of quantitative easing, with no loss to the value of the yen or to the credibility of its central bank. Europe has done it too. And so has America. The US Fed bought $1.25 trillion worth of Wall Street’s castaway credits in the ’08-’09 rescue effort. But instead of losing faith in America’s central bank, investors bend their knees and bow their heads. Incredibly, the US now announces the heaviest borrowing in history while it enjoys some of the lowest interest rates in 55 years.
A threat to undermine the currency, we conclude, is only credible when it is made by someone who has already lost his credibility. That is, someone with nothing more to lose. Bernanke, Bullard, et al, are not there yet.
Thursday, August 5, 2010
You surely didn't think that the governing elites would let this economic crisis pass without pushing some cockamamie scheme for control. Well, here is the cloud no bigger than a man's hand, a revival of a 60-year-old idea of a global paper currency to fix what ails us.
The IMF study that calls for this is by Reza Moghadam of the Strategy, Policy, and Review Department, "in collaboration with the Finance, Legal, Monetary and Capital Markets, Research and Statistics Departments, and consultation with the Area Departments." In other words, this paper shouldn't be ignored.
It's a long-term plan, but the plan has the unmistakable stamp of Keynes: "A global currency, bancor, issued by a global central bank would be designed as a stable store of value that is not tied exclusively to the conditions of any particular economy.... The global central bank could serve as a lender of last resort, providing needed systemic liquidity in the event of adverse shocks and more automatically than at present."
The term bancor comes from Keynes directly. He proposed this idea following World War II, but it was rejected mostly for nationalistic reasons. Instead we got a monetary system based on the dollar, which was in turn tied to gold. In other words, we got a phony gold standard that was destined to collapse as gold reserve imbalances became unsustainable, as they did by the late 1960s. What replaced it is our global paper money system of floating exchange rates.
But the elites never give in, never give up. The proposal for a global currency and global central bank is again making the rounds. What problem is being addressed? What is so desperately wrong with the world that the IMF is floating the idea of a world currency? In a word, the problem is hoarding. The IMF is really annoyed that "in recent years, international reserve accumulation has accelerated rapidly, reaching 13 percent of global GDP in 2009 – a threefold increase over ten years."
You see, monetary policy isn't supposed to work this way. In their ideal world, the central bank releases reserves and these reserves are lent out, leading to a boom in consumption and investment and thereby global happiness forever (never mind the hyperinflation that goes along with it). But there is a problem. The current system is nationally based and so the economic conditions of one country turn out to have an influence on the borrowing and lending markets. Without borrowers and lenders, the money gets stuck in the system.
This is a short history of the last two years. By now, if the Fed had its way, we would be awash in money. Instead the reserves are stuck in the banking system. It's like the whole of the population of the United States has suddenly been consumed by the moral advice: neither a borrower nor a lender be.
And why? Well, there are two reasons. Borrowers are just a bit nervous right now about the long term. They are watching balance sheets day by day, consumed with a weird sense of reality that had gone out the window during the boom times. Meanwhile, the bankers are just a bit risk averse, happier to keep the reserves in the vault than toss them to the winds of fate. They have the bank examiners breathing down their necks right now, and lending doesn't pay well, not with interest rates being suppressed down to the zero level.
Under these conditions, yes, hoarding seems like a pretty good idea. What's more, we should be very grateful indeed for this retrenchment. The idea of plunging back into another bubble seems rather shortsighted.
The IMF has a problem with this practice, though it doesn't dwell on it. The problem is that this practice of maintaining high reserves is putting a damper on consumption and investment, prolonging the recession. The simple-minded solution coming from the high-minded eggheads at the IMF is to find some system, any system, that would push the money from the vaults into the hands of the spending public.
The rationale for the global currency and global central bank is that the reserves could always find a market in a globalized system, and would not therefore be so tied to the exigencies of a nationally based banking and monetary system.
An academic paper can wax eloquent for hundreds of pages about the advantages of a global system. It will lead to more stability, efficiency, and less politicization of money and credit. And truly, there is a point here: a real gold standard is always tending towards a global currency system. Different national currencies are merely different names for the same thing.
But there is a key difference. Under a gold standard, the physical metal is the limit and the market is the master. Under a global paper system, the paper provides no limit whatsoever and the politicians are the masters. So there is no sense of talking about the glories of globalization in the current context. A world paper currency and world central bank would heighten the moral hazard and lead to a global inflationary regime such as we've never seen. There would be no escape from political control at that point.
Every proposal of a drastic solution such as this always comes with a warning of some equally drastic consequence of failing to adopt the proposal. In this case, the IMF actually raises questions about the survivability of the dollar itself. "There has been a long-running debate speculating on whether the dollar could collapse," says the paper. It raises the worry that if a run on the dollar materializes, central banks could attempt to race each other to dump it permanently.
But, the paper points out, many people wonder whether "good alternatives to the dollar exist." And for this reason, it might be a good idea to cobble together such an alternative sooner rather than later.
There is probably more truth in that statement than most people want to grant. But the right alternative is not yet another and more global experiment in paper money inflation. God forbid. If we want an alternative to the dollar, there is one that could appear before our eyes if only we would let it happen. Private currencies traders the world over could, on their own, give rise to a new currency rooted in gold and traded by means of digital media. On many occasions over the last 20 years, such a system nearly came to be. But guess what? The government cracked down and stopped it. The governing elites have decided that there will be no currency reform unless it comes from the marble palaces of the monetary elites.
Saturday, July 31, 2010
WHEN the Bretton Woods system was cracking in the early 1970s the price of a troy ounce of gold, in dollar terms, was raised in two steps from $35 to $42.22. This was, in effect, a devaluation of the dollar.
[My Comments: the phrase, “was cracking,” without any context presumes the system itself was unsustainable and therefore was collapsing. On the contrary, the Bretton Woods system “was cracking” because, politicians being as they are, refused to play by the rules; namely, don’t print more money without sufficient gold holdings.]
The authorities then still thought it worth expressing the shift in terms of bullion, rather than against another currency like the Japanese yen or French franc. In the 1930s Franklin Roosevelt had a specific policy of devaluing the dollar against gold, pushing the price from $20.67 to $35 in the belief this would push commodity prices (and thus farm incomes) higher and reduce the burden of debt service.
[My Comment: This is classic half-truth statement. Indeed, “Franklin Roosevelt had a specific policy of devaluing the dollar against gold.” He did this, however, by declaring the use of gold as currency to be a criminal activity; the people were required to sell to the federal government all their gold holdings at $20.67 per ounce. After doing this, FDR sold the gold holdings they legally confiscated to the Federal Reserve at $35 dollars. And they return the extra $15 per ouce to the people, right? Don’t be silly, of course not. They pocketed the difference. Read about it here.]
Nowadays the price of gold is set by the market rather than by official diktat. When explaining shifts in the bullion market people tend to think in terms of supply and demand. Perhaps, however, they should view gold-price movements in terms of investors’ confidence in the dollar, and in paper money in general.
[My comment: agree]
After gold was set loose in 1973 its price rose at a rapid rate for the rest of the decade, peaking at $850 an ounce in 1980. In other words the dollar had lost around 90% of its value since the demise of Bretton Woods. The 1970s was a period when economic policy in the developed world seemed to be in disarray, with inflation and unemployment high, and confidence in central bankers low.
[My comment: The devaluation of the US Dollar happened despite the fact that one of the function of the central bank is to maintain stable prices.]
The appointment of Paul Volcker as chairman of the Federal Reserve in 1979 appeared to be a turning-point. He broke the inflationary spiral in the early 1980s, albeit at the cost of a double-dip recession. From 1982 onwards developed economies seemed to enter the “great moderation”: inflation was low or falling, and recessions were rare and mild. The authorities developed the knack of delivering stability with paper money, thanks to independent central banks committed to a low inflation target. Gold fell from $850 to $253 by 1999. With confidence in economic policy restored, the dollar was revalued by 236% over almost two decades.
[My Comment: This statement is a classic example of “correlation does not imply causation.” The reason for falling price inflation and mild recessions had less to do with monetary policy and more about luck. The 1980s witness the fall of communism and a greater push of market-based economics in China. These two events alone caused in large measure the so called “great moderation.” These events also explain why gold went on a 20 year bear market starting in the early 1980s.]
By the late 1990s, however, belief in the eternal wisdom of central bankers was nearing its peak: “Maestro”, Bob Woodward’s portrait of Alan Greenspan, came out in 2000. The dotcom and housing bubbles led to a reappraisal of Mr Greenspan’s career. Many commentators now feel he paid too little attention to credit growth and asset prices. As Charles Dumas of Lombard Street Research tartly remarks, Mr Greenspan displayed “asymmetric ignorance”. He claimed not to know when asset prices were in a bubble but he did always claim to know when falling asset prices were likely to cause havoc. Investors were given a one-way bet.
[My comment: I cannot agree more with Mr. Dumas’ assertions.]
The credit crunch also laid bare a conflict in central banking that goes back to the days of the gold standard. As well as safeguarding the value of the currency, central banks act as lenders of last resort. When push comes to shove the latter duty seems to outweigh the former, and the bankers turn on the monetary taps. The result has been a loss of confidence in the dollar. Gold’s rise since 1999 in effect means a near-80% devaluation of the dollar over the past decade (see chart).
[My comment: Rule # 1 in life: there is no such thing as a free lunch. Rule # 2: Do not forget Rule # 1. Rule # 3: Don’t listen to anyone who rejects Rule # 1 and Rule # 2.]
What is striking about the history of the past 40 years is that these three swings in the value of the dollar (ranging from a rise of 236% to a fall of 90%) are huge by previous standards. But they have not been noticed because the dollar is now compared with other paper currencies—like the euro and yuan—where shifts have been nothing like as extreme.
[My comment: Ben Bernanke, et. al., do not want you to know this truth. The erosion in the value of the dollar is called by economists as seigniorage; however, in the real world it would be called theft. In addition, when the dollar is compared with other paper currencies we are not measuing value, but prices. All paper currencies have zero (yes, ZERO) value.]
This raises a further puzzle. One reason why countries tried so hard to maintain the gold standard and the Bretton Woods system was to reassure creditors that they would be repaid in sound money. Since 1971 most countries have had the right to repay creditors in money they could print at will. The likes of America and Britain are now perceived as “lucky” because they, unlike Greece, can devalue their currencies and default in real terms.
[My comment: This “puzzle,” at The Economist puts it, is what will bring the collapse of our present monetary system. One truism about life is that if things aught to be a certain way, but aren’t at this moment, at some point in the future it will be. The day of recknoning is fast approaching among us where this “puzzle” will cease to exist.]
That prospect did alarm creditors in the 1980s when the real yields on government debt shot up. But it does not seem to now. America and Britain are paying only 3-3.5% to borrow for ten years. That may be because deflation seems the more immediate threat. It may be because bond markets are now dominated by other central banks, which are more interested in managing exchange rates than in raising returns. But it is not stable to combine low yields, high deficits and governments that are happy to see their currencies depreciate. Something has to give.
[My comments: Indeed, “something has to give.” And it will.]
We are told that Wall Street analysts expect “earnings [revenue (minus) costs] for 2010 to be nearly 7 per cent higher than they did in January. These bottom-up forecasts call for the companies in the S&P 500 to grow earnings by 33 per cent this year and another 16 per cent next year.”
To put analysts’ forecasts into perspective, consider that in 2008 they were expecting operating earning [= Earnings (minus) interest (minus) tax] for 2009 at $102.78. As it turned out, actual earning almost 50% lower, at $57.20.
Currently, operating earnings stand at $95.79. Growth in revenue, which is tied to growth in GDP, is expected to decline from 6.3% in 2011 from 8.8% in 2010. “US nominal GDP growth averaged 3.25% in the past decade, but companies in the S&P 500 grew their sales by an extra 2.75% on average. Since nearly half their sales go abroad, this was helped by booming emerging markets and big decline in the dollar, which translates to higher reported revenue.
Analysts expect operating earnings to be 9.11% in 2011, which is almost with levels seen at the high of the bubble period of 2005 – 2007. Since 1997, operating earnings have averaged 6.8%.
However, “what if we plugged in revenue growth of 5.75%, forecast nominal GDP growth that S&P 500 have enjoyed over the past decade [= 3.25% + 2.75%], and then applied the average corporate margin [=6,8%]? Earnings would be just $71 a share [in 2011].”
In addition, “plugging in these numbers, the US stocks would be trading at 15.5x [=1,100/71] 2011operating earnings rather than a far more attractive 11.5x [= 1,100/95.79 currently trading]. And since operating earnings are on average about 19% higher than reported net earnings [= (71 – X)/X = 0.19…solve for X, which = $59.66], that would put the market’s actual 2011 P/E multiple at a somewhat pricey 18.5x earnings [=1,100/59.66] using normalized forecasts.”
Whatever happened to European sovereign risk? Yields on the government bonds of the weakest eurozone members have been gingerly tightening in the past few days. This is particularly true of Spain, which seems to be enjoying a mini re-rating: bond spreads along the curve have fallen by up to 100 basis points this month. The sovereign, along with Portugal, saw refinancing costs fall this week – not substantially, but every basis point helps.
The better tone in the markets is being attributed to a relief rally after the European banking sector was given a mostly clean bill of health by stress tests, which have made banks’ balance sheets a little more transparent. But just because you have a new pair of spectacles doesn’t mean the film you’re watching is any better
Take Greece. The country’s 10-year bonds yield about 745 basis points over German equivalents, about 220 basis points less than at the height of the crisis. To be sure, five out of six Greek banks passed the stress test with varying degrees of distinction. The government has made progress in tightening fiscal policy, including reform of public sector pay and pensions. In general, the system was so inefficient that the mere enforcement of existing rules was always likely to yield higher tax revenues. Indeed, the government claims to be ahead of the targets it agreed to in the spring in return for its €110bn rescue.
That is great, but the reality is that Greece is still heading for a debt-to-GDP ratio of nearly 150 per cent by 2013 and its economy is not growing. Spain, Portugal and Ireland will see minimal growth this year and next, even though they’ll have significantly lower debt levels. Spanish bonds are no longer pricing in the possibility that Spain will become the next Greece, but Greek bonds are still pricing in a debt rescheduling. This scenario was the elephant in the room that the stress tests conveniently ignored. European sovereign risk hasn’t gone away. It’s just on its summer holidays.
Saturday, July 17, 2010
Contrary to popular belief, including those spouse by court economists, of which the Central Bank is replete, economic recessions are the result of government’s interference in the free market. Recessions, in a way, are the free market’s way of correcting the bureaucratic (i.e. political) allocation of capital. Recessions are not haphazard, unpredictable, or without merit. Recessions are not caused by “irrational exuberance,” “animal spirits,” “not enough fiscal stimulus.” These explanations are nothing short of fantasy and make-believe.
There is no doubt in my mind that we continue to head for a major contraction in capital markets. Indeed, we will witness extreme volatility, but the trend is down. Why this practically a forgone conclusion, you have to understand the “Austrian Theory of the Business Cycle:” growth in the rate of printing money and keeping dead companies alive, couple with the inherent price (not necessarily consumer, however,) inflating effect of such government policy, gives the impression of a robust economic environment. When the government slows the rate of growth, the economy is on its last legs. In other words, monetary inflation is bad because when growth declines, the economy is doomed.
One way we can see monetary inflation is by looking at the adjusted monetary base. Consider the following chart:
As you can see, (roughly speaking) the rate of growth has been declining. This implies a recession is coming. It will surprise many, because while they believe a recession is possible, it is highly unlikely of ever coming into fruition. My prediction is that, absent of another massive government intervention program, a major pullback is due before 2010 is over.
Saturday, June 26, 2010
Sunday, June 20, 2010
Wednesday, June 9, 2010
measures of corporate distress, which track borrowing costs for junk-rated companies, rose last month amid growing concerns over sovereign debt. While levels are much reduced from a year ago, Moody’s speculative-grade corporate distress index rose to 14.9 per cent at the end of May, up from 14.1 per cent in April in the first rise since February.
Rating agency Standard & Poor’s is finding a similar trend. Its distress ratio, which tracks the number of high-yield securities trading at spreads greater than 1,000 basis points relative to US Treasuries, rose 40 per cent from March to May 14.
A rising distress ratio typically proves to be a precursor to more defaults if accompanied by a market disruption, S&P said.
The article further quotes S&P:
In the slim chance that the economy experiences a double-dip recession, many of the surviving leveraged issuers originated during 2003-2007 could face renewed default risk unless they significantly reduce their debt burdens.
It is not a matter of if, but rather when. We have entered into what i believe is the second leg of the crisis that began in the spring of 2007. Unless drastic changes in the meddling fiscal and monetary policy occur, the Dow Jones and S&P 500 will fall significantly below the March 2009 lows.
Saturday, June 5, 2010
That said, when that occurs, you should see a rise in prices in the secondary market for U.S. government debt. This provides a buffer to the Federal Reserve to print more money. While in the near term the Fed’s action may prop up the market, it is ultimately doomed.
Pay close attention to the graph of the price of copper. This commodity has been attributed as being the metal with a PhD in Economics, because it is highly correlated to the business cycle. An increase in the price of copper signifies higher demand for other higher order products, which is representative of a booming market. The opposite is true: a lower price signifies lower demand, which is indicative of a depressed market.
Saturday, May 29, 2010
Monday, May 24, 2010
May 21, 2010
ANNANDALE, Va. (MarketWatch) -- How now, Dow Theory?
Was Thursday's plunge enough to trigger a sell signal, indicating that a major bear market has now begun?
Or is the jury still out, which in effect means we should give the bull market the benefit of the doubt?
Those are crucial questions to ask of any market timer right now, of course. But there are several additional reasons to ask them of the Dow Theory.
One is that it is perhaps the oldest market timing system still in widespread use today. Another is that it has a stellar long-term record.
Yet another reason to ask these questions of the Dow Theory: According to two of the three Dow Theorists I monitor, the system is still on a buy signal. If they're right, then the Dow Theory is among the very last of technical trading systems still in this market -- since, especially after Thursday's market action, most of the others are now in cash. (Read commentary on Thursday's breaking of major support levels.)
You might wonder why there is any doubt as to whether a sell signal has been triggered. The reason is that the Dow Theory's creator -- William Peter Hamilton, who introduced the approach in numerous editorials over the first three decades of the last century in The Wall Street Journal -- never codified his thoughts in a set of complete and precise rules.
This failing becomes particularly evident in determining whether the three Dow Theory preconditions for a sell signal have, or have not, been met by the market's gyrations over the last month:
-- Step #1: Both the Dow Jones Industrial Average and the Dow Jones Transportation Average must undergo a significant correction from joint new highs.
-- Step #2: In their subsequent rally attempt following that correction, either one or both of these Dow averages must fail to rise above their pre-correction highs.
-- Step #3: Both averages must then drop below their respective correction lows.
Let me start with Richard Russell, editor of Dow Theory Letters. He believes that Step #1 was satisfied by the market's drop from its April highs to its May 7 low, and that Step #2 was satisfied by the failure of the two Dow averages, during the rally off those lows, to surpass their April highs.
And then, with both Dow averages closing Thursday below their May 7 lows, the sell signal has cleared Step #3.
As Russell wrote earlier this week: "If the May 7 lows are violated by the Industrials and Transports, I expect some severe downside action by the stock market. If that occurs, I would expect traders and investors to panic. I believe it will affect the sentiment of not only investors, but the sentiment of the whole nation. The current rosy optimism could fade and reverse in a week. It could fade because it is built on BS propaganda from the government and hopes on the part of the populace. The 14-month stock market rally has served to brainwash the nation."
"Not so fast" is the essence of Jack Schannep's response to Russell. Schannep is editor of a service called TheDowTheory.com. Schannep's interpretation of the Dow Theory did a better job of navigating the 2007-2009 bear market and subsequent bull market than any of the nearly 200 other stock market timing strategies monitored by the Hulbert Financial Digest.
Schannep believes, in contrast to Russell, that we're still stuck in Step #1 of the three-step process required to generate a Dow Theory sell signal. On his interpretation of how Hamilton's writings apply to today's markets, the initial pullback must last at least two weeks in order to move to Step #2 in this process. This turned out not to be the case:
"The S&P [500 index ] decline did last two weeks (barely)," he writes, "but the Dow Industrials were a day short and the Transports' decline only lasted four days." On Schannep's interpretation, therefore, this week's big plunge simply represents the continuation of the pullback that will eventually become Step #1.
That, in turn, means that the bull market's fate rests with how stocks do in their first significant attempt to rally off of whatever low is set during this pullback. If they fail in that rally to surpass the April highs, and then close at new lows, a sell signal will indeed be triggered.
But not until then.
The third Dow Theorist I monitor is Richard Moroney, whose service is entitled Dow Theory Forecasts. Though he has written relatively little recently about the specifics of his interpretation of the Theory, he did say earlier this week that because "this year's new highs [were] the last confirmed signal under the Dow Theory -- we are sticking with a mostly invested posture."
So there you have it.
One of the three Dow Theorists I monitor is firmly bearish -- along with most of the other technical analysts I follow. The other two are remaining bullish, despite the stock market's recent carnage.
If you don't find their reasons for remaining bullish compelling, then you may want to join the others who have already thrown in the towel.
Thursday, May 20, 2010
European leaders have proudly claimed in the past that this crisis was American made and it would have no impact to their economy. We have seen this is clearly false. They are the same leaders today saying that the weak European states bailout is sufficient to restore prosperity. Unfortunately it will not work.
In the very short term, expect the market to gyrate based on the last thread of hope maintained by “investors.” Nevertheless, the writing to this market is on the wall…."it’s been weighted and found wanting.”
Monday, May 17, 2010
Published: May 16 2010 (Financial Times)
Concern about the exposure of European banks to the debts of weaker countries in the eurozone is stoking growing risk aversion in money markets and increasing the amounts banks charge to lend to each other.
The London inter-bank offer rate, or Libor, has risen in recent weeks to its highest level since last August, especially for dollars, which is significant because the rate has served as a leading gauge of stress during the financial crisis.
The rise in Libor – which affects consumers and companies because it is the reference rate for many floating rate loans and mortgages – has come even though central banks are in no rush to tighten monetary policy.
Analysts say Libor’s recent ascent reflects fears that the €750bn ($928bn) emergency funding facility agreed by the European Union and International Monetary Fund last week will fail to fully resolve the crisis in the eurozone.
The Bank of Japan became the first central bank to react to concerns over sovereign debt strains in Europe 10 days ago by adding overnight liquidity to help investors looking to switch out of euros and into dollars.
“Although stresses are not anywhere near those seen after Lehman Brothers collapsed in 2008, the fact money market rates are rising is a warning of potential problems and shows how nervous many people are in the market,” said Don Smith, economist at Icap.
Brokers expect three-month dollar Libor will rise to 0.46 per cent when banks open for business on Monday, up from Friday’s setting of 0.445 per cent and extending a rise from under 0.30 per cent since early April.
As Libor has risen, the quotes from the 16 contributing banks have diverged, indicating that some banks are seeing tougher funding conditions than others. Last Friday, HSBC provided a low quote of 0.38 per cent, while West LB contributed a high of 0.51 per cent.
Another indication of rising fear can be seen in the cross-currency swap market, which is more liquid than Libor. Demand for dollars through such swaps has not eased in the wake of the eurozone bail-out package revealed last week.
Before the crisis, traders paid an extra 60 basis points to swap euros for dollars for three months. That cost rose to 102bps before the bail-out plan was announced, dropped to 78bps earlier last week, but was back up to 94bps on Friday.
European banking stocks fell 4.5 per cent on Friday while the S&P 500 index dropped 2.7 per cent.
“There is a lot of uncertainty about the exposure of banks and what kind of debt is on their balance sheets,” said Gerald Lucas, senior investment adviser at Deutsche Bank.
Saturday, May 8, 2010
Those of us who adhere to the “Austrian” view of economics, events such as the recent stock market crash that happened on Thursday do not come as a surprise. Massive government intervention produces misallocation of capital, which will unravel once the intervention decreases or stops. Read here what I wrote recently about what lies ahead.
I can bore you to death on the economic technicalities of what “Austrian” economic theory says and how it works…or you can hear what this man has to say.
Wednesday, May 5, 2010
In light of the longevity of budget deficits, few private (brave…or disingenuous) investors will cover the required funding costs. As usual, the government will pick up the tab. Where will they get the money if they are broke, you may ask? Well, from the Central Bank by way of debt monetization. Either way, like their counterparts in the U.S., the EU can only postpone the inevitable collapse of the PIGS.
Keynesians economists are in the driver seat in the world these days (not only in the EU but also in the USA.) They do not understand the “Austrian” view of economics, and therefore reject it. Rest assured that the car they (Keynesians) are driving will certainly crash. All one can do is to try to get out of the day.
Tuesday, May 4, 2010
Monday, May 3, 2010
By Anousha Sakoui in London and Nicole Bullock in New York
Published: May 3 2010 - Financial Times
Prices of junk bonds have rallied so strongly over the past year that a key market benchmark suggests that they are collectively trading at near 100 per cent of face value, a level not seen since before the credit crisis took hold in 2007.
US junk bond prices, measured in a Bank of America Merrill Lynch index, last week reached a price of 99.55, the closest it has been to par - that is 100 per cent of face value - since June 2007.
That marks a sharp recovery in investor confidence in junk bonds - the borrowings from companies below investment grade - from a nadir struck on December 12, 2008, when the index hit a record low of 54.78.
"The return close to par is symbolic," said Martin Fridson, chief executive of Fridson Investment Advisors, which specialises in high-yield bonds.
"With the strengthening of the US economy and signs accumulating of revival in consumer demand, money is coming out of money market funds where yields are abysmally low, and going into high-yield bonds.
"Investors wouldn't do that if they did not have confidence these companies would repay them."
The European bond market has also staged a big recovery in recent weeks, but bonds are still collectively priced at a near 10 per cent discount to par. The Bank of America Merrill Lynch's index of European currency junk bonds reached a high of 92.71 last week, its highest level since November 2007.
While the recovery in European bonds has not been as fulsome as the US market, it is recovering off lower levels. The European index reached a low on December 15, 2008, of 48.02.
Mr Fridson said the lower prices in European junk bonds is a reflection of weaker growth expectations for the European economy. Concerns of a potential default of Greece also hit European junk bonds last week.
Richard Phelan, head of high-yield research at Deutsche Bank, said that despite the sovereign concerns, there was strong interest in high-yield bonds as an asset class, leading to a recovery in prices and new bond sales.
Companies have sold risky debt in record volumes this year. Global issuance of junk bonds totalled $67.8bn (£44.4bn) at the end of the first quarter - a record high for the first three months of the year, according to Thomson Reuters.
Last week alone saw $9bn sold, including a $600m issue from clothing company Phillips-Van Heusen and €500m (£435m) from the French chemicals group Rhodia.
"Investors see the high-yield market right now like a patient that's out of the operating room and been given a clean bill of health. Confidence is being driven by improving corporate quality," said Mr Phelan.
However, he said after such a rally there were fewer opportunities for investors to generate outperformance.
Saturday, May 1, 2010
"With Standard & Poor's estimating a recovery rate on [Greek] government debt of between 30 to 50 per cent, investors could lose vast amounts in what would likely prove to be a long and drawn-out battle to retrieve their money. Significantly, one of the biggest losers in a default would be German and French investors as they hold an estimated €78bn of the total of €295bn in outstanding Greek bonds, according to Barclays Capital.""If recovery rates were only 30 per cent, these French and German investors, mainly made up of commercial banks and insurance funds, would lose €55bn, more than the original international rescue proposal of €45bn.""Other big holders of Greek debt include Italy (€20bn), Belgium (€17bn) and the Netherlands and Luxembourg (both €15bn). Eurozone countries hold in total €164bn."
But the problems extend beyond economics. We are witnessing the capitulation of promises made by politicians. These promises were impossible to keep, yet many conjured up expectations that they would. In America, the roots of the same problems presently being experienced by Greece exist. Yet, the pride of this nation accepts the haughty proposition that “it won’t happen to us.” History, however, dictates otherwise.
Published: April 27 2010 (Financial Times)
[My comments: Mr. Johnson is head of Risk Capital Partners, a private equity firm located in London, UK. His commentary hits at the core of why fundamentally all forms of socialism fail. He brings to the forefront the ethical link that economists and politicians alike do not regard when it comes to policymaking. The art of theft is well camouflaged in their intentions to do go. Indeed, as someone once said, it is easy to do "good" with resources that belong to somebody else. Our human nature is to obtain something with the least amount of energy spent. Current economic theories and political rhetoric try to exploit this loophole in human nature to advance the perceived credibility of their proponents. Theft is wrong and immoral. No amount of "proofs" of the opposite will change that.]
Politics of envy will kill wealth creation
Is envy a helpful motivator for those who want to succeed? I rather think not. It strikes me as a negative, destructive emotion, usually possessed by small-minded individuals who see economics as a zero-sum equation. Entrepreneurs I meet very rarely covet another’s possessions: what they want to build is their own business, independent, better than the competition.
Politicians all too often pander to the envious tendencies among the electorate. As George Bernard Shaw said: “A government which robs Peter to pay Paul can always count on Paul’s support.” Socialism, or “progressive” politics as it is now called, essentially encourages envy under bogus intellectual arguments about equality and egalitarianism. As Sir John Rose, chief executive of Rolls-Royce, put it in this newspaper last week: the proponents of redistribution programmes are so obsessed about how the cake is sliced they forget about enlarging the cake – to everyone’s detriment.
The pessimistic, leftwing view of the world sees it as a place of rapidly shrinking resources, where any elites should be levelled down so that we can all be immiserated together. Thus the Liberal Democrat cure for unemployment and a fiscal deficit is to increase capital gains tax in Britain to 50 per cent, the highest rate in the world. In almost all countries it is half that, or less – in rapidly growing economies like Singapore, Hong Kong, Brazil, Russia and India it is 15 per cent or zero. But their Treasury spokesman Vince Cable, who claims to be an expert in finance and business, (although he has never actually dealt with a payroll in his life) expects entrepreneurs to take all the risk, and the government to take half the reward. At a stroke they would kill initiative, and send a massive signal to wealth-creators: do not invest here.
Almost trebling capital gains tax in the UK would be especially stupid. It would probably raise no extra revenue for the state, and would drive talent and capital elsewhere. Research shows that most job creation in the private sector in recent decades has taken place in companies less than five years old. In sensible economies they cherish start-ups – not burden them. Founders of new ventures make considerable sacrifices to realise their dreams.
Recently I met the chief executive of a dynamic business who has certainly struggled. Five years ago he sold his flat to fund his business, and slept on the sofa in his office for two years. Now his creation is booming and he has a real home again. Building a company from scratch is a perilous task – but the west desperately needs such heroism if it is to generate the surpluses to pay down debt and provide work.
The issues facing the west are straightforward. Possibly the biggest change to impact society in recent decades has been the growth in the number of full participants in the global economy from 700m to 3bn. The arrival of China and India and other developing nations alters everything. India alone graduates 350,000 qualified engineers a year. These young, hungry workers are competing for jobs, wealth and commodities with 21-year-olds from Europe and the US. Average wages in China are less than 5 per cent of average wages in Britain. Investment in education and infrastructure means these emerging superpowers are rapidly catching up with the west in terms of productivity.
If we do not genuinely encourage entrepreneurs to invent and invest here, to search for competitive advantages and to boost productivity, then I can see no alternative but relentless decline – certainly relative, but perhaps even in absolute terms. Big government and a culture of dependency and entitlement is a recipe for disaster. Instead we must grow the private sector, which is the engine for innovation and exports, and the only cure for unemployment. But if we elect amateurs to high office who stimulate jealousy and punish dynamism, they will foster a society rank with stagnation, underinvestment, worklessness and despair. A sense of grievance and adoption of the victimhood complex – all ailments promoted by certain politicians – are the opposite of what is needed. When will they ever learn?
Monday, April 26, 2010
In a speech to Wall Street today, President Obama talked of a "failure of responsibility" in Washington and on Wall Street. But the financial sector is the most regulated part of the economy, so surely responsibility lies mostly with Washington. It was the federal government that created deposit insurance, which removed risk (and therefore caution) from bank deposits. It was also the feds that created "too big to fail," our new system of private profits and socialized losses. Most importantly, it was federal taxes and regulations that undermined our productive capacity, rendering us weak in the face of financial shocks.
In this speech castigating private greed, no mention was made of Fannie, Freddie, or the FHA's role in encouraging sub-prime loans, nor of the Fed's ultra-low interest rates which made the mortgage "teaser rate" possible. The maligned "unregulated derivatives" market was largely based on exposure to these government-backed loans.
Obama claims he wants "common sense rules" to be put in place. Yet, his reform proposal defies common sense.
The new "resolution authority" is an attempt to replace the traditional bankruptcy court system with a bailout bureaucracy that subordinates the rule of law to political expediency. The result of this reform will be to increase uncertainty for any honest market participants - and create a protected sandbox for firms connected to the executive branch.
The "Volcker Rule" to split up large firms runs directly counter to this, and the past, Administration's encouragement of dominant banks to buy their weaker competitors. Ironically, the additional regulations put in place by the bill will create tremendous barriers to entry for new firms, and strongly advantage those firms that can create the largest economies of scale (number of productive employees per compliance officer).
So long as the Fed continues to hold interest rates artificially low and the government continues to guarantee mortgages, real estate prices will remain distorted, credit will be misallocated, moral hazards will increase, and the underlying fundamentals of our economy will continue to deteriorate. Contrary to the President's assertion, government bailouts and stimulus have weakened the underpinnings of our economy, not saved it. As a result, the next economic crisis, likely to hit within a few short years, will be that much worse. Not only will this new regulation do nothing to prevent the second phase of the crisis, it will more than likely increase its severity.
The President seems to insinuate the he saw the crisis coming. Well, I was on national television as far back as 2005 explaining the problem and warning of an impending crash. This was back when Senator Obama was voting for the bills that made it all possible.
Saturday, April 24, 2010
Chart of the Day commentary puts it as follows:
[The] chart presents the median single-family home price divided by the price of one ounce of gold. This results in the home / gold ratio or the cost of the median single-family home in ounces of gold. For example, it currently takes 153 ounces of gold to buy the median single-family home. This is considerably less that the 601 ounces it took back in 2001. When priced in gold, the median single-family home is down 75% from its 2001 peak and remains well within the confines of its five-year accelerated downtrend.
As mentioned in previous posts, gold is a measure of long-term wealth; therefore is a good relative indicator when comparing different products/service on an intertemporal basis. Based on the trajectory of the graph we are headed to levels seen around 1979-1980. This means that house prices will fall further.
Wednesday, April 21, 2010
Sir, John Kay is only partially correct about the failure of economics (“Economics may be dismal, but it is not a science”, April 14). Economics is indeed a science, just like psychology or sociology. The problem is that, just like certain psychologists and sociologists, many economists today are not acting scientifically.
In the social sciences, knowledge acquisition is limited first by the focus on human conduct that is itself not yet fully understood, and second by the difficulty of isolating human experimental subjects from their social, cultural and temporal contexts. We are, after all, studying ourselves. Yes, recent macroeconomic theory has gone astray. However, the reason for this departure is not in the individual ideas, but in the public administrators’ (and certain scientists’) premature reliance thereon to make policy decisions that are way beyond the scope of current economics.
Markets are efficient; but they don’t take only data into account, they also react efficiently to fear and excitement. Most long-term investors may resent being subject to these sometimes violent market stimulants.
Rational expectations theory doesn't suggest people act rationally in the sense of “logically”. The stickiness here is one of word definition. People are sometimes emotional, and scientists should “rationally expect” seemingly irrational behaviour resulting – quite rationally – from the play of emotion.
The dynamic stochastic general equilibrium theory can be a useful tool to understand certain cause-effect relationships, but it cannot be applied outside the laboratory without risk. Anyone but an ivory-tower theoretician realises that too many unexpected variables will invariably spoil the desired effect.
My father, Edward C. Harwood, founder of the American Institute for Economic Research, spent his life studying the acquisition of knowledge and the nature of economics as a science. He, professors George A. Lundberg and Stuart C. Dodd of the University of Washington, and a small team brought a good dose of common sense and insight to economics, but unfortunately the unpopularity of true scientific rigour limits its appeal and prevents a more lucid evaluation of the validity of the results.
I hope that George Soros and his New Economic Thinking are serious about their effort to re-energise the field, but let’s hope he goes about it in the right direction, ie, towards modesty. It will not be easy, because most academic economists and their political counterparts just don’t have the incentives. Humility doesn’t lead to “breakthroughs”, published work, tenure, and public office.
Marina Del Rey, CA, US
Tuesday, April 20, 2010
(graph obtained from "The Recession: when did it end?", printed in The Economist Magazine)
Saturday, April 17, 2010
After the Lehman Brother collapse in 2008, the Federal Reserve Board (FED) engaged in the expansion of its balance sheet (i.e. its monetary base) in an unprecedented manner. The FED’s balance sheet represents money that is in the economy. Through fractional reserve banking, this money is multiplied many times over, consequentially causing prices to rise. When the FED withdraws money or slows the pace of its creation, its balance sheet’s must inevitably contract. Against this backdrop, prices will fall. Consider the following graph (see clear view here):
This graph illustrates the behavior of the “percent change from a year ago” (aka year-over-year or YOY) for the adjusted monetary base from 1984 to April 2001. We can easily see that the contraction in economic activity (synonymous with market crash) almost always preceded the trough of the most recent credit expansion. In other words, when the YOY figure dropped sharply, a market crash is probable. The graph should contain another shaded rectangles to demonstrate the bond market crash in 1994 and the Asian and Russian crisis in 1997.
Notice this next graph, which illustrates data for the first decade of 2000 (see clearer view here).
The gyrations in the YOY change of the monetary base were less pronounced. In fact, the downward trend was relatively smooth in comparison to prior periods. This allowed the appearance of stability to extend longer than it should have. Ultimately, however, the market ran out of steam by 2008 and the previous bull market subsequently turned bear and severely crashed. All of the FED’s liquidity facilities (TALF, TAF, etc.) have now expired; therefore I don’t expect the monetary base to continue to increase (this means rates will go up). Notice the sharp fall, hitting (what appears to be) the low in January 2010. Indeed the trend can continue lower to a YOY change between 5-10%, a percentage consistent with what was seen in the early parts of the 2000s. In light of the massive expansion of monetary policy, this is inconsequential. If history is any guide, a market crash is in the works for sometime later this year.
Let’s look back to some of the major financial crises since 1980.
1982: Emerging market debt crisis.
1987: U.S. stock market crash
1990: Japanese stock market crash
1994: Bond market crash
1998: Asia financial crisis/Long-Term Capital hedge fund insolvency
2000: Technology stock market crash
2006-2007: U.S. housing market crash & subsequent stock market crash (in 2008).
The most recent financial meltdown has been the one of greatest intensity and longevity since the institution of the fiat monetary system. As a result, it required an unprecedented amount of money printing to stabilize the system. The money printing represents future obligations (i.e. debt) which should be paid but never will. Our economic future doesn’t bode well, despite what U.S. elected leaders say. As can be noted, every 4 years or so we’ve had a major crisis. There is no evidence that this patter won’t be sustained. However, it is difficult to predict how much longer we have until the present market rally peters out.
“On balance, the incoming data suggest that growth in private final demand will be sufficient to promote a moderate economic recovery in coming quarters. Significant restraints on the pace of the recovery remain, including weakness in both residential and nonresidential construction and the poor fiscal condition of many state and local governments.”
Carefully crafted, his statement forecasting economic activity achieved its intention: give the impression things are looking up, despite “weaknesses.” Make no mistake, Mr. Bernanke is a Keynesian economist. Never judge a person by his/her words, but rather by their actions. And Mr. Bernanke’s actions reveal a deep trust and abiding faith in an economic interventionist policy, a modern legacy of Lord Keyes.
The aforementioned “weaknesses” are quite obvious. This deep recession has cut significantly a vast source of revenue for governments: taxes. The fact of the matter is that long-term unemployment, i.e. those people who have been out of work more than 27 weeks, currently stands at 6.5 million. This number constitutes approximately 44% of those unemployed. This can only mean that people that have been let go from their jobs are not finding new ones. Furthermore, this gives evidence that jobs that were created during the last boom period are not returning. It is no wonder why the Obama administration extended for several months unemployment benefits.
The housing market, it goes without saying, is in shambles. Over the last year, the government, through the Federal Reserve Board, committed to purchased $1.2 trillion of Agency mortgage back securities with the objective of keeping mortgage interest rate low. Rates began a downward trajectory. However, these purchases ended in March 2010. As you can see here, 30-year mortgage rates are going up, which will undoubtedly put pressure on housing prices.
Overall, the trillions of dollars of fiscal and monetary stimulus have had a relatively subdued effect, particularly if one considers that present levels of debt are not only nonproductive but also a restrain on economic growth. See here. We are in a period of transition, which is being sustained by government intervention of the economy. When the pace of such support slows, invariably its effects will subside over time, ultimately leading to an economic bust. Support has slowed. It is only a matter of time before this sham economic growth extolled by Mr. Bernanke reverses. Court economists will be the last ones who will see the oncoming crisis.
Friday, April 16, 2010
Today's chart illustrates rallies that followed massive bear markets. For today's chart, a 'massive' bear market is defined as a decline of greater than 50%. Since the Dow's inception in 1896, there have been only three bear markets whereby the Dow declined more than 50% (early 1930s, late 1930s until early 1940s, and during the very recent financial crisis). Today's chart also adds the rally that followed the dot-com bust during which the Nasdaq declined 78%. One point of interest is that the current Dow rally has followed a path that is fairly similar to that of the Nasdaq rally that began in late 2002. It is also worth noting that each rally lasted from about 300 to 370 trading days and then moved into a trading range/choppy phase that lasted for a year or more. In the end, the current post-massive bear market rally is by no means atypical.
Tuesday, April 13, 2010
Monday, April 12, 2010
04/12/10 Buenos Aires, Argentina – Argentina is for economists with a sense of humor, if there are any left. It’s for anyone who likes a good drink and a good laugh. And for anyone who wants a peek at the future.
What do defaults look like? Look at Argentina. The Argentines pulled off the biggest default on sovereign debt in history. In 2001, they defaulted on $132 billion in loans. Later, they negotiated a settlement that left lenders with their worst haircut ever.
But at least the lenders must have had fun. They came down to Buenos Aires on rich expense accounts. They stayed at the Four Seasons. They ate steaks that were thicker than glaciers…and washed them down with a whole rio of malbec. They probably went to a few tango shows too. The visit may have cost them billions…but heck…
…it wasn’t their money.
How about inflation? Want to see that? Argentina has had plenty. Even hyperinflation. In 1989 alone, prices rose 5,000%. By 1992, it took about 100 billion 1982 pesos to equal one single new peso. And who remembers the austral? That was a currency introduced in ’85. It was worthless by ’92.
Don’t think you have to worry about inflation? The lure of a little inflation will be irresistible. The arrival of a lot of inflation will be irreversible.
Ask the Argentines; they’re the experts.
So what kind of crisis will the US have? No one knows. But our bet is that it will have them all. Inflation…deflation…default…hyperinflation… Get ready; they’re probably all on the way.
Saturday, April 10, 2010
1. Hubris born of success. Or, as Bill Bonner from the Daily Reckoning often remarks, “nothing fails like success.” This is characteristic of complacency that emanates from good fortunes (i.e. success). You believe that because you are successful, you must be good at what you do. In fact, success could have been solely the outcome of being at the right place at the right time; not because you were actually good at what you do. A false impression gets created.
2. Undisciplined pursuit of more. Or, in plain English, this is the idea that says, “hey, look, I’m good, I’m going to up the stakes to show you how exceptionally good I am.” Of course, in this stage, undue risk is taken.
3. Denial of risk and peril. That is, ignoring the obvious warnings. As Mr. Collins writes, when these “Internal warning signs begin to mount, [the] external results remain strong enough to 'explain away' disturbing data or to suggest that the difficulties are 'temporary' or 'cyclic' or 'not that bad,' and 'nothing is fundamentally wrong.'... leaders discount negative data, amplify positive data, and put a positive spin on ambiguous data ... blame external factors for setbacks rather than accept responsibility" ... slogans and ideologies beat out "vigorous, fact-based dialogue that characterizes high-performance teams ... those in power begin to imperil the enterprise by taking outsize risks and acting in a way that denies the consequences"
4. Grasping for salvation. This is the stage of desperation. Actions are taken, which under normal circumstances would not be considered. In this stage, the true character of the organization is evident. Loss is inevitable, yet a grasp of hope is retained.
5. Capitulation to irrelevance or death. After all silver bullets have been fired, it become obvious that jumping ship is the best thing to do. As Mr. Collins writes, “accumulated setbacks and expensive false starts erode financial strength and individual spirit to such an extent that leaders abandon all hope of building a great future. In some cases the company's leader just sells out; in other cases the institution atrophies into utter insignificance; and in the most extreme cases the enterprise simply dies outright."
Where is our society, i.e. the U.S.A., in this continuum? In my view, we are at stage 4, grasping for salvation.
America was founded with the concept of the right to life, liberty, and the pursuit of happiness. These aspects are unique in historical perspective; that is, no other nation since time immemorial had been created under a creed of individualism. Sure, the Magna Carta can be argued to be the first western civilization creation trumping the concept of individual rights, yet it was limited in comparison to the foundations of America.
It was the belief that one can come to America, mind his/her own business, and live the life he/she has imagine (as H. Thoreau wrote), that garnered the nation unprecedented prosperity, not only in monetary terms but also in non-monetary terms. Indeed, it was not a perfect nation, but in relative terms it was.
But there was underground force that sought to stir its control over politics and invariably the economy. This was manifested by the creation and subsequent dissolutions of several Central Banks. This can be encapsulated in what President Andrew Jackson said of the operators of the Second Bank of the United States,
“Gentlemen, I have had men watching you for a long time and I am convinced that you have used the funds of the bank to speculate in the breadstuffs of the country. When you won, you divided the profits amongst you, and when you lost, you charged it to the bank. You tell me that if I take the deposits from the bank and annul its charter, I shall ruin ten thousand families. That may be true, gentlemen, but that is your sin! Should I let you go on, you will ruin fifty thousand families, and that would be my sin! You are a den of vipers and thieves.”
But the financiers and their political appointees who aimed to extend the control over all economic activity ultimately won out. This was first manifested in the creation of the Federal Reserve Board in 1913, the institution of the federal income tax in the same year, and America’s official imperial ambitions by entering in WWI. The goal was expanded in the 1930s by the creation of the New Deal. The military-industrial complex, which was left over after the involvement in WWII, was amplified in the subsequent decades through the coercion of foreign nation building (i.e. gunboat diplomacy, or spreading democracy by force). These affairs invariably involved (and continues to involve) a significant cost. For some time now, the expansion of centralized political power has determined the allocation of economic resources, which almost always redistributes them inefficiently. This inefficiency manifests itself in the form of recessions. Of course, the economic theory taught in higher learning institutions funded by the same centralized political powers never exposes the fallacy of their expositions.
The crisis America is currently experiencing is the result of policies and other political maneuvers that have been in place for well over a century. The masses have learned to live with them. In 2008, America officially (out of desperation) embraced the socialization of all economic risk. This was unprecedented in American history. This is a point of no return. The only enigma now is how long we, as a society, will stay in stage 4. Stage 5 is inevitable.
Thursday, April 8, 2010
Bubbles lurk in government debt
As the global economy reflates, many people are asking: “Is the next bubble in gold? Is it in Chinese real estate? Emerging market stocks? Or something else?” A short answer is “no, yes, no, government debt”.
In my work on the history of financial crises with Carmen Reinhart , we find that debt-fuelled real estate price explosions are a frequent precursor to financial crises. A prolonged explosion of government debt is, in turn, an exceedingly common characteristic of the aftermath of crises. As for the probable non-bubbles, most emerging markets face better prospects in the decade ahead than does the developed world, and their central banks will probably want to continue diversifying their reserve holdings. Of course, huge volatility and corrections along the way are normal.
But a deeper question is whether economists really have any handle on ferreting out dangerous price bubbles. There is much literature devoted to asking whether price bubbles are possible in theory. I should know, I contributed to it early in my career.
In the classic bubble, an asset (say, a house) can have a price far above its “fundamentals” (say, the present value of imputed rents) as long as it is expected to rise even higher in the future. But as prices soar ever higher above fundamentals, investors have to expect they will rise at ever faster rates to make sense of ever crazier prices. In theory, “rational” investors should realise that no matter how many suckers are born every minute, it will be game over when house prices exceed world income. Working backwards from the inevitable collapse, investors should realise that the chain of expectations driving the bubble is illogical and therefore it can never happen. Are you reassured? Back in my days as a graduate student, I know I was.
But then along came some rather clever theorists who noticed that bubbles might still be possible (in theory), if we lived in a world where the long-run risk-adjusted real rate of interest is less than the trend growth rate of the economy. Basically, this condition raised the possibility that the bubble might grow slowly enough that houses would never cost more than world gross domestic product. Oh, no! But there soon followed empirical research reassuring us that we did not live in such a bizarre land.
Science moves on. Eventually, economists realised that in a real-world setting replete with non-linearities and imperfect markets, the same set of fundamentals can, in principle, support entirely different classes of equilibria. It all depends on how market participants co-ordinate their expectations. In principle, prices can jump suddenly and randomly from one equilibrium to another as if driven by sunspots. (I believe this notion of self-fulfulling multiple equilibria is quite closely related to George Soros’s notion of “reflexivity”.)
The problem of reflexive bubbles turns out to be even more acute when the government’s policy objectives are inconsistent, as they so often are. For example, Maurice Obstfeld famously demonstrated how self-fulfilling investor expectations can bring down a fixed exchange rate. If investors gather with enough sustained force, and if the central bank lacks sufficient resilience and resources, investors can blow out a fixed exchange rate regime that might otherwise have lasted quite a while longer.
The real issue is not whether conventional economic theory can rationalise bubbles. The real challenge for investors and policymakers is to detect large, systemically dangerous departures from economic fundamentals that pose threats to economic stability beyond mere price volatility.
The answer, as Carmen Reinhart and I demonstrate drawing on centuries of financial crises, is to look particularly for situations with large rapid surges in leverage and asset prices, surges that can suddenly implode if confidence fades. When equity bubbles burst, investors who made money in the boom typically swallow their losses and the world trudges on, for example after the bursting of the technology bubble in 2001. But when debt markets collapse, there inevitably follows a long, drawn-out conversation about who should bear the losses. Unfortunately, all too often the size of debts, especially government debts, is hidden from investors until it comes jumping out of the woodwork after a crisis.
In China today, the real problem is that no one seems to have very good data on how debt is distributed, much less an understanding of the web of implicit and explicit guarantees underlying it. But this is hardly a problem unique to China. Even as published official government debt soars, huge off-balance-sheet guarantees and borrowings remain hidden for political expedience around the world. The timing is very difficult to call, as always, but even as global markets continue to trend up, it is not so hard to guess where bubbles might be lurking.