Saturday, July 31, 2010

Looking at the dollar in the old-fashion way

Below you will find my critique, highlighted in bold font, of a recent article which appeared in the periodical, The Economist.


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.]

When upbeat analysts consensus spells danger

(Thanks for Spencer Jakab's market comentary, The Long View, Financial Times 7/31/2010 edition)

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.”

Caveat emptor!

They Think It's All Over

(My Comments: This brief commentary came by way of the Financial Times...commentary appeared in the 7/29/2010 edition. The fact of the matter is that economic risk has neither disappeared nor subsided, irrespective of what the political/expert consensus claim. The day of financial reckoning is getting closer. It will be much worse than what we experienced in 2008 because the bubble in faith that market intervention is working (or has worked) will implode. This is not too far in the distant future. It is sooner than anyone thinks. Plan accordingly.)


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

Back from my hiatus….but nothing much has changed!

I have been on a six-week hiatus caused by the quadrennial football World Cup celebration. Quite frankly, being the avid football fan that I am, it was extremely difficult to take notice what was going in the world around me. But now that the tournament is over, I can return to monitoring the actions of “world improvers” – that is, those people that want to run other’s lives. One of the organizations that is a primary target of my accusation is the Federal Reserve Board, the federal government’s central bank.

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.