Traveling through the blogosphere, I've noticed a disquiet. Even a murmering. Smart people who thought that the world was about to end are sticking their heads out of their nuclear bunkers and finding that maybe, they were a little early in their predictions of financial Armageddon.
Amongst those frustrated are 'the Austrians', those followers of Mises and Hayek, who believe in an almost nihilistic economic theory that rejects all statistics and mathematic modelling in favour of a philosophy which rejects any government intervention or contribution whatsoever. The Austrian school is economic Darwinism at its most fundamental. To them, Obama and his G20 colleagues represent the evil empire.
The gold bugs have also been in the forefront of predicting disaster and roundly mocked for it too. Talk of $2000 per ounce by mid 2009 now looks faintly ridiculous and the more famous bugs such as Turk, Casey, Conrad and commentators such as Faber, Roubini and Mobius have appeared to have been bullish on the yellow metal for very little result.
Why hasn't gold lived up to the hype? As an advocate of gold who is responsible for millions of dollars of client money, I have a stake in its performance. Investing other peoples' money comes with much accountability. But an investment which trades within a narrow range can appear indolent and that my dear reader, just won't do. So what is the problem with gold?
Bullion has little in common with equities. It pays no dividend and its performance is a reflection of external circumstances. In the last year those external circumstances have been dire for equities and the world economy in general. You'll need no reminding that we have all witnessed and experienced the worst financial crisis and recession of our lives.
Below is a chart (please click to enlarge). You'll immediately notice two dynamics. The first is the comparative stability of the gold ETF (GLD). The second dynamic is the performance of the NASDAQ, S&P 500 and Dow Industrial Average. To look at this part of the chart is to see an argument against diversification. It appears that when markets fall, they do so in lockstep. Asset quality doesn't matter, everything becomes dreck. Except it seems, for gold. Gold thrives on uncertainty and benefits from volatility.
As mentioned in a previous post, the GLD ETF is now backed by 35,000,000 ounces of gold, an increase of 16,000,000 ounces in the last year. Whilst this has no discernible effect upon the value of gold per se, it is a strong indication that gold is still perceived as an alternative to fiat currencies whose value is dictated only by scarcity and the faith placed in it by the people who use it.
The situation that we have now, is that the UK and US governments are running a Ponzi scheme. By borrowing from the future to pay off the banks now, they are effectively committing the same crime as Bernie Madoff.
Take a look at the chart below from Richard Guthrie of Broadlands Property (click to enlarge) and make your own assessment of how optimistic Alistair Darling's projections are. For Bernie Madoff to succeed, he had to create turnover. For him to succeed as long as he did, those turnover projections had to be realistic. The projections from Her Majesty's Government's Exchequer are fanciful to say the least.
More worryingly, is the projection of gilt issuance from the UK as a percentage of GDP. The projection is that within 3 years, this will amount to 20% of UK GDP.
20%! In 2006, the entire financial sector of the UK represented only 10% of GDP.
The Guthrie chart (click to enlarge) below illustrates this brilliantly. Gilt issuance was steadily rising for years (post 911) to finance the Iraq War. Since then, other than for a short period, issuance has surged out of control.
This is third world territory and potentially disastrous. America will not fare much better. In fact Goldman Sachs has recently predicted that the US will need to raise over $3 trillion this year in bond sales, which is well over 20% of their GDP (assuming GDP of some $14 Trillion). This all has to be paid for. In the UK, the largest business sector is banking. But the banking sector has diminished and no longer has access to the type of financial instruments that fueled growth in the last ten years. The days of 35x leveraging are well and truly over.
So we now have greater debt backed by nothing other than promises. We have a much smaller corporate tax base and lower projected GDP.
However, we are in the middle of a market rally. The question is, is it bull or bear? Back in 2002, Marc Faber wrote eloquently upon the 1930/31 bear market rally. It is a fascinating read:
The treacherous nature of bear market rallies
" 'The market itself is forecasting recovery' reads the recent headline of a well known financial publication. As someone who follows market movements very closely and tries to read signals the markets may give about future business conditions, I was also interested in the market's recent strength.
However, I would be extremely careful in concluding that rising stock prices after a terrific decline, such as we had in the NASDAQ since March 2000, do signal improving business conditions. For a market, which has become very over-sold, it is only natural to rebound, but frequently these rebounds are merely bear market rallies, which are subsequently followed by vicious declines.
Probably the most famous bear market rally in history is the rise, which took place following the October crash of 1929. Stocks began to recover strongly following the November 13th 1929 low amidst wildly bullish comments and confident statements by a very large number of respected Wall Street personalities.
In fact, for a while the bulls were right. From a low at 199 on November 13 - down from the September 4, peak at 381- the Dow Jones Industrial rallied to a high of 294 in April 1930 (up 48%). This famous and well-documented bear market rally took place for a number of reasons. After the October 29 crash, the market had become very oversold - incidentally far more oversold than the US stock market's position on September 21, 2000. Thus, a technical rally was natural.
Also, the Federal Reserve Bank cut the discount rate immediately following the crash from 6% to 5% on November 1, 1929, to 4.5% on November 15, and to 4% on January 30, 1930. Subsequently the discount rate was repeatedly cut to 2.5% in June 1930, to 2% in December 1930, and 1.5% in mid 1931.
The interest rate cuts after April 1930 did, however, no longer support the stock market, which began to sell off once more. And by the end of the year 1930, the Dow Jones Industrial had broken below the November 1929 low and fell to 158 (from there it fell 41 in July 1932). Another reason for the 1929/1930 rally was that the economy held up following the October crash, which led a number of leading business and stock market personalities to make positive comments and to buy equities.
During the first six months of 1930, the business curve of the Harvard Barometer was almost horizontal and, therefore, did not signal a recession. Thus, the October 1929 stock market crash was widely regarded as a financial accident - a direct consequence of excessive speculation, but not as the beginning of an economic crisis that was to jolt the social and economic structure of the entire world.
No one anticipated a recession, let alone a depression. Charles Mitchell who headed the National City Bank, announced soon after the crash that the trouble was 'purely technical' and that 'the fundamentals remained unimpaired'. While President Hoover assured the American people that 'the fundamental business of the country, that is production and distribution of commodities, is on a sound and prosperous basis.'
US Secretary of the Treasury, Andrew Mellon also remained confident about the economy: On December 31, 1929, he stated: 'I see nothing in the present situation that is either menacing or warrants pessimism… I have every confidence that there will be a revival of activity in the spring, and that during this coming year the country will make steady progress' and in February 1930, he added, 'there is nothing in the situation to be disturbed about'.
Economists were not unduly alarmed either. Keynes said that the crash might be beneficial, as money, which had previously been used to speculate on stocks could now be diverted to more productive enterprise. Irving Fisher stated that the 'factors leading to the crash of the American stock market were not factors of depression but of prosperity, unexampled prosperity' and thought that stocks were 'ridiculously low' (subsequently they fell another 80%).
To some extend, Fisher had a point. At its November low, the Dow Jones sold for only 10-times earnings after having peaked at 15-times earnings in early 1929. This was inexpensive when compared to interest rates of less than 4% on long-term government bonds - not to mention the current S&P 500 P/E of over 35!
In fact, these seemingly low stock valuations and sound economic fundamentals led several well-known investors to accumulate shares. Jesse Livermore, who in the summer of 1929 had sold short, publicly stated in November of that year that the decline had run its course and that he expected the market to recoup from its October setback.
Livermore subsequently lost all his money in the 1930-1932 decline and eventually committed suicide. John D Rockefeller who had not spoken publicly for several years, issued a statement in which he said: 'these are the days when many are discouraged…In the ninety years of my life, depressions have come and gone. Prosperity has always returned, and will come again…Believing that the fundamental conditions of the country are sound, my son and I have been purchasing sound common stocks for some days.'
Even Bernard Baruch, who had correctly anticipated the stock market collapse, later confessed: 'I never imagined, in these last months of 1929, that the collapse of stock prices was the prelude to the great depression. Anyone who knew the potentialities of the American economic system, as I had come to know them, could not help but believe that the market break would just inevitably be followed by an even greater prosperity.'
The point I should really like to emphasize is that rally phases after a serious break frequently lead to a false sense of security and confidence among the investment community 'that the worst is over' because stocks are rebounding strongly. Moreover, because business conditions do not deteriorate very badly during the first phase of a bear market, economists and well-known market observers remain optimistic about the future.
However, we all don't know if a strong rally after a sharp decline is a bear market rally, the extension of a secular bull market, such as occurred after the declines in 1987 and in 1998 or an entirely new bull market. But we ought to be careful in concluding that because US stocks have been rising recently, an economic recovery is just around the corner and that corporate profits will shortly begin to rise again.
We simply don't know how the world will look in a year's time. But it is clear that aggressive interest rate cuts, which led to the furious housing refinancing boom, and zero interest rate car loans have borrowed from future consumption, which will be curtailed once interest rates no longer decline.
Don't forget that following each recession over the last 100 years, in the initial recovery economic phase, interest rates continued to decline boosting stock prices and profits. Judged by the recent bond market action, interest rates will, however, go up even before this recession comes to an end.
Thus, given the S&P's still lofty valuation, I remain of the view that US equities have at present very best little upside potential and at worst, still significant downside risk. In fact, I lean toward the view - based on technical factors - that we may very well already have seen the recovery highs for the market or will see them in the next few days and that from here on the down trend will resume".
It is a prescient piece. However, This is not 1930 nor is it 2002. Our economy and this crisis is fundamentally different. The 1929 crash was very much concerned with a stock market bubble, whereas 2008/9 is more about economies that are fueled by record levels of debt created by disproportionally powerful banks. Being the distributors of money, they (along with their governments) encouraged massive borrowing in all sections of society and then structured complex financial instruments that created artificial profits backed up by nothing other than paper.
In 1929, gold was money. You could go to the bank and say, "If I give you $50.00, give me a gold coin". Alternatively, if you gave a bank gold, they gave you paper money. If you gave that paper money to somebody, they could take it back to the bank and get that gold.
Today, debt is money. Money isn't backed by anything. Gold is just a commodity you can purchase with your paper dollars. So as the value of the paper money changes, the amount of gold you can obtain changes. And the supply of that money is determined by the Federal Reserve.
As the value of the US dollar depreciates, the value of gold appreciates. As inflation increases so does the value of gold. The same equation can be made with uncertainty and fear. In overseas markets on September 11th 2001, the gold price spiked 6%.
So to conclude:
If we are not in recovery mode, then the bear market rally is bogus and overdue for a correction. Government borrowing is at historic highs and central banks throughout the world are busy printing record amounts of fiat money.
Ironically,
Alan Greenspan, Federal Reserve Chairman from 1987 to 2006, was an early critic of fiat money arguing in his essay,
Gold and Economic Freedom, that,
"This is the shabby secret of the welfare statists' tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists' antagonism toward the gold standard". A record bear market rally combined with massive levels of newly printed dollar bills and historic government debt can only lead to a catastrophic event. The politicians offer only variations of more of the same, ultimately only exacerbating the crisis. They offer no solutions other than what they believe is required to get re-elected.
We could be heading toward a new phase in this crisis, one which will let all the poison out of the system.
So whilst the Austrian School and the gold bugs may be looking nervously at the surging indexes, a little patience will allow them to say the most satisfying four word sentence in the English language:
"I told you so"
