THE OBVIOUS IS OBVIOUSLY WRONG (2007)
CONSENSUS FORECASTS FOR 2007
The S & P 500 WILL BE UP 10 to 15% IN 2007
For the first time since 2001 all the analysts surveyed by Barron’s are in unanimous agreement that the S & P 500 will be up 10% at the very least. Well the surest bet for 2007 is that not only will the market NOT be up but it is my firm conviction that it will be down at least 10%
A WEAK US DOLLAR:
Another unanimous forecast for 2007 that everyone, and I mean everyone, is in complete agreement with; is that the US Dollar is weak and heading sharply lower in 2007. To tell you the truth I think so too, but if there is only one truth that I have learned in fifty years of investing it’s that whenever there is this strong a consensus on anything, you can rest sure that it is wrong. The obvious is obviously wrong! So what will happen to the US dollar and why? Right now I can’t offer you a well thought out answer, but I will try to find one for my next letter. BUT rest assured it is NOT going to hell in a hand basket
The other side of a “weak dollar” coin should be a strong consensus for a sharply rising Gold prices to new highs or at least it should be, but luckily for us it just ain’t so. To a good deal of our readers who have been believers in gold for over 20 years it may seem so, but even though gold mutual funds have been the top performing funds over the last five year: Up 23% last year, nobody except the gold bugs are recommending them and whenever there is a mutual fund expert(?) on TV, they never mention gold. Don’t despair; that’s good for us gold investors. The only thing that worries me is all those Gold Bars on the cover of Time. To me that means there are still some unforeseen hiccups in Gold’s upward march, probably in response to the unexpected dollar strength that will surely blindside everyone this coming year. Or as I forecast in my last missive; a test of the $560 area to complete the diagonal Wave 2 triangle by the middle to end of Jan./07 before Gold’s Wave 3 lift-off to $1000 +
“THE WORLD IS NOT, I REPEAT, NOT COMING TO AN END”
Another sure thing is what seems to be the unanimous consensus that the FED’s next move is to lower interest rates: The question is not if, it’s when. Here is a perfect example of hearing and seeing only what they want to hear and see. In the face of all of Wall Street and the Media’s talking heads calling for a cut in rates, the world seems to have not heard the FED’s warning that their next move is most probably up! This is exactly the kind of stupidity you get whenever (which is all the time) you isolate one and only one factor and try to base a prediction on that one factor. Question: If the assumption is that the Dollar is weak and getting weaker, what if anything can the FED do about it ? DAH, raise interest rates?
HISTORY”S BIGGEST RISK
“The biggest risk is the “One” that nobody perceives it to exist”
If the FED has to raise interest rates in their attempt to protect the Dollar, what would happen to our Goldilocks Economy, Bond and Stock Markets? Dah, I hadn’t thought about that.
Has anybody noticed that the spread between treasuries and junk bonds is near the lowest in history; under 3%, down from a normal 7 to 10% and a high of over 15% in the 80’s The world is now taking on risk at a higher and faster rate than ever before. I guess that’s what happens when you grow up believing in fairy tales and believing that the Government and the FED will take care of us all, from cradle to grave: Which is only possible if there is nothing between the cradle and the grave.
Looking for a SURE FIRE BET, try buying Treasuries and shorting Junk bonds.
THE INVERTED YIELD CURVE
In the past, every inverted yield curve was precipitated by the FED sharply curtailing money supply in conjunction with rapidly rising short term rates thus eliminating all short term liquidity and precipitating a recession. The inverted yield curve did not cause the recession; it was just one of the “effects” of the FED taking away the punch bowl.
With the FED’s continued shoveling of money into the system faster than I used to be able to shovel coal into the boiler of the great lakes freighter I worked on some 50 years ago, restricted money supply is certainly not the cause of today’s yield curve. So what is? And why is nobody even questioning it, let alone looking for an answer. I guess it’s easier to believe in fairy tales like Goldilocks. Do you really believe that people are buying long term bonds at these rates because they believe that inflation will stay below 2% for the next 30 years? Those dummies can’t even predict next months inflation rate let alone what it will be in 30 years.
Ever hear of Supply and Demand or is that just something you all learned about in first year university and along with the rest of our Economists, promptly forgot. Has anyone even noticed that 30 year bonds which once made up over 30% of our National Debt has now fallen to below 5%; while Short Term paper which used to be under 30% is now over 50%? Does anybody still remember what happens to price when you reduce the supply of one product and at the same time increase the supply of another competitive product? (Remember; bond prices up means interest rates down)
have on numerous times in past letters explained the carry trade as well as the
different goals of the super rich and the desires of exporting nations like
The Interest Rate Anomaly
It is impossible for the tremendous volumes of bond purchases to have been funded simply out of savings. This anomaly has not attracted much attention or investigation. Instead, most analysts now find this state of affairs to be utterly normal. "Deficits don’t matter" perfectly summarizes the prevailing attitude. The massive accumulation of government and corporate debt while still maintaining a low inflation environment no longer provokes much curiosity, even among professional economists. What’s even more curious is that an ever rising bond, stock and real estate markets have become accepted as the normal state of affairs, requiring no special explanation our counter-action. Periodic bouts of inflation, the tell-tale signs of a long-standing debt addiction, have all but vanished. The central banks, as financial physicians, seem to have affected a miraculous cure. . . . Few have ever bothered to ask how the central banks have accomplished this feat. But as long as inflation, like your wayward daughter, is out of sight, who really cares exactly what the central banks have been up to.
The character of the 21st Century inflation is different from that of the 1970s. Since 1987, price changes following huge increases in money supply have been restricted to stocks, bonds and real estate rather than to wages and consumption goods at least so far. How can inflation sometimes affect financial assets and other times mostly consumer prices? The particulars depend on where and how the new money enters the system, and most importantly, what the initial recipients spend it on. As the initial recipients (the banks, the creators of new “out of thin air” money, the big Brokers and Hedge Funds) find themselves with a surplus of cash relative to their needs and since they don’t consume, they will bid for financial assets (Bonds) which, the sellers of those assets, the government, will supply as much of as is wanted. In this way, monetary expansion will affect some prices more than others. For example, during inflation, the relative price of apples in terms of oranges might no longer be 1:2, the apple might now cost $2 and the orange $6, a ratio of 1:3. Price ratios are not stable under inflation. However, suppose that instead of comparing apples to oranges, we compare apples to the DJII. If apples cost $1 and the DJII is 5,000, and then money is created and used by the initial recipients to buy stocks, the apple may still cost $1, while the DJII becomes 10,000. That is a financial disaster just waiting to explode.
GLOBALIZATION AND A WORLD WIDE INVESTMENT BOOM
financial assets absorbing most of the impact of the newly created money, the
outbreak of inflation into wages and consumption goods that proved so
disastrous in the 70s has been, for the time being, repressed. A large part of
that can be explained by globalization and the massive capacity over investment
that is associated with every massive credit expansion and low interest rate
induced boom. The inflationary price adjustments rest assured will eventually
leaked out of financial markets into other markets, the first was real estate.
Normally, the latter recipients of the new money spend it on consumer goods and
cause inflation to creep into the CPI. But the massive worldwide over capacity
build up has kept prices of consumer good and wages in check so far. However,
in recent years, money that has been injected in ever increasing amounts into
the financial markets was either contained there or poured into real estate.
The GAO’s (FMN & FRE) taking a lesson from the Banks,
quickly jumped into the fray. Normally all this would have showed up in the
CPI, but this time the government, in its infinite wisdom, decided to only
measure rents, which were falling, instead of home prices which were
skyrocketing. The mechanisms of this containment in conjunction with interest
rate arbitrage geared through financial derivatives, a stronger
THE FEDERAL RESERVE BANKS HAVE LOST CONTROL OF THE MONEY SUPPLY
Entrepreneurial activity is the activity of insightful entrepreneurs who perceive profit opportunities and are willing to risk their capital to back up their ideas. The continuing rearrangement of productive activities by entrepreneurs aligns production with consumer preferences.
The Management of Expectations
The purchasing power of money depends on the supply and demand for money itself. The greatest determinant of the demand for money is public expectations of future prices. If prices have been stable, people will expect them to remain stable and money demand will remain about the same or actually decline.
In spite of accelerating money supply growth, if people do not believe that prices will rise in the future, inflation expectations can remain low. On the other hand, if the people perceive a large increase in the money supply and hence future increases in prices. . In response to inflationary expectations, people buy now, drawing down their cash balances and raising prices. Their lowered demand for investments (bonds) pushes up interest rates as well as the prices of goods and services now, rather than later. The more people anticipate future price increases, the faster those increases will occur. . .
Deflationary price expectations lower prices, and inflationary expectations raise them.
Recent history suggests that people attribute more importance to the recent price changes of consumption goods in forming expectations about the future. Similarly, consumer's attribute more importance to price trends in financial assets in forming opinions about the future prices. Moves in asset price attract little interest from the masses until a trend has been in place for some time.
the extent that any money at all has leaked out of financial assets into
consumption goods, the deliberate distortions in the measurement of the
Consumer Price Index (CPI) has been introduced in order to create a false consensus that "there is no
inflation." A variety of questionable price adjustment stratagems have
been instituted in the CPI computation: The exclusion of food and energy, the
use of "quality-adjusted"
prices, seasonal adjustments, and the replacement of home prices with rental
rates. The index incorporates only consumption goods, when most of the price
increases are showing up in financial assets and the costs of health care. So
successful has been the management of expectations that inflation has
disappeared from public discussion. Most of the public did not view a
succession of all-time highs in the stock market in any way relevant to the
price they would have to pay for milk. Growth in the money supply attracted no
analytical attention from the mainstream financial media. Some prominent
"supply-side" economists even advanced the ludicrous idea that the
The Corruption of Savings
A peculiar feature of the social psychology of financial asset prices is their self-reinforcing character. The upward trend in stock and bond prices has served to enhance the respectability of capital markets and their perceived safety as repositories of money. Some commentators reason that inflation must now be quite low because the credit markets are patrolled by "bond vigilantes," astute traders ever alert to punish central banks for their inflationary indiscretions and always ready to dispense rough justice in the form of higher interest rates. However, this analysis assumes that inflation is reflected primarily in consumption goods and that bond yields are free to move on their own to convey meaningful information about changes in the value of the monetary unit.
These assumptions are more or less the reverse of reality: The funneling of inflation into bonds as described above provides a floor under bond prices and hence a ceiling on bond yields. The bond vigilantes have gone on an extended vacation. Another popular argument is a stock market that is expensive, when measured by P/E ratios, is cheap because low interest rates justify higher P/E ratios. Stocks appear to be cheap in a dividend discount model that uses the current bond yields to discount present value. This view fails to take into account that the bond bull market is a symptom of high inflation, not low inflation. Inflated prices for bonds might make stocks look relatively cheap in comparison to bonds, but in the absolute sense both are inflated.
But what does it matter if stock and bond prices rise relative to consumption goods? "It's paper gains today, paper losses tomorrow; who cares?" The problem with financial inflation is that investment decisions by entrepreneurs are based on relative prices and interest rates. When interest rates and relative prices are distorted, the entire productive structure of the economy looses it’s direction and becomes distorted. The movement of real savings into real investment is stymied and we end up with jobless growth first and then over investment into enterprises that should have not been entered into because their rate of return is too low given the risks involved. All this ends up denigrating all currency matters and distorts economic calculation. Like it or not, A GUNS and BUTTER economy must eventually produce inflation.
INTEREST RATES ARE THE TRAFFIC SIGNALS OF THE ECONOMY
The expansion of the financial sector relative to that of the economy (mining, agriculture, manufacturing, transportation, energy, transportation, and retail) is but one example of these distortions. The increasing domination of stock market activity by financial institutions and financial services companies have quietly come to dominate not only the S&P 500 but the entire economy. For example, right now financial companies make up 40 percent of the index, up from 12.8 percent 20 years ago. The current weight of financial services is almost double that of industrial company stocks and more than triple that of energy shares.
… It is also worth noting that the current weight of
financial services companies in the S&P is significantly understated because
the 82 financial stocks in the index do not include the likes of General
Electric, General Motors, Chrysler or Ford etc., all of which have huge
financial operations that last year represented more than 100% of their
earnings. Financial companies
now generate about 40 percent of total profits of all
The economic purpose of capital markets is to provide a nexus between savers and borrowers for the financing of productive investment. Financial entrepreneurs, such as venture capitalists, traders and speculators, need a true interest rate, which is essential in forecasting the best uses of Limited available real savings and the measuring of risk in an uncertain world. But a society cannot prosper by printing ever-increasing quantities of paper tickets representing claims for real goods and drawing more of the population into trading these tickets back and forth among themselves. All of this is nothing but a financial fantasy and fraud and like all Ponzi schemes must come to a sad end. The fantasy being that central bankers have found a way to inflate without any negative consequences. While the effects of money supply growth can be confined to stocks and bonds for a time as inflation is hidden in plain sight. The inevitable adjustments cannot be postponed indefinitely and its unwinding will be neither easy nor painless and is most probably threatening both an economic as well as financial disaster.
THE FED’S Conundrum
question that most analysts and especially Bernanke
are asking is: Why were long term
interest rates still not rising in the face of 17 consecutive ¼ point discount
rate increases? The answer my friends is both simple
and very worrisome. All these Banks, Hedge Funds and other financial
institutions that have had it so good for so long, making all that easy money
are now between a “rock and a hard place”, as they are now locked since their
positions are too big to liquidate (CASH OUT). They can’t get out because there
is nobody to sell to. They are all forced to continue to keep playing the game
until the bitter end. The same holds true for all the Central Banks that have
been buying up all the
CONCLUSION: Now I have hopefully addressed the question that heretofore nobody has bothered even asking. What’s making the stock and bond markets behave like they have never done before, if it’s not a New Paradigm? If, as I surmise, a financial and economic disaster is in our future, then the only question not yet asked is, when and how will it begin? The best answer that I can come up with is that it depends. Since I don’t have a crystal ball, I can only guess. The deadlock that will ensue this year as the Democrats take over both Houses of Congress cannot be positive. Even if there were easy solutions, all eyes are on the 2008 Presidential Elections and neither party will give the other a platform to run on; no matter how much the country needs it. “The Piper Must Be Paid” - the only question remaining is not IF, but when and by how much?
Aubie Baltin CFA, CTA, CFP, PhD.