They knew it was coming

Karl Denninger looks at the cash-rich balance sheets of non-financial companies, many of which could now pay off all their bank debts from the kitty. Whatever they may have been telling you, it looks as though they've been voting with their wallets.

Laying it on the line

Some people will act beyond their self-interest. Karl Denninger is an expert investor, but is moved to be an economic prophet for his country and like other prophets, despairs of the passivity of his people:

This financial weapon of mass destruction is going to detonate.

It will make it impossible for the government to pay your Medicare and Social Security benefits.
It will result in double the tax burden you have now being laid on your children and grandchildren, OR MORE.

And when that happens, if I am still alive I'm going to spend MY MONEY on a full page advertisement in The Wall Street Journal (or whatever the "mainstream media" is at that point) telling your kids (who will then be adults) that you scr*w*d them on purpose because you were too much of a cheap j*ckoff to get on a plane and go raise h*ll in Washington DC to put a stop to this cr*p!

I wonder what their reaction will be to "Dear Old Dad" when they're living in poverty as a direct consequence of you fiddling while Rome burns?

I wonder if Moses used expletives when he came down off the mountain and found the people worshipping a statue of an ox?

Good man.

A secular bear market in housing?

It's now generally accepted that houses are overpriced. I think valuations will not only go down, but (notwithstanding bear market rallies) stay down for at least a generation.

Here's some reasons, some having a longer-term effect than others:

• house prices are now a very high multiple of earnings, choking the first-time buyer market.
• presently, there is increasing economic pessimism, which will further inhibit buyers.
• the mortgage burden now lies in the amount of capital to be repaid, rather than the interest rate; that's much harder to get out of, and will prolong the coming economic depression, either through the enduring impact on disposable income, or through the destruction of money by mortgage defaults on negative-equity property - and as valuations fall, there will be more and more of the latter.
• fairly low current interest rates allow little room to drop rates further to support affordability - and at worst, rate drops could sucker even more people into taking on monster mortgage debt. But interest rate reductions are unlikely to benefit borrowers anyway. The banks have survived for centuries on the fact that while valuations are variable, debt is fixed. They got silly with sub-prime, but by George they will remain determined to get all they can of their capital back, and preserve its value. The people who create money literally out of nothing - a mere account-ledger entry - are now tightening lending criteria and will continue to press for high interest rates; for now, they will content themselves with not fully passing on central bank rate cuts, so improving the differential for themselves, as compensation for their risk.
• food and fuel costs are rising, and given declining resources (including less quality arable land annually), a growing world population and the relative enrichment of developing countries, demand will continue to soar, cutting into what's left of disposable income.
• our economy is losing manufacturing capacity and steadily turning towards the service sector, where wages are generally lower.
• the demographics of an ageing population mean that there will be proportionately fewer in employment, and taxation in its broadest sense will increase, even if benefits are marginally reduced.
• the growing financial burden on workers will further depress the birth rate, which in turn will exacerbate the demographic problem.

In short, there will be less money available to chase house prices; and in my view, less to chase investments, too. It may be very similar in the USA - as Jim from San Marcos says now (repeating himself from last May):

A market goes up when more people want to buy, than those that want to sell. Well, all of these first time home buyers have no spare cash for the Stock Market. The Baby Boomers, sometime in the future are going to want to sell. The question arises, "Sell to Whom?"

Returning to houses, there are still those who think valuations will continue to be supported by the tacit encouragement of economic migration to the UK.

Now, although this helps keep down wage rates at the lower end (where is the Socialist compassion in that?), the government is pledging the future for a benefit which is merely temporary, if it exists at all. Once an incoming worker has a spouse and several children, how much does he/she need to earn to pay for the social benefits consumed now and to come later? State education alone runs at around £6,000 ($12,000) per annum per child.

And then there's the cost of all the benefits for the indiginous worker on low pay, or simply unemployed and becoming steadily less employable as time passes. And his/her children, learning their world-view in a family where there is no apparent connection between money and work. The government makes get-tough noises, but in a recessionary economy, I don't think victimising such people for the benefit of newspaper headlines will be any use. I seem to recall (unless it was an Alan Coren spoof) that in the 70s, Idi Amin made unemployment illegal in Uganda; not a model to follow.

So to me, allowing open-door economic migration to benefit the GDP and hold up house prices doesn't work in theory, let alone in practice.

Besides, I maintain that in the UK, we don't have a housing shortage: we have a housing misallocation. There must be very many elderly rattling around alone in houses too large and expensive for them to maintain properly. This book says that as long ago as 1981, some 600,000 single elderly in owner-occupied UK property had five or more rooms; the ONS says that in 2004, some 7 million people were living alone in Great Britain. Then there's what must be the much larger number of people who live in twos and threes in houses intended for fours and fives. Before we build another million houses on flood-plains, let's re-visit the concept of need.

Maybe we'll see the return of Roger the lodger - if he's had a CRB check, of course.

Would I buy a second home now? No. Would I sell the one I live in? I'd certainly think about it - in fact, have been considering that for some years.

Desperate hope

"Desperate hope" is an oxymoron, which sounds like a dumb bull: mine is that we will have a tough landing rather than a complete crash. Goading the dumb bulls is The Mogambo Guru (Richard Daughty), who delivers another comical end-of-the-world sermon on inflation. He thinks dropping interest rates will encourage borrowers to take on still more debt.

However, many have already pointed out that (a) lending criteria are tightening and (b) not all of the interest rate cut is being passed on to the borrower. So lenders are trying to reduce their exposure and are also being paid more for the risk they have already assumed. And we see from this Christmas shopping season that (c) the consumer is becoming more reluctant to spend.

That's not to say that we won't get inflation (in some sectors, not housing), since falling interest rates tend to depreciate the currencies of debtor countries relative to their cash-rich trading partners. On the other hand, the latter will continue trying to hold down their currencies, in an attempt to keep the show on the road - the show being the osmosis of wealth from the lazy, spendthrift West to the hard-working, hard-saving developing world.

We're going to be buying less, but I don't know how fast the Eastern co-prosperity sphere will take up the slack. In his book "The Dollar Crisis", Richard Duncan argues for a worldwide minimum wage to stimulate demand; but maybe events have overtaken him. Certainly, China aims to expand its middle class, rapidly.

But there's another way for China to stave off depression while waiting for the sun to rise in the East. According to James Kynge, manufacturing and transportation costs account for only about 15% of the end-price of Chinese exports to the US. Some of the expanding Chinese middle class will surely go into advertising, marketing, sales, distribution and finance. As China develops its own version of Wal-Mart, Omnicom and banking, credit card and financing operations, it'll own more of the total profit in the supply chain - some of which it can sacrifice to retain market share. And they're motivated to do so by the fact that domestic consumption yields very little profit for their companies: the money's in exports. The longer this game goes on, the more the decline of capital and skilled labour at our end.

So let's worry about the effects at home first. Yes, for investors inflation may be a worry, but perhaps they should extend their concern to include the stability of the society in which they live, as unemployment and insolvency stalk through the West. The issues are no longer financial, but political and social.

And we'd better hope that we don't go for the wrong solutions. Daughty quotes Ambrose Evans-Pritchard's 12 December article in The Daily Telegraph, which concludes (amazingly), "... it may now take a strong draught of socialism to save the Western democracies." I do not think Mr Evans-Pritchard is very old. Or maybe he's just saying that to bug the squares, an expression I'll wager he's too young to remember.

Hark what discord follows

David Galland rehearses the argument for gold. He points out that, relative to stocks, the gold market is so small that a small shift into it from stocks would massively inflate demand. Against that is the fact that it hasn't happened yet, and that a small market can also be manipulated downwards by suppliers, particularly the central banks. Besides, in a real panic, Joe Average isn't looking to make a killing in commodities, he's trying to pay bills in cash and buy food and fuel ditto. Nice area for speculators with quick reflexes, though.

What is inflation, anyway? Ronald Cooke looks at the damned lies and self-serving statistics that underpin the official Consumer Price Index.

Jim Patterson reads the stockmarket runes and concludes:

Sub-Prime issues have been discounted. With overall market returns compressed the downside is limited. We expect a better market in the weeks and months ahead.

In his slightly starchy prose, The Contrarian Investor agrees with Patterson, up to a point, but also gives a serious warning:

1. In today’s market, the probability of the market going up is higher than the probability of it coming down. Hence, it is rightly called a bull market.

2. But should it come down (which is unlikely), it can collapse at extremely great speed and magnitude.

Hence, the stronger and longer this uptrend continues, the greater in magnitude and speed (as in volatility, not timing) the Great Crash III will be. Hence, the coming Great Crash III is a Black Swan event—an improbable but colossal impact event.

The importance of a particular event is the likelihood of it multiplied by its consequences. Black Swan events are events that are (1) highly unlikely and (2) colossal impact/consequences. One common mistake investors (and many professionals) make is to look at the former and forget about the latter i.e. ignore highly unlikely but impactful events.

Therefore, when contrarians are preparing for a crash, it does not necessary mean that they are predicting doom and gloom. Rather, they see the vulnerability of Black Swans and prepare for them.

Denninger: depression, but when?

Karl Denninger offers two options for the US financial regulators. The first is to get banks to put all their potential liabilities on their balance sheets - financial suicide for some.

The other is to keep the door closed until the smell is too bad, and then we have far worse problems - but it could take years. End result: deflationary depression.

A moment of sanity

At times of crisis, unlicensed preachers and wild-eyed prophets roam the streets, gathering their crowds. But their rule never lasts.

My grandfather used to say, things are never as good as you hope or as bad as you fear. As I reported some while ago, members of the Chicago Stock Exchange in 1934 papered their club room with what they thought were now worthless stock certificates, but within five years were steaming them off the walls again.

The Thirties crash hit debtors, unwary investors (especially those trading with borrowed money) and insolvent banks. The lessons from this are easy to learn.

Long or short crisis? Inflation or deflation?

Terry Gilliam's take on the old tale

An interesting post from Michael Panzner, commenting on the views of derivatives expert Satyajit Das. The latter thinks we're in for a 70s-style inflationary grind, whereas Mr Panzner leans towards a 30s-style deflation.

I am reminded of Borges' short story, "Pierre Menard, Author of the Quixote". In this, a modern author attempts to re-produce the 16th century novel "Don Quixote" by Cervantes: not copying - writing it again exactly, but as though for the first time ever. Since Menard is writing in a different period of history, the same words have quite different meanings, implications and associations. To pen the identical lines today, spontaneously, would involve a monstrous effort. So Borges' tale is a wonderful parable about the near-impossibility of our truly understanding the mindset of the past, and how history can never be quite repeated, because the present includes a knowledge of the past that it takes for its model.

For those reasons, we'll never have the Thirties again, or the Seventies; but we might have a retro revival. And the differences may be as significant as the similarities.

Ken Kesey's bus (named "Furthur"), and part of the commercialised modern follow-up

Why the sea is salt, and why we are drowning in cash

We are said to be heading for a recession, so I had another look at Bank of England statistics for M4 - money supply as measured by private lending by financial institutions.

Since June 1963, there has NEVER been a quarterly period when M4 contracted. In fact, here are the only times in the last 44 years when UK quarterly monetary inflation ran at less than 5% p.a. equivalent:

As you see, mostly it was the nineties, with one instance in 1975 and three times in the sixties. The average rate for the whole series up to December 2006 is 13.47%. So the hand-mill never stops grinding.

But should it? Wikipedia gives an account of recession and the Great American Depression, and notes that during the latter period the money supply contracted by a third. Great for money-holders, bad for the economy and jobs.

This page points out that we tend (wrongly) to think of a period of economic slowdown as a recession, and says that technically, recession is defined as two successive quarters of negative economic growth. By that measure, we haven't had a recession in the UK (unlike Germany) for about 15 years - here's a graph of the last few years (source):

And then there's the stockmarket. It doesn't seem to reflect the real state of the economy - until you shift the lines, when for example the S&P 500 turns out to be a fair predictor of changes in GDP, as shown in a graph in a 2005 entry from this blog ("Capital Chronicle", by RJH Adams):

The same post also provides a brilliant graph of a measure of fair value for investors, known as Tobin's Q. Look at the wonderful opportunities presented by two world wars and the economic shock (blamed on oil prices, but maybe the causality is the wrong way round) of the 70s:

Mind you, looking at Wikipedia's Tobin's Q graph, the median market valuation since 1900 seems to be something like only 70% of the worth of a company's assets. Can that be right? Or should we take the short-sighted view of some accountants and sell off everything that might show a quick profit?

Nevertheless, it still feels to me (yes, "finance with feeling", I'm afraid) as though the markets are over-high, even after taking account of the effects of monetary inflation on the price of shares. And debt has mounted up so far that a cutback by consumers could be what finally makes the economy turn down. Not just American consumers: here is a Daily Telegraph article from August 24th, stating that for the first time, personal borrowing in the UK has exceeded GDP.

The big question, asked so often now, is whether determined grinding-out of money and credit can stave off a vicious contraction like that of the Great Depression. Many commentators point out that although interest rates are declining again, the actual interest charged to the public is not falling - lenders are using the difference to cover what they perceive as increased risk. Maybe further interest rate cuts will be used in the same way and keep the lenders willing to finance the status quo.

Some might say that this perpetuates the financial irresponsibility of governments and consumers, but sometimes it's better to defer the "proper sorting-out" demanded by economic purists and zealots. History suggests it: in the 16th century, if Elizabeth I had listened to one party or another in Parliament, we'd have thrown in our lot with either France or Spain - and been drawn into a major war with the other. We sidestepped the worst effects of the Thirty Years' War, and even benefited from an influx of skilled workers fleeing the chaos on the Continent. If only we could have prevented the clash of authoritarians and rebellious Puritans for long enough, maybe we'd have avoided the Civil War, too.

So perhaps we shouldn't be quite so unyielding in our criticisms of central bankers who try to fudge their - and our - way out of total disaster.

Is an irregular cycle a cycle at all?

And 'mid this tumult Kubla heard from far
Ancestral voices prophesying war!

There is a kind of thrill in contemplating destruction - it's a whorl in the grain of human nature. Jeffrey Nyquist indulges this tendency in a piece about Robert Prechter Jnr's views on mass psychology and the markets, and our facing possibly the biggest economic depression since the founding of the American Republic.

You know how everything seems so bright when you get out of the cinema?

Tough, but believable

Read Karl Denninger's Thursday piece over at Market Ticker. Semi-apocalyptic, but with hopes for America's survival, in what he thinks will be a deflationary depression accompanied by civil unrest and regional conflict in the East.

He thinks it's not too late for the US to recover its economic base. I hope the same for my country.

Doug Casey: business cycles and subprime loans

"The Man In The Moone" by Francis Godwin, Bishop of Hereford (1620)

I noticed years ago that you get the crispest explanations from someone who's busy trying to get to their main point - Isaac Asimov's "Extraterrestrial Civilizations" (1979) is an excellent example. Even if you disagree with the conclusion, you have learned so much on the journey, and so quickly.

Doug Casey in DollarDaze yesterday summarises the theorised relationship between the money supply and the business cycle, plus subprime mortgages and hedge fund gearing, as part of the argument for gold mining stocks. Again, you may not agree with him that gold "is going to the moon", but in the meantime he has given us a clear and concise exposition of two important economic topics.

Doug Casey goes to Argentina

This is getting very 1920s/1930s - Argentina as the home for the jet set. Here's Doug Casey:

...we're at the end of a 25-year boom. It's gone on more than a full generation now. And I'll tell you how it's going to end: It's going to end with a depression, and not just a depression; not just another Great Depression; it's going to be the Greater Depression...

I think what you ought to have is your citizenship in one country, your bank account in another country, your investments in a third, and live in a fourth. You've got to internationalize yourself...

What am I doing about this? I've been all over the world. I guess I've lived in 12 countries now. And out of 175, I've been to most of them, numerous times actually. What am I doing, where do I want to go, where am I living? Well, in New Zealand.... But... the currency has doubled and the real estate within that currency has doubled at least. So I'm getting out of New Zealand. Where am I going now? I'm going to Argentina...

I wouldn't touch Europe with a ten-foot pole...

...everything in Argentina costs between 10% to 30% of what it costs in North America. That's correct. It's that cheap... So you're getting a massive immigration from rich Europeans that can see the handwriting on the wall and like it down there. And I really like it down there. It's just a great society, great society, great place to hang out, prices are right. I mean this can solve most of your investment problems right there, just by transplanting yourself, if you've got some capital.

This may sound like it's only for the really rich, but I have had perfectly ordinary clients sell up their over-priced ordinary British homes and move permanently to the Far East. For personal reasons, I can't be a globe-trotter, but international relocation is happening on a much bigger scale than London to Provence. For a while, I subscribed to one magazine, "International Living", that looks for bargain locations to spend the rest of your life - Panama appears to be a good one, if you dress conservatively and mind your own business.

So although Mr Casey talks dramatically in a non-Brit sort of way, he is backing his judgement with his considerable money; and ordinary types like ourselves currently have options that we could scarcely have dreamed of before WWII. Whether we will always have such options, is another question.

Doug Casey: sounding grim and clear

A trenchant interview with Doug Casey in Financial Sense today. Some highlights:

At some point there’s going to be a panic out of the dollar. When it happens, it’s likely to be the biggest financial upset since the 1930s. Part of the question is what they’ll panic into. The euro? As I have said many times, if the dollar is an “I owe you nothing,” the euro is a “Who owes you nothing?”...

If an American doesn’t get significant assets outside the U.S. now, it may be impossible in the future. The best thing to do is buy real estate abroad, since it’s currently not reportable, like bank and brokerage accounts, and they can’t very well make you repatriate it...

We’re now experiencing a lot of monetary inflation, which eventually will be reflected in price inflation. What’s really going to tip this over the edge, however, is the rest of the world deciding to get out of dollars. A lot of those $6 trillion abroad are going to come back to the U.S., and real goods are going to be packed up and shipped abroad. Inflation will explode...

Markets are about trade... At some point the Chinese will want payment in something other than dollars. In the meantime the yuan will go higher...

What do I think is likely? Certainly a depression, probably of the inflationary type. But if there are widespread defaults in the mortgage market because of a housing bust, hundreds of billions of dollars worth of buying would disappear, which is deflationary. You could have both things happening at once, in different parts of the economy...

I hate making predictions, but if things continue down this path, I think we could see gold going over $1,000 within the next 12 months, and maybe even before year-end. And then the mania starts for the mining stocks.

We need bad times

iTulip has just issued its latest email newsletter - I do suggest you subscribe, especially since it's free.

Their thesis this time is that the Dow will NOT continue to rise much, because the private investor isn't going to come in and be fleeced again. It's not just "once bitten, twice shy" but the fact that money's getting tighter (energy and food costs rising, etc) and the value of assets (especially houses) is in question. On the other hand, iTulip are not doomsters, either.

My view, for what it's worth, is that we have to wait for something unexpected to trigger a real correction, but the sooner it comes, the better. While our governments put off the evil day with borrowing and monetary inflation, our productive capacity is being exported. One firm I know is having an (atypical for here) bumper year; but whereas once their business used to be moving other people's machinery from one site to another, now they're shipping it abroad. How do you make a living if you sell your tools? Even administrators in bankruptcy can't force you to do that. But the economic folly of our rulers can.

In the British Midlands where I live, I've heard engineers complain (like Lewis Carroll's Oysters) about industrial decline ever since I attended a British Association for the Advancement of Science conference in 1977, but our leaders have plodded on, chatting comfortably to each other like the Walrus and the Carpenter, while the Oysters' numbers dwindled. I drive past new man-about-town city centre flats where only 17 years ago I was talking to a self-employed woman turning metal parts. The mighty Longbridge car plant is a broken shell, and the surrounding area is turning over to drugs, alcohol, crime, teenage gangs, domestic abuse and all the rest.

The system continues apparently unaffected, but I think it's a fool's paradise. Only last night, I watched a TV programme about India. The city of Bangalore (home to tech giant Infosys) is modernising and booming; its university aims to attract the world's best. When industry and learning have gone East, what exactly will the West have that anyone could want? We'd better start making it again now, and at a price that our trading partners are willing to pay. Or at least, make sure we have what we need to produce what we consume, as locally as possible.

Yes, currency devaluation means inflation and recession, but better that than a full-on, generation-long depression. We've got to take the nasty-tasting medicine while it can still make a difference. But who will force us to do it?

The US Presidential elections are still a year away, and the new President won't take over until January 2009. In the UK, we have a Prime Minister we didn't elect, who could choose to defer the next General Election right up to 2010. If we're going to get the right people to deal with the heavily-disguised crisis we're in today, the economic issues will have to break out into the open within the next 12 months.

In the meantime, investors must prepare for turbulence.

Bargain hunting

I've been looking for something to illustrate how you can take advantage of pessimism.

Here is a blog about Consett, a small town in the North of England that was shattered by the closure of its main employer, a steelworks. The writer says (28 Dec 2006 entry), "I came across a copy of the Consett Guardian from 1983 - the year when you could buy a house for just £10,000..."

I looked on NetHousePrices for houses sold during 2006, to get an idea of the cheapest in a whole 12-month period. A terraced house is one joined to other houses left and right: the lowest individual sale price I could find for last year was £42,000. Yes, it's much lower than the national average for such properties (£186,316 according to the 9 March 2007 article on this site), but had this house in Consett sold for that £10,000 in 1993, the new owner would still be looking at a capital gain of 6% compound per annum. The article just mentioned gives an average Northern terraced property price as £125,058, and the Consett street that had most (27) sales of such properties last year showed an average price of £127,733.

So what happened to Consett? Their MP Hilary Armstrong explains:

...contrary to predictions the people of the district did not let the town die. After the closure, Project Genesis was launched to revive the local economy and regenerate the town. New industries have arrived, such as Derwent Valley Foods and aerospace company AS&T and unemployment is now down to the national average level. The site of the Steel Works has been reclaimed with new housing, a retail park and environmental landscaping. There is still a long way to go but Consett is still very much alive and is now seen as a successful case study in regeneration.

Financial experts like Bill Bonner and Marc Faber have revealed their purchases of cheap agricultural property in selected areas around the world; and sure enough, there's people out there now in the US who have spotted the opportunity in depressed housing areas like Detroit.

The worst hasn't happened yet, in any case - but think of bargains, when others can only see ultimate defeat. Remember Sir John Templeton.

Fragility of the stockmarket

Ben Steverman in Business Week (20 July) gives reasons to worry about the US stockmarket, one of them being the amount of borrowed money powering it, which is something Richard Daughty also comments on (see link in previous post). A credit contraction could trigger a collapse in stock prices.

My comment: this might sound like a reason to hold cash, but the hyper-inflation scenario espoused by some is predicated on what they expect will be the response of the government to the threat of a depression.

Puplava on inflation, commodities

Financial Sense, July 14: Jim Puplava discusses inflation figures and the management of our perceptions of inflation.

The effects of expanding the money supply must, he feels, eventually spill over from assets to consumer prices. He sees three scenarios:

1. A credit contraction, leading to recession.
2. An inadequate credit expansion, resulting in consumer price inflation.
3. A change in public perception of inflation. If people expect their money to become progressively worthless, they will eventually try to get rid of it as fast as possible, in exchange for tangible things.

Conclusions:

• Cut unnecessary living expenses, shop smarter.
• Avoid bonds.
• Because there is no sign of (1) or (2) above happening, we are heading for a US hyperinflationary depression, perhaps starting around the same time as the oil crisis, i.e. 2009. So invest in tangibles: gold, silver, oil.

By the way - some thought-provoking replies to listeners:

• Puplava agrees that Israel may be sitting on a valuable oil field!
• He says creditor nations in Asia may have a deflationary depression, while ours will be inflationary.
• He notes that Iran now demands payment from Japan in yen, not US dollars.

Puplava on debt and credit

Financial Sense, 14 July: Jim Puplava notes that there is a US credit contraction underway. Real incomes are falling by 6% per year; bank credit is going down; the quality of loans is worsening.

Consumers appear to loading up their credit cards to maintain living standards, but this is more expensive than mortgages; the Federal Reserve is buying Treasury bonds to keep the interest rates down, hoping to prevent a real estate recession from becoming a depression.

Consequently, Puplava anticipates lower discretionary spending and a cut in interest rates by the end of the year.

Housing to drag the Dow down?

iTulip is pessimistic about the effect of a housing downturn on the US stockmarket, and skeptical about reported GDP.