Dow update

Adjusted for CPI inflation, the Dow is now back to where it was in December 1995.

This is still above the peak of the previous long cycle, ending in January 1966 - and still over 4 times higher than the low of July 1982. We only think of it as catastrophic because we got used to more recent, wildly inflated valuations.

I'm still hoping that the end position will be no worse than 4,000 points - a drop of 45% from today's close.

Theft by inflation has begun already

The UK Debt Management Office website shows that a UK Treasury bond offering 5% annual interest is, because of its current traded price, actually yielding 2.522793%.

But the risk of default, almost as high as Italy's government debt and far higher than even the USA's, is (as Jesse quotes) currently priced at 1.63%. (The market currently prices the risk of USA default at 1%.)

So after insuring for risk, 5-year UK sovereign debt earns you less than 0.893%.

Inflation, as measured by the Consumer Price Index*, now runs at 3%. In other words, a "safe" government bond loses you more than 2% a year.

And that's before inflation really gets going.
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*The Retail Price Index is a different measure of inflation, which takes into account mortgage costs. So after recent savage cuts in the bank rate, currently RPI should be negative. But wait until the private capital credit strike leads to higher interest rates, and judge.

How long will the bear market last?

Jesse quotes this comparison of the current bear market with three previous ones, mixing stats for the Dow and the S&P 500:

But taking similar periods for the Dow only, adjusting for CPI inflation, and adding the long period from 1966 to 1982, we get this:

I'd suggest we should look at when the recent bubble really burst - end 1999, then desperately disguised by monetary inflation from 2002/03 onwards; if that's right, we have maybe another 6 years to go through.

The shapes of these two lines do sort of rhyme, don't they? And if so, looking at where the end of the red line is, maybe a bear market rally is now due, like the c. '75 - '76 mini-recovery.

End point in real terms this time, my guess, is the equivalent of 4,000 points today. However, there are features unique to the present situation, especially the size of debts, the loss of much of the West's manufacturing base, and the interconnectedness of modern world markets and economies.

Cash (equivalent) and gold - iTulip

Our primary concern at this stage is no longer our readers' portfolios but their ability to weather a US dollar crisis if one erupts. In response, we are increasing our gold allocation to 30% and moving all Treasury holdings to the very shortest maturities, to three month Treasury bills, until we see indications that conditions are stabilizing. We encourage you to engage with the community to actively discuss strategies that are appropriate for you.

The rest is here.

Good luck, right action

Reportedly, George Soros doesn't see the bottom of the market yet. We judge by recent experience and think ourselves hard done by, yet look at the following chart, which takes the Dow and adjusts it for inflation:

All that has happened is that the illusory gains of the last 12 years, more than accounted for by extra debt taken on in that time, have now unwound. Yet we're still nowhere near where we were in 1987, which (if you were around then) we thought of as an exciting time for investment. To get back to that peaklet in real terms, the Dow would have to drop below 5,000 points.

But to return to the low point of the recession that preceded it - around July 1982 - the Dow would have to break down below 1,800. Even then, that miserable score is a big advance on the low of 50 years before that (July 1932: CPI-adjusted Dow would equate to c. 833 points).

Karl Denninger has said recently that he sees 2,000 points as a possibility; I've suggested a low of c. 4,000, because in these 40-year cycles, each peak and each low has been higher than in the previous cycle.

However, seeing how unbelievably high the Dow went in recent years (way above anything that could have been extrapolated from the highs of 1929 and 1965!), maybe a correspondingly low low is not out of the question.

So why am I planning to set up a new brokerage on my own? Why don't I send a copy of this blog to all my clients, together with news of my retirement from the industry and a valedictory "Good luck, because you're going to need it"? (Actually, I have repeatedly advertised this blog to clients; I only wish the viewing stats could show me that they all read it.)

The Mogambo Guru has taken to signing off his rants with a sarcastic "Wheee! This investing stuff is easy!" - he recommends gold, silver and oil. Over on Financial Sense a couple of days ago, Martin Goldberg opines, "The important question for most investors is whether to be in cash or gold" (cash for now, he thinks). Marc Faber has long been saying that we are entering a long bull market in commodities, and has just said he thinks an ounce of gold will one day be worth more than the Dow.

What they're really talking about is inflation. Debt, which is fixed in nominal terms, becomes cruelly heavier as the assets pledged against it become worth less and less. The pain will get so bad that the government will crack, as it always does, and debauch the currency. Holding cash just now is great, for those lucky enough to have it; but if Robin Hood can't confiscate it through taxation, he'll bleed it white by printing lots more fiat currency for himself (and the people who keep voting for him), so sucking real value out of your money. If you can't face investing, be prepared to spend like a sailor on shore leave when inflation hits town.

My clients generally aren't traders. In the same interview cited above, Faber said:

Recently I bought some U.S. stocks for the first time in a long time. If you buy Intel , Cisco , Yahoo! , Oracle and Microsoft , you will do much better in the next 10 years than you would with Treasuries. These stocks will double and even triple -- before going to zero.

That's not for my clients - they like the idea of the double and triple (who doesn't?), but not enough to risk the "going to zero".

That said, investment - including in commodities - is going to be part of their fight back against the attempt to take away everything they've saved. Inflationary periods do sap the real value of shares, they hit cash even worse. Look at the position of the man who invested in the (dollar-denominated) Dow from the start of 2008 up till last Friday's seeming debacle, compared with the poor chap who "played safe" and held good old British pounds:

The picture will change when the dollar dives, of course; though maybe the pound will dive along with it. To hold what you have, you'll have to keep on your feet, balancing the relative merits of currencies and asset classes. For me and most of my clients, it won't be about getting rich; it'll be about not getting robbed.

I'd have been happier with a world where money kept its value, and I'm not alone. The blogosphere is now crowded with people who have their own schemes for a fair and just economic world. But none of these ideal arrangements will enter into reality. There's too much to be made out of destroying it, by a handful of traders, and the politicians - and the bankers who will eventually employ the politicians when they leave office. We must take, not the right action, but the appropriate action.

Good luck, because you're going to need it.

Deflation, inflation, distress

The Contrarian Investor gives a lucid explanation of the potential consequences of deflation.

In Australia (as in the UK, as I think I showed here), the nation owes more money than it has in savings, so it depends on foreign investment.

If interest rates fall, foreign capital will go away to where it can earn more. This reduces the demand for our currency and makes it cheaper. So goods we sell to foreigners get cheaper, and things they sell us get more expensive. They buy more from us, we buy less from them (or they have to cut their prices so we can afford their stuff). More money comes into our economy; all well again.

Except...

• What if , thanks to decades of spending lots without earning much (and borrowing the difference), we no longer make things foreigners want?

Then we become "distressed gentlemen". As the money runs low, we run up accounts at the tailor and the wine merchant, and write IOUs which we hope will not be presented to us soon. Maybe we begin to cut a few luxuries, but old habits die hard, not to mention ingrained addictions.

• What if they sell us things we can't do without, and won't cut their prices?

The money runs out. Unless we are Royalty, and too dangerous to dun, eventually the bailiffs must arrive. In the modern world, the sovereign wealth funds, perhaps.

What can they take? In Australia, there are mineral deposits the Chinese will want, thinks the Contrarian Investor. Here in the UK, maybe some remaining profitable businesses and valuable technical expertise, maybe patents and secret technologies. And it's not only the Chinese that have been lending us their surpluses. We have other creditors.

Then, as the laden carts depart and the keys of the mansion are handed to the new owners, the decayed gentry become vagrants and vagabonds.

Unless we are too dangerous to dun. Perhaps America is; can we be so? And what if our creditors are not certain of our might? Uncertainty can trigger inappropriate actions. There is a Chinese saying, I believe: fear a weak enemy. Catastrophe can be avoided, but unless our leaders are tough with us now, we will learn a harder way later.

But if the master has become poor, what of his servants?

What if, like me, you're not one whose power and social status protects him from the worst effects? Do you believe that democratic societies can do the right thing? If not, this is a time for individuals to make their own quiet plans and preparations.

Historic inflation in the USA and UK compared

Just for interest...

Denninger: deflation

Belatedly, I refer you to Karl Denninger's end-year review and forecast. He sees continuing deflation, and makes a number of other plausible and worrisome predictions - scroll to the end of his post for the horrid gallery of prognostications.

In short:

...rallies are to be sold, cash is to be raised and prudence is to be practiced in your own personal financial affairs. Don't get creative in all things finance, get stingy and prudent. Your personal financial survival could well depend on it.

So instead of staring at the low interest on your cash balance, think of the real capital appreciation of your money as measured by what big-ticket items it will buy. And for once, the government can't easily tax your capital gain.

You may also want to hold more cash away from a bank ("Round #2 of severe bank instability gets served up on us in the second half of 2009").

And maybe diversify your currency holdings:

The Dollar will not collapse. This is not because we're in great shape or will truly recover, it is because the rest of the world is in worse shape than we are... The rest of the world is literally on the precipice of a full-on collapse. European banks are more-levered and less-transparent than our banks as just one example... I see the potential for the pound and euro to both reach par with the dollar.

I think Denninger on the one hand, and Faber/Janszen on the other, may both be correct. It's a matter of timing - deflation now, debasement of the currency later. Because nominal debt gets relatively bigger as assets and incomes decline in value, something will have to give.

Denninger demystifies "the Fed"

You tend to get a clear and concise explanation from somebody, when they either blow their cool or are in a hurry to get somewhere else. Here, in a very crisp and useful post, Karl Denninger blows away the conspiracy theories surrounding the Federal Reserve.

He explain that his beef with them is that they are acting ultra vires (very damagingly), and notes that there is, unfortunately, no statutory penalty for their doing so. The caning will, he thinks, have to be administered by the bond market instead.

Some, like Eric Janszen of iTulip, would say that's exactly what the government intends.

Janszen, Faber: hyperinflation is government policy

(Graph reproduced by iTulip from NowAndFutures.com)

In an extended "Titanic" analogy, Eric Janszen describes what he sees as the government's response to the crisis: "send rescue", "boil the ocean" and if terrified investors refuse to relinquish the security of Treasury bonds, "sink the rafts" by devaluing the currency. Around the world, he sees a policy of inflation and even hyper-inflation. So does chipper doomster Marc Faber, who now thinks we must eventually have 200% inflation in the USA. 1974 - 82, here we come again?

Inflation bubbling up

Richard Daughty, aka The Mogambo Guru, comments on the sharp rise in raw materials prices.

Further to my recent post on whether gold is overpriced, it's worth pointing out that gold can remain for long periods above trend. Those who mock new buyers of gold may have overlooked this.

UPDATE

Marc Faber: "If I look at government debt in the US, and debt in general, I think the only way they will not default physically on their debt is to inflate." (htp: Michael Panzner)

Restoration, not revolt

"What is a cynic? A man who knows the price of everything and the value of nothing," says Lord Darlington in Wilde's Lady Windermere's Fan. That perfectly describes the man who doesn't understand inflation.

Inflation is The Mogambo Guru's bete noire, and he gives us another comedy riff on that today. His principal cure for it is gold, the stock in trade of another ranter, Jim Willie, who sees the price of the yellow metal breaking out in various currencies (it's soared in sterling, for example).

Both men habitually connect gold, the US Constitution and the decayed professional morals of the politico-judicial elite, and try to stimulate the people to restore the old, good order. In short, they are prophets, and there's plenty more out there at this time.

For it is a sign of societal stress that ranters, dreamers and revolutionaries begin to drag out their soap boxes and declaim to passers-by. We had it in the Old Testament, the English Civil War, the American Revolutionary War and most other times that the world was turned upside down.

If buttercups buzzed after the bee
If boats were on land, churches on sea
If ponies rode men and grass ate the cows
And cats should be chased to holes by the mouse
If the mammas sold their babies to the gypsies for half a crown
Summer were spring and the t’other way round
Then all the world would be upside down

There is a difference between civil war, and the revolt of colonies from their distant parent. Having said that, the crisis is now cracking the cement between the States and the Federal Government, as we see in New Hampshire and elsewhere. America, remember history and avoid secessionary talk.

The results of revolution are rarely pretty. Norman Cohn's famous book , about the horrifying aftermath of prophet episodes in the Middle Ages, shows that once the mix is brought to the boil, it becomes very volatile. The outcome is often not what the prophet expected; and always, the people suffer. Rather than overthrow our rulers, it would be far better (if possible) to make them see the danger to us all of continuing their course, and have them turn back.

But can they see it? Do they know the difference between price and value? Will they permit the theft of real wealth by inflation? Or is it, worse still, their intention?

The best we can hope for, is that our leaders are not cynics, and so do not need correction from dangerous idealists.

Global monetary inflation and the threat to peace

Last week, I suggested that we could be entering an era of competitive currency devaluation. Now, Mish sees it happening in Russia, Mexico, Indonesia - and hints of intervention in Japan. The Canadian National Post predicts a drop in the US dollar, too (htp: Jesse).

Can the Euro -already strained by member countries moving in different directions - take this pressure? A friend told me recently of an old restaurant incident involving people he knew, where first one "did a runner", then another, so that the last man left at the table was stuck with the whole bill. This is a game that punishes the virtuous.

Gold is supposed to be a haven in such conditions, but is already above its long-term post-1971 trend, as I show here. So the bold investor might buy in now, knowing it's high but hoping it'll go higher (or fearing that other things will go lower still). Others say silver, or oil, or agricultural land. "The best lack all conviction, while the worst / Are full of passionate intensity."

These are tricky times. As in revolutions generally, it's hard to see which faction will be victorious, but loss, injustice and confusion are certain: "we are here as on a darkling plain / Swept with confused alarms of struggle and flight / Where ignorant armies clash by night."

This may seem over-dramatic; but when money ceases to be dependable and deadly dull, everything else becomes much too exciting. If the middle classes suddenly find their savings wiped out by inflation, their assets generally devalued and their businesses and employment under threat, watch out.

IN- vs. DE- and an upcoming opportunity

Jesse echoes my hunch: deflation now, inflation soon-ish, with high interest rates for a bit. At that latter point, get your annuity and /or bonds, and benefits as rates subside. A guess, but it's comforting to see wise owls coming to the same conclusion.

You now have our investment gameplan for what is likely to be the rest of Jesse's life.

No, no "Jesse"; live long and prosper.

Gold overpriced?

Gold's price since President Nixon closed the gold window on Aug 15, 1971 has been generally higher than in the era up to then, but still very variable. If we adjust it for inflation as measured by the Consumer Price Index (CPI) in the USA, and take September 1971 as being a "1", the mean and median values since then are of the order of 2.8 - 2.9.

Currently the gold/CPI ratio is about 4, which is somewhat above trend, though nowhere near the spikes of the early 80s. So I'd regard gold's price as a bit high for getting in now, unless you're speculating, which is not my game. But if you got in 9 years ago, well done, and I guess you'll want to hold for some time yet.

Michael Panzner interview

Some salient points in Michael's answers:

• The crisis could continue for another decade;
• investors will have to tread carefully and consider the risk of dealing with others;
• dividend yields could increase 2 - 4 times (suggesting that current stock prices could halve or quarter);
• after some more deleveraging during this year, it may be useful to accumulate precious metals

Read it all here; htp: Abnormal Returns

Also linked on AN is a story about Warren Buffett's firm insuring third parties against a long-term market drop. Berkshire Hathaway has taken $4 billion in bets; are they right? Or are they right only in the sense that nominal prices will hold, while inflation will mask the real reduction in value?

The banking crisis: did we have a choice?

Could any of the leading nations have retained their moral fibre during the monetary inflation of the last decade and more? Wouldn't prudent, restrained lenders have lost out to foreign sellers of "liar" and "fog a mirror" loans? Wouldn't the currency have risen and crippled exports? Could considerations like this form part of the "don't shoot me" defence of our busted banks and discredited politicians?

Or would it have been a trial by fire, where the virtuous are rewarded at the end? Denninger: "It is also increasingly clear that there are literally hundreds of midsize and smaller banks that are perfectly fine. They did not lever up, they did not write a bunch of crap commercial or residential construction paper that cannot be serviced and they most certainly did not drink the KoolAid of securitized synthetic garbage debt. Even in bad economic times traditional banking is a very profitable business - so long as you lend money to people who can pay you back or you have sufficient collateral so that if they default you don't lose your shirt."

In which case, the original offence of reckless finance has been compounded by the failure to punish it. The bailouts whisk away the deserved reward of the good, and teach a hugely damaging lesson to all onlookers: you can Get Away With It.

Of course, you can't - or rather society can't, though individuals will. And when injustice finally falls, it will take down with it many of the good, the poor and the powerless.

Money and life

The previous post is a summary of Brad Setser's views on China and the dollar. What with the oil price coming down and the trade deficit reducing because of declining demand, it seems reassuring for Americans. But Michael Panzner also returns to one of his themes, the inflationary phase that he (and many others) fear may succeed the recession-depression.

Marc Faber has observed that this is the first time in history that economies around the world are affected simultaneously, since we are now much more inter-connected. So if inflation should take hold, perhaps it will not be fully reflected in the exchange rates - it might be that the dollar remains relatively buoyant against the pound, Euro, renminbi etc.

So maybe the real victims of global inflation, or hyperinflation, will not be this nation or that, but cash savers as a class. They have set aside some of the rewards of work, instead of spending it, and will come back to the cupboard to find it turned half-rotten, as happened in the 70s (if they'd put it in the stockmarket instead, it would only have been a bit mouldy).

How is it that China can award death sentences to those who adulterate milk with melamine, but adulterating the currency - the accumulation of millions of years of human labour - is not even punishable by loss of office? In the year George Washington took Presidential Office, "coining" in England was treason, and perpetrators were accordingly hanged, drawn and quartered (or, in the case of women, burned).

Money is stored life, and devaluing money is stealing life. Next month will be the 20th anniversary of my becoming a financial adviser, and the people I have advised would mostly not bother with investments if only their cash savings could hold their real value. What a scam this all is.

Desperate diseases call for desperate remedies

Mervyn King at the Bank of England refers to "unconventional unconventional measures". One seems to be to stop publishing what he's doing; what else can he have in mind?

Brad Setser thinks the pound sterling may crash through the floorboards.

"If you cannot bring good news, then don't bring any."

Gold, silver, what you will... but not sterling

Jim Rogers says exit the pound and sterling-denominated assets. (htp: Wat Tyler)