Thursday, January 15, 2009

Forecast for 2009 and beyond

Equities will bottom this year, while housing may bottom 2010--best-case. The dollar will break down further, and when the market realizes that, gold will rise. When the market recovers with a false rally, inflation will kick in, prompting gold's rise. Gold is not like most commodities--it is a currency of real value--a hedge against inflation. There is usually a year lag before inflationary fiscal and monetary policies kick in. In other words, money supply M is in place for inflation, but inflation will remain subdued until banks start lending (increasing money velocity V). And banks can't lend right now, despite huge capital injections because they are hoarding cash to strengthen their crippled balance sheets. Not sure when that will happen (banks lending to each other, to businesses, to individuals, etc.), but it's gotta happen at some point. Either that, or the whole banking system collapses, and we go back to barter....maybe the muslims are right. Even in that worst-case scenario, gold will hold its value--what other paper currency will hold its value in an Armageddon scenario--the USDollar?

Either way, gold will rise--it's not a matter of if, it's a matter of when. This downturn will be worse than the 1973-74 deep recession, when gold increased 2325%. I don't think it will be as bad as the Great Depression of the 30's, when we had almost 25% unemployment. Even in that deflationary environment, gold went up 69%. So if we are closer to a repeat of the Great Depression, you are right, gold may languish around the $500/oz to $1000 range , up from its 1999 low of $253. But if a full-fledged recovery occurs, a 2325% spike translates to a price of $5882. Realistically, the 1980 $850 peak, deflated in today's dollar indicates a $2400 price.

But with the accelerated debasing of the dollar in concert with other currencies, inflation is already in place. The definition of inflation is an increase in money supply, not necessarily the Consumer Price Indicator, the official government statistic. An increase in CPI is a symptom of inflation, not the source. It is a combined result of an increase of money supply flowing into the economy. Prices increase when more money supply chases scarcer assets. Having said that, the CPI is notoriously underreported as money supply growth is in the double digits, while CPI remains under 4%. The reason why it is underreported is another topic, but it does not match money supply growth.

So the targets above will trend higher if we take into account money supply growth--the very definition of inflation. Gold has increased almost 4-fold since 2001--another way to interpret the data is that the USDollar has been devaluated by almost 75% during that period. If that trend continues (and it looks like it will accelerate as the Fed and Treasury continue to print dollars ad nauseum to the tune of trillions of dollars), the current deflation of asset values will eventually yield to inflation--perhaps even hyperinflation.

The result will be higher taxes to pay for these government-sanction bail outs, and the debasing of the USDollar. Despite rhetoric that the government is interested in a strong USDollar, their actions speak otherwise. It makes sense because inflation is a form of taxation without legislation (Milton Friedman). It is more politically expedient to slowly, stealthily tax the population than to let unemployment increase and recessions deepen. Congressmen and the Administration aim to get re-elected. Hence the bailouts. Inflation allows the government to slowly tax the population under the radar, while at the same time, lower their massive debt obligations with deflated dollars (a $10 trillion debt becomes smaller as inflation eats into the principal). If I owe someone $10, but if 10% inflation kicks in, that debt is only $90 in today's dollars a year from now--and declines going forward. Propping up failing businesses is politically populist, but ultimately detrimental to the overall economy--it lengthened the Great Depression, and it's kept Japan's economy in decline for 19 years. It's a form of rewarding bad businesses, while taxing its productive businesses--it's misallocation of financial resources. Would you rather have GM manage your investments, or Google? Well, the government is investing in the GM's of the world--or any other industry that is insolvent, and in the process, taxing its citizens and profitable industries.

The problem is that hyperinflation reduces the purchasing power of consumers and invisibly reduces corporate profits. Our standards of living decline. These bailouts just defer and exacerbate our huge debt problems, but politically, Keynesian economics is the government's only option. We are past the point of no return, as we sink into a death debt spiral. Our financial crisis was caused by overleveraged debts gone bad, by consumers, businesses, local and state governments. Now the federal government is compounding that billion dollar problem into a trillion dollar problem (their own, in this case). That solution has never worked. When interest rates rise (they are at all-time lows), that trillion dollar debt only accelerates, forcing the government to accelerate money supply again, further debasing our currency. US Treasury bondholders, bidding up prices in a flight to safety, will get crushed when interest rates rise. The biggest buyers of said bonds--Chinese and Japanese sovereign banks and funds, will be net sellers, no longer willing to prop up our deficits, while earning 0% for the privilege. Besides, they will need to prop up their own economies. The US Treasuries market will be the last bubble to burst, and this time there will be no backstop, as the US government itself will be insolvent. The Fed can control the short end of the curve, but the long-term bond market dwarfs any government reserves, and is more influenced by market expectations of inflation, not government central bank intervention. The Fed and Treasury can only prop up 30-year T-bonds for so long, before the dam breaks. We are at the mercy of China, Japan, and the Arabic petrodollars. All 3 entities have explicitly warned the US government that they will no longer be buyers of US Treasuries. The Saudis are already in the process of creating their own exchange, creating their own currency for trading oil, as they realize their reserves denominated in USDollars have been a losing proposition. The Chinese and Japanese are also retreating in US Bond purchases. Interest rates will have to rise to attract new demand.

To look at our future, see Iceland--the country imploded, their banks froze up, as their debt exploded in a massive unwinding of leverage. The US Treasury will lose its AAA credit rating, driving up interest rates further. Eventually, the government will default, unable to meet its debt obligations. Guns and gold--if you think I am joking, ammo prices have doubled in the last year. The gold market is pausing, yet holding up while equities re-test their November lows. But once reality hits, it will rise. Not sure what the trigger event will be--another big bank failure, WWIII (Israel is discussing bombing Iran), Pakistan/India posturing, California insolvency (all State employees will start receiving IOU's next month, as California has run out of cash). Arnie has been unsuccessful with the state legislature on resolving a budget expected to be $42 billion short, and if unable to receive a Federal bailout, state employees will be unpaid).

The 1991 riots will be like a walk in the park when cities and counties cut back on basic services like law enforcement and fire protection. I know one city in LA county has lost 60% of their detectives already--even as crime is soaring. Rape case samples are already extended out to 10 years for DNA results. I visited a coin dealer who had exactly one $20 St. Gaudens double eagle to sell. Gold bullion buyers are demanding physical delivery instead of cash settlement, causing spot prices to carry a premium above forward futures delivery contracts--the first time this has ever happened on the Comex gold futures exchange. Sure, the downside is a 30% temporary drop in price, but the upside is 100 - 800% potential upside. Not one stock mutual fund gained in 2008. Gold was the only asset class that gained last year--up 6%--and that was a bad year for gold. It was also the 8th consecutive year of gains. The Nasdaq plunged 80% after the tech bubble. The S & P lost 40% again last year. Treasury bondholders did well in a false flight to quality, but once they figure out tying up your money for 30 years yielding 2.6% is a losing proposition, they will flee that market as well. T Bills yielding 0% will prove problematic as an inflation hedge. Stocks have retreated to 1998 levels, and are headed lower. What else is left? Meanwhile, gold has already quadrupled in this decade.

The reason why financial planners and brokers (gee, they've given good advice over the years) don't advocate gold is because clients purchasing gold don't generate fees for them. Gold ETF's generate some commissions, but overall, there is no incentive for investment and commercial banks to pimp gold. Having said that, many conservative advisors do recommend clients keep 10% of their portfolio in gold bullion, preferable over paper securities (ETF's, futures contracts, gold mining shares). Storing bullion is inconvenient, but it's part of a diversification strategy. Once more people realize this, some sideline cash will be deployed to purchase precious metals, base metals, soft commodities, and dividend-yielding equities. Companies with leading market share, moat-like pricing power, strong balance sheets (loads of cash, no debt), high profit margins, and increasing dividend payouts on cash flow, will thrive in a market where access to debt is increasingly difficult.

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