An Ill Wind Indeed

I don't know what I did before YouTube. With just a few mouse clicks, I can pull up literally hundreds of interviews, editorials, and broadcasts about anything that suits my fancy. And lately, my fancy consists of interviews with some of the most vocal and compelling minds daring to speak out against the atrocious fiscal policies the U.S. is employing to battle this economic crisis.

I have seen Jim Roger dress down countless reporters and anchors bent on defending the status quo. I've seen Marc Faber confidently proclaim that 2009 is the year to "massively short Treasuries." I've seen Peter Schiff stand firm while being publicly jeered at by the likes of Art Laffer, as well as Ben Stein (who proudly proclaimed that investment banks were undervalued in late 2007), only to be vindicated within months.

And now, Ben Stein has even reversed course, jumping on the "Schiff Bandwagon," as it were, predicting nothing less radical than the possible breakup of the U.S. as we know it. Where were you, Ben Stein, when I proposed such a dissolution in 2001? Would you have jeered at me too?

Our critics call us pessimists, defeatists, and killjoys. They attack our characters and our intentions. They say we're trying to destroy the world. And yet nothing could be further from the truth. Yes, I do believe the dollar will soon be reduced to only a fraction of its former value -- and it certainly will lose its status as the world's reserve currency. It's also true that I believe other major currencies – like the euro and the yen – will suffer similar fates.

The United States used to be one of the largest manufacturing and creditor nations on earth. It exported vast amounts of goods. Over the last several decades, however, the U.S. has transitioned to being the largest debtor nation on earth, manufacturing relatively little, and consuming far more than any other nation in history. It has become soft.

Unfortunately, contrary to the popular belief -- that this is a mere secular economic correction -- what we are witnessing is only the beginning of an economic collapse deriving from decades of mismanagement and mal-investment; for over a century, the U.S. government has employed gimmickry and sleight of hand to prop up a bogus consumer class that couldn't, in any other context, afford the goods and services put before them in such quantities. The result has been a gluttonous spending-spree that has bankrupted the nation.

The Obama administration, along with Fed Chairman Bernanke, have committed an unprecedented amount of money – more than $12.8 trillion – to battling this economic crisis. You may be one of the multitudes still clinging to the Keynesian status quo, remembering relatively minor recessions of the recent and distant past, desperately clamoring that we got through it before, and we will get through it again.

Did you read what I just wrote? $12.8 trillion. I'll give it to you another way: $12,800,000,000,000.00. If you are a citizen of the United States, and you have a pulse, your share of the commitment is just a little over $42,000. And that sum has nothing to do with previous obligations, nor will it be included in future budgets. Your $42,000 share only applies to this economic crisis.

I'll say it again: the U.S. is now the largest debtor nation on earth. Credit card and housing loans have all but disappeared. The country has no savings. There are no more sources of capital left to feed the fires of consumption. We have only seen the beginning -- the U.S. economy has no option but to unwind – for a very long time. Add to this the fact that the government is "fighting" this crisis by using the same rotten policies that got us here in the first place, and the economic outlook only becomes gloomier.

You can see I'm not terribly enthusiastic about the prospects of the United States. But before you dismiss me as the quintessential pessimist, you should know that I actually do see a prodigious number of opportunities out there. I certainly don't believe the entire global economy is simply going to disappear; I simply cannot think in such absolute terms.

The first law of thermodynamics requires the conservation of energy – that is to say, that energy can neither be created nor destroyed. And this is perhaps the closest metaphor I can procure: capital is like energy; I don't see wealth simply drying up and blowing away so much as I see it transitioning to a new paradigm.


Who Wants a Job?

Where the United States is full of overweight union workers who believe it is their God-given right to work a mere thirty hours a week, collecting exorbitant wages, Asia is full of very thin, motivated people, who are not only willing, but actually want to work six or seven days a week -- for a mere fraction of the wages enjoyed by their western counterparts.

Almost every country in Asia boasts net savings. And while these countries may not be able to export to the U.S. and Europe in the mass quantities they have enjoyed in recent decades, they will make up for much -- if not all -- of the shortfall by fulfilling the needs of their own burgeoning middle classes. Compare it, if you will, to the U.S. from say, 1875 to 1925. As the financial center of power shifted from London to New York, The U.S. prospered in spite of England's downward slide.


How Will the Money Go?

As technology has improved in recent decades, capital flows that might have -- only forty years ago -- taken days to move from one point to another can now occur in a fraction of a second. The ability for people to transfer wealth from medium to medium has grown exponentially faster, and as the world's major currencies disintegrate, people and institutions will quickly find alternatives – some public, and some private – with which to make transactions.

So what will be the world's new reserve currency? Well, as I said, it won't be the euro or the yen – or any major fiat currency, for that matter. One of my astute readers reminded me this week that no fiat currency has ever survived for very long in this world, and yet every major currency on the planet today holds that status. The people who use these currencies are about to get burned – and burned badly; we're going to see a massive return to currencies backed by assets, and that probably means gold, primarily.

People laugh and say silly things like, "Have you ever tried to by soap with a gold coin?" And I throw my head back and laugh with them. For a moment or two. And then I remind them that it doesn't take much effort to put gold in a vault and issue a piece of paper representing a fixed amount of that stockpile. In fact, it's not difficult at all.

As I said, capital is more efficient today than ever in history, and I see no reason why private institutions wouldn't issue currencies backed by their own assets. Why shouldn't they – especially in the wake of demonstrable failures by governments charged with protecting their citizenry's wealth? It's going to be profitable as hell, and how much credence do you think people are really going to give legal tender laws after this party is over? My guess is not much.


Where Will the Money Go?

Asia, of course – for all the reasons I've already listed, and more. And everyone on earth knows it.

Once the most powerful sources of capital in the world recognize that efficiency, innovation, and productivity are going to create colossal rates of return in Asia, the mass exodus will be unstoppable. We will finally see the return of real investment and true wealth creation – nothing like this fraudulent house of cards that's been perpetuated in the United States for so long. Further, I believe the shift is coming soon, and that it will be explosive and unrestrained.

Asia will be the world's next financial center, and I am a strong believer that any investment in these economies will provide superior returns over the next 50 to 100 years. But equity investment in the east is by no means the only place where I see huge returns.

There are two reasons why I'm extremely bullish on energy and agriculture. First, people are never going to stop needing these commodities. Demand may continue to wane a bit as we transition into the new economic paradigm, but as major currencies fall, energy and agriculture will not only keep pace with inflationary price increases, but they will outperform – if for no other reason, simply because investors tend to overshoot intrinsic value when they become exuberant. And when the bottom falls out of world currencies, investors are all but certain to become exuberant about energy and agriculture.

As I'm sure you are well aware, loans are extremely difficult to come by these days, and the second reason I'm so optimistic about these sectors is that farmers and energy producers are no exceptions to this difficult truism. It doesn't take a Nobel Laureate to recognize that, if producers can't produce, then supply will suffer, and prices will go higher. Coupled with my reasoning in the previous paragraph, I see nothing but upside in these commodities.


The Ill Wind…

Over the last few nights, I've been watching a documentary about Benjamin Franklin. I was surprised to find out that he remained a loyalist for so long -- despite the fact that many of his fellow Americans were already starting to rebel. Finally, however, he recognized that change was inevitable, and that his perception had been flawed. He thus became a champion of the American cause – even at the expense of his relationship with his son -- the person to whom he was arguably closest in the world.

Gloom-and-doom may be unpalatable, but sometimes, no matter how much it hurts, it represents the state of the universe. And when these conditions arise, we would do better to acknowledge them and face them with courage, rather than to simply ignore them – or worse still, waste valuable resources trying to "fix" them. Sometimes the only way to deal with a fire is to simply let it burn itself out.

The other side of this equation is the immutable fact that with every tragedy, there is opportunity. It might be easy to blame the people whose perspectives offer the most accuracy, but it is likely more prudent to simply listen to the message, and then to react appropriately by finding those opportunities.

No matter how you choose to see it, there's no question that for the last year members of the Austrian School of Economics – of which I am a proud and vocal member – have been correct at almost every turn. Every day that passes only offers more evidentiary confirmation of our theories. And yet, despite the pain that comes with the actualization of our predictions, there are still bright spots in this story.

Unfortunately, finding those bright spots is going to take the courage and conviction to admit that the U.S. government not only caused this crisis, but that it is only perpetuating it by employing the same rotten policies that got us here in the first place. There are ways to ride this out, and even prosper, but clinging desperately to the broken ideas -- based only on the tattered shreds of empiricism -- is a sure means to financial devastation.

Pledging allegiance to the flag and eating apple pie aren't going to get us out of this one. The only way to prosper is to embrace change. And change is surely coming.

Disclosures: Paco is long TBT, UGL, and DXO. He also holds U.S. dollars by necessity, pending the advent of private gold-backed currencies. Paco has been a financial analyst and a portfolio manager for 18 years. You can buy his novel Discipline wherever books are sold. Or visit www.DisciplineNovel.com. Email your questions or comments to questions@pacoahlgren.com. Copyright 2009, Paco Ahlgren. All Rights Reserved.

Don’t Kill the Messenger

 

"If we win another such battle against the Romans, we will be completely lost"

-- Plutarch, Pyrrhus 21,14

 

I have a friend who is some sort of a project manager at BioWare. He is one of the most brilliant people I've ever known; for fun, he studies subatomic physics. In Russian. He's also a bona fide cynic and drinks copiously. So we get along just fine.

For those of you uninitiated, BioWare designs video games, and last night, my friend showed me a two-minute trailer for a new Star Wars game he is involved with. I was impressed.

"It cost us a million dollars to make it." He looked concerned -- as though he might have gone over budget. "And we're making three more in the next month."

"Don't worry," I said. "If you discount back the true future value of the project -- based on the inevitable inflationary price explosions marching at us like an army of angry Storm Troopers -- it's probably justifiable."

Another moment of silence ensued. "You know," I said. "I'd give anything to have your job."

He pulled his head back. "Why? It's just a huge load of stress."

"Yeah, but you believe in what you do."

"And you don't?"

"No." I thought about it for a moment, and then said, "I'm going against everything I've ever believed in. I'm a value investor, and yet I haven't held any stocks for over a year. I'm short the entire U.S. economy, and I'm making a lot of money, but it's a pyrrhic victory; every single day I hate being right that much more."

A lot of you obviously liked my last article – to which this is a follow-up -- and I want to thank you for your praise. But judging from the spectrum of attacks I've also received in the last week – ranging from "you're stupid," to "I hope God kills you," I'm guessing some people aren't terribly excited about my mathematics -- nor, perhaps, my Jeffersonian propensity to decry unjust governments. Nonetheless, $12.8 trillion is a lot of money, and in case you missed it the other 22 times I posted it, here's a link to an article that epitomizes -- in real dollars -- just how much trouble we're in. The only inaccuracy I can find in it is the premature estimation of how much the government has actually committed to this train wreck of an economy; a piece that appeared in Bloomberg on March 31 more realistically depicts how deep in the quicksand we've really sunk.

Again, for the record, I do not like the fact that the United States is losing its status as the premier financial power in the world. Likewise, I do not like the fact that the U.S. dollar is losing its
status as the world's reserve currency. Nonetheless, the absolute worst thing any of us can do during a paradigm shift is shove our fingers in our ears and start singing the Star-spangled Banner at the top of our lungs; I am not going to sit idly by while "what-used-to-work" disintegrates around me, nor am I going to simply remain silent – for two reasons:

1. If I can help even one person make better decisions in this crisis, I'm going to.
   
2. Publishing my findings generates criticism, which can help refine the theories behind those findings.
   

 

Unfortunately, most of the criticism I've received over the last week has been more of the ad hominem variety than it has been of the constructive type. And that's a shame, because I know many of you read what I write hoping to gain perspective and insight into what's happening around us. Nothing facilitates that process more than healthy dialogue. I hope this week we can get closer to that objective.

 

THE FOUNDATION OF THE CRISIS: PAST, PRESENT AND FUTURE

I've discussed a lot of these points in earlier articles, but they bear repeating here. When governments create easy money, they necessarily distort demand – and by extension, prices. You want to know why tuition is so high? The government has created a market full of decidedly cheap student loans, driving demand for education exponentially higher in recent decades. And when demand increases, so do prices. There are other sectors of the economy that can thank governmental intervention for ballooning prices, as well – namely, healthcare and, you guessed it: housing.

Most people only see the housing bubble – and its ultimate collapse – as a self-contained crisis. In other words, when the deleveraging of the housing market stops, then the entire economy will correct itself and we can get back to business as usual. Unfortunately nothing could be further from the truth; the housing bubble was only the first phase of an economic crisis whose magnitude we can't even yet begin to fathom.

In battling the crisis, instead of taking the necessary steps to correct the very things that caused the bubble in the first place, the government has instead ramped up its policy of easing – driving rates almost to zero -- encouraging still more mal-investment
by people who wouldn't otherwise consider placing borrowed capital into the economy. Toward this objective, the government has committed the $12.8 trillion dollars I referred to earlier. And its sole purpose? To confront this crisis – and this crisis, alone; the money won't be used for any historical obligations, nor will it be earmarked for any future budgets.

Do you know where the money is going to come from? I can say with a great degree of confidence that almost none of it will come from taxation, because there's absolutely no way the government could get even a fraction of that sum from its citizens.

Will it come from debt? How could it? Will foreign nations continue to lend to the United States, despite the fact that it is the largest debtor nation on earth? Why would they? In years past, the loans were justifiable because the American consumer bought so many foreign goods. But the American consumer seems to have lost his heretofore insatiable appetite for material things – specifically because he has nowhere to get the money! He can't borrow against his house. His credit cards are either maxed-out, or else the card companies themselves have reduced limits so severely that they're next to useless. So how will Americans continue the gluttonous shopping spree they have enjoyed for the last few decades? The answer is, of course, they won't. And there is absolutely no incentive for foreign nations to continue to loan money to the U.S. if Americans have no means by which to return those funds to the source.

So the United States will simply try to print itself out of this mess – and indeed, the presses are already smoking and groaning from the strain. But the government can't just print trillions of dollars, and lower rates to unprecedented levels, without expecting massive inflationary price explosions in the near future. Further, the Fed is not run by wizards; it is manned by human beings who are both fallible and politically motivated. Instead of cutting rates, Bernanke and his sycophants should have been raising them. Instead of printing money and buying long-term Treasuries, they should have been pulling currency out of circulation by selling the long-end of the yield curve. Unfortunately, the point of no return has come and gone, and we're all going to have to weather the coming storm together. I'm doing it by shorting Treasuries, and buying commodities. So far, I couldn't be more pleased with my returns since December. Of course, all of this is offset by the fact that I'm going to have to watch a lot of people suffer in the coming years. That prospect certainly doesn't thrill me.

I encourage you to take a long hard look at your commitment to your government and its currency. If you believe I'm wrong, ask yourself why you've come to that conclusion. Then carefully lay out your argument, because I assure you, I want to hear it. But if your reasons for defending the "almighty dollar" and the government that prints it derive from blind patriotism, dogmatism, and/or irrepressible empiricism, all I can do is wish you luck. I want no part of it. You can wave the stars and stripes until your arms fall off, for all I care. You can even call me a traitor (you won't be the first). But I say our corrupt government deserves its fate, and the tyrants (and their supporters) who are systematically destroying our currency much more aptly fit the description than do I.

Remember, I'm only one of many messengers who are presenting an extremely cogent and dire warning. Calling me names isn't going to affect the outcome – one way or another – and you certainly aren't going to hurt my feelings enough to make me stop writing. If anything, you're simply wasting your time, because the next article is just around the corner, and barring some miracle, I doubt its contents are going to be any more optimistic than its recent predecessors.

 

Disclosures: Paco is long TBT, UGL, and DXO. He also holds U.S. dollars by necessity, pending the advent of private gold-backed currencies. Paco has been a financial analyst and a portfolio manager for 18 years. You can buy his novel Discipline wherever books are sold. Or visit www.DisciplineNovel.com. Email your questions or comments to questions@pacoahlgren.com. Copyright 2009, Paco Ahlgren. All Rights Reserved.

 

 

A Taste…

 

Continuation

Austin, Texas

Early Spring, Year Thirty-Three

 

I smiled as the familiar peace rippled through my body – contentment, and maybe even a little bit of security in the knowledge that everything happened exactly the way it was supposed to. Then something distracted me – glimmering in the afternoon light, pulling my eyes to the edge of the board, gently reminding me.

The quarter blazed in the autumn light.

I raised my head slowly and looked into his eyes, facing the same question I had a thousand times before: they're so blue, they're almost unnatural. As if he were reading my thoughts, his eyes narrowed, crow's-feet appearing at their edges. He lifted the corner of his mouth into a smile, and that old familiar dimple appeared beneath several days of stubble. Then Jack said, "What the fuck are you looking at?"

I smiled too, and it occurred to me that in all the years I had known him – even when I had been furious with him -- I had never been able to resist it for long. When I was a child, his ability to make me smile through my rage had often only angered me more. And yet I have always been helpless before it…

The Last Drink Before the Weekend Ends

"Are you going to gamble while you're in Vegas?" The woman asking the question was one of my post-workshop straggler's, bent on extracting every last shred of evidence leading to my conclusion that the dollar really is going to fail. She had followed me out of the lecture hall to question me in the foyer – apparently oblivious to the fact that I was both psychologically and emotionally "done" imparting my bleak and macabre message to the world for the day.

Done.

I took a long pull from my glass of bourbon. Her accent bled slowly a thick, nasal Scandinavian root, shouting, "FUCK YOU, I'M FROM THE MIDWEST!" like a premium billboard aimed at rush hour traffic. I stared at her for a moment -- neutral on the outside, but positively roiling on the inside. I raised my eyebrows and we continued to stare at one another until I simply couldn't resist glancing at a girl in a tiger-striped dress standing shoulder-to-shoulder with another girl -- both speaking enthusiastically, yet cautiously to a couple of young Hispanic men. Or boys. Or whatever.

The badges around the boys' necks told me they were part of the convention in the hall next to us -- in town to absorb the delicate intricacies of franchising a Pizza Hut. My guess was that their day was done, and now they were going after these two kittens. Their badges bore the bold word "ARIZONA." The girls were laughing and nodding, in that sort of polite yet frantic I just want to go have about ten shots of tequila and get laid by someone hot kind of way. I'm probably not the best judge, but I'm good enough to know the boys from Arizona weren't making the cut.

"Mr. Ahlgren?"

I looked back at the woman. "I'm sorry. I'm very tired. I need to get back to my hotel."

"Oh! Where are you staying?" She smiled with an eagerness that terrified me far worse than the prospect of the dollar's failure. Her boingy-bouncy accent affected me like screeching metal, and I noticed the wedding ensemble on her left hand. I found myself wondering what it would be like to spend my life listening to that accent, and suddenly the Swedish Chef from the Muppet show took center stage in my brain, after hibernating for decades, and I had to suppress what would have only come across as a condescending guffaw.

I closed my eyes. I opened them again. She was still there. I took another sip of bourbon and said, "I'm staying at Hooters."

"Excuse me?"

I leaned forward a bit. "Hooters."

"Oh."

Normally I would have lied. But somehow I was beyond that here. Another moment of silence passed before she finally said, "Well, you didn't answer my question."

I smiled patiently. "What question was that?"

"Are you going to gamble?"

I let my smile broaden a little, and the bourbon took the moment. "As soon as I find the right prostitute."

In 1990 I took a tour of William Faulkner's estate in Oxford, Mississippi. At the time, I had written little more than a few dark pop songs about abandonment and broken love. I found it strange that the last stop on the tour was Faulkner's bedroom, in which a dresser stood -- a quarter-full bottle of Jack Daniels resting on its surface.

I stared at it for a moment, almost mesmerized. "Why is that there?" I asked the guide.

She smiled gently. "We don't talk about it."

Somebody else said, "Why not?"

More firmly, the guide said, "We just don't."

Three or four years later, a historian from Mississippi told me the bottle is original. "They keep it there," he said, "because it was both the source of Faulkner's brilliance, and the catalyst for his demise…" He let the words trail off dramatically, and for years, I thought it was simply a tactic to immortalize a legend.

It turns out on the night of his death, Faulkner reached for that bottle and begged the paramedics charged with transporting him to the hospital in Memphis to let him bring it along…

When I finally got out to the strip, I became aware of one inescapable truth: I needed to get to a fucking keyboard. Fast. But first, I needed more bourbon.

I walked quickly, chewing on this abject loneliness sitting in the pit of my stomach like a piece of rotten fish. The nearly inconceivable number of tragedies over the last month played in my mind, looping infinitely, reminding me just how the universe works.

Remember when you were on top of the world? Remember? Remember when you thought you were cool, and you had more money than you knew how to spend, and you didn't have to worry about shit anymore? Remember? Remember when you didn't have a daughter whose very existence makes you ache with emotions you never knew existed? Hmmm? Yeah, well we fixed that little snap of haughty fatuousness, didn't we?

I stopped and looked at the Vegas skyline as the sun melted into the horizon, and suddenly I was stricken by how much it had changed since the last time I was here. And I thought about how much everything has changed.

I slowed my pace, watching the sun disappear, wondering how this oasis of pure decadence in the middle of the Nevada desert was even moderately sustainable in light of the current economic crisis. And yet here it was, full of all the same throngs of fat, tattoo-covered bovines plugging up the walkways as they ambled to the next casino, dumping endless sums of money in ceaselessly flashing, dinging machines sporting themes ranging from Dale Earnhardt, Jr., to EBay. Yes, that's right. EBay.

What is the appeal? And why do these herds of cattle continue to pay five dollars for a small bottle of water, or $15 for a barely palatable cheeseburger? Why?

For my part, I was here by invitation to speak to a
group of investors -- many of whom still refuse to acknowledge that the U.S. government has just printed the dollar into its immortal place in history. They accepted my presentation with cautious skepticism, and I can't say I blame them; after all, who really wants to face the fact that everything we have ever known about our society is about to disintegrate? The whole world is coming apart at the seams; it has become imbalanced, and somehow I'm in the middle of it – inexorably and irrefutably. And here I was in Vegas. Confused. Scared. Angry. Tired. And driven…

In the last 36 hours, I've been cornered by brilliant people turning to me for advice on which leveraged ETFs will protect their portfolios most effectively… I've been approached by prostitutes better endowed than I am – which, granted, isn't difficult to achieve. A 21-year-old biology student from some college in California seduced me, only to abandon me, leaving me writhing in my passion like a hungry infant. I have walked miles and miles and miles in the unrelenting Nevada heat. And last night, I blew my chances with a 23-year-old supermodel because I refused to pay $32 for a drink, along with the privilege of wearing a fur coat in a glorified cooler containing a bar made of ice.

And I miss my little girl so much…

I guess my priorities are just all fucking out of whack. But as the day drew to a close, I knew one thing with a conviction so near certainty that my blood veritably boiled with a passion I have not felt for a very, very long time. Most of us know what it's like to experience that erotic perfect storm – that moment when you meet someone to whom you are so attracted, and from whom the attraction is so requited, that you almost can't get to a secluded place fast enough to shred the fabric from each other's bodies, like dog's scratching at the entrance of some elusive rodent's home. And when this happens, oddly enough, it's the unqualified, unquenchable desire that etches itself forever in our memories, whereas the inevitable sex itself results in an anticlimactic debacle that usually embarrasses everyone involved.

If you know what I'm talking about, then you know how I felt about getting to a place where I could write.

Now. This minute…

I needed to get this out of me… to spill it to the world… to offer one last temporary explosion before I launched into the sequel with all the strength I have left.

I marched into the Hooter's gift shop with all the confidence of an Oscar-winner traversing the void between his precarious membership in the audience, to his sacred place at the podium -- where his position in history is guaranteed, and his acceptance speech graduates from an insurance policy to a declaration of greatness.

The fat woman in front of me wore white socks beneath her Crocks, and some sort of shiny pink tracksuit that would have embarrassed Elvis Presley. She had a cigarette dangling between her lips which bobbed up and down as she counted coins in a pile next to her Michigan driver license, trying to achieve the exact cost of the bona fide Hooters golf ball, shot glasses, and bottle of Jose Cuervo. My guess was that she buying this crap for her family back in Kalamazoo – or whatever shitty hovel she came from.

The cellulite that composed the majority of her upper arm bore a tattoo that might have been a butterfly at one point. Or it could just as easily have been a likeness Nikki Sixx. There was just no way of knowing.

The clerk seemed as impatient as I was. She sighed and turned her eyes to me. "What can I do for you?"

I nodded once at the shelf behind her. "Bourbon."

She stared at me, and I felt something familiar. The faintest smile touched her lips, and involuntarily, one thought stampeded my mind: she knows…

She turned slowly – only pulling her eyes away from mine at the last possible instant. She turned back and handed the bottle to me in exchange for the cash I gave her.

"Keep it," I said.

She narrowed her eyes and smiled a little more…

I finally made it back to my room, where poured a quick, sloppy drink and tore off my clothes. I fumbled with the zipper, pulled out my laptop, and fell onto the bed. What you're reading is what came next…

Nine years ago, it took me three months to write the first draft of Discipline. Those three months followed the worst year I had ever known – up to that point. But compared to the last two years, that time of my life seems like a goddamn day at the carnival.

I'm trembling right now, because the ghosts are back, and they are angrier than I ever remembered. They are screeching at me, forcing me to see things I didn't think I'd ever have to look at again. This place is so black, and it hurts so much, and yet this is what it takes. This is where I have to go, and I was a fool for thinking I could ignore it forever.

But, of course, there's something new now. She is the most beautiful thing in the universe. So fuck it. It's not like I have any choice anyway. Let's see what happens this time.

As the Dollar Continues to Collapse, Where Will You Put Your Money?

 

Before, I launch into this article, I want to thank Seeking Alpha and The Money Show for allowing me to present my workshop not long ago at Mandalay Bay in Las Vegas. I'm always nervous when I speak to crowds about the inevitable failure of the dollar and Treasuries – I never know how safe I am, playing the role of messenger. The response, however, has been overwhelmingly positive; it seems the most astute investors are beginning to accept – and even prepare for – the advancing collapse.

I also want to make a quick point about my intentions: I have very little to gain, financially, by convincing any of you that I'm "right." I do have a novel on store shelves that subtly incorporates many of the epistemological constructs that have gone into my research, but these articles are by no means part of a massive campaign to sell copies of Discipline; my objective is to disseminate these theories to as large an audience as possible in order to generate debate and criticism. More than anything, if I am right, I want people to prepare for what's coming, so we can all minimize the shock and pain that will ensue. As a species, we will have to find a new way of doing things, because the consequences of the old ways are descending upon us like a maelstrom. And if I'm wrong, well, I'd just like to know it as soon as possible. But I obviously don't think I am.

This piece follows a previous article, in which I warned against shorting equities -- despite the fact that I believe the stock market is going to fall dramatically, at least in real terms (which I'll again expand upon later). As usual, my cautious outlook prompted a flurry of emails from readers asking what they should be doing with their money in order to prepare for the impending firestorm of rising prices that will derive from the inflationary printing and unprecedented credit-easing governments worldwide are foisting on their citizens.

It's important to note that, although I refer to "the" collapse of the dollar and Treasuries, these events are not going to happen in one minute, or one day, or even one week. Indeed, since I started writing about this scenario in December, the government has done so much to try to reverse the course of this trend, and yet the cracks have widened, and the dollar and Treasuries continue their inexorable march downward. Even though I don't believe, however, there will be any particular event that will trigger the collapse, I do believe it will accelerate with time -- ultimately exploding in a quick, catastrophic climax.

I am forever an analyst, but I am no longer an adviser or manager, and I want to encourage anyone investing money to do a prodigious amount of research before committing funds to anything – especially in this environment. Having said that, the best and safest place to start discussing my own opinions about capital allocation is to reiterate what you shouldn't be investing in: stocks, Treasuries, and dollars. As I said in my last article, although the stock market may trade sideways or even go higher from here, once the consequences of the unparalleled governmental printing spree and credit-easing of the last few years finally do hit the economy, earnings and dividends growth -- which are the main drivers of stocks – will never be able to keep pace with the inevitable and substantial inflationary price increases in the general economy. And this highlights what I consider to be the most dangerous part of this environment: your portfolio will appear to be going higher, but in real terms, you'll be losing money – on a scale greater than, I believe, even that of the 1929 to 1932 collapse. The only thing I can imagine worse than watching the market fall the 90% or so that it did 80 years ago is watching a stock market rise in a period in which it is vastly underperforming inflationary price explosions. The drop from 1929 to 1932 may have been painful, but at least it was an honest market.

So where do you go to survive, or even to outperform?

 

SHORTING THE DOLLAR INDEX?

The dollar index is merely a gauge of the dollar against a handful of the rest of the world's major currencies – leading to a general misperception that I call "currency relativity." Unfortunately, the fact is that every other central bank on earth is employing the same quantitative easing principles as the U.S., and so their currencies are equally doomed. If you short the dollar index, you are merely taking a position that the dollar is going to be weak relative to other major currencies, and that probably isn't going to be the case; they're all trapped in the same burning house.

On a related note, you may want to pay attention to the fact that Treasuries and gold seem to be decoupling from their heretofore nearly direct inverse relationship with equities. What does this mean? Mainly, in my eyes, it decries the old notion that, just because the stock market goes down, people will run to Treasuries as a safe haven; apparently the so-called "risk-free" rate of return isn't so risk-free anymore. Likewise, it would seem that, just because the stock market is going up, people aren't necessarily dumping gold. And this lends credence to my theory that investors not only expect inflationary pressures to drive stocks higher in nominal terms (but not real terms), but also that, in order to really survive rising prices, gold is one of the best places to be.

 

REAL ESTATE?

Have we hit the bottom, and are prices going to rebound from here? My best guess is that -- again in nominal terms -- we are near a "bottom," but as with the stock market, what does that mean? Yes, housing prices might rebound, but will those prices outperform inflationary pressure in the entire economy? Probably not. I will say this, however: when rates and prices are shooting skyward, having a personal residence with a relatively low interest-rate fixed-rate mortgage is a great position to be in – assuming you have a job, and you are going to be able to keep it. First, there's the tax deduction on the mortgage interest. But more importantly, a fixed-rate is just that: fixed. Even as all other prices and rates move higher, the mortgage payment doesn't – making it a progressively smaller part of a household budget.

To illustrate the way fixed-rate mortgages work with inflationary trends, think about the house your parents or grandparents bought for $20,000 several decades ago. Their monthly payment remained fixed at around $200 per month for thirty years, and yet their wages undoubtedly increased dramatically in that time. At the beginning, $200 was likely a hefty part of their budget, but toward the end, it was probably insignificant. Now, imagine how much that effect would be amplified by a hyper-inflationary economy – which, unfortunately, our government has all but guaranteed in the coming years. Remember, we all have to live somewhere, and if part of your cost of domicile is going toward equity, and the interest you're paying is fixed -- in an environment of rising rates and prices -- well, I guess it doesn't get much better than that. The alternative is to rent -- and leases escalate with inflationary surges.

In general, however, the reason I believe housing won't outperform inflation is that credit is all but gone; no matter what any of the pundits say on CNBC, the stark reality is that people can't get loans. It doesn't take much to recognize that, if the consumer can't borrow, then he can't buy a house. And if that condition has become the status quo – and I believe it has – then what will drive the housing market?

 

COMMODITIES?

People call me a gold bug. I'm going on the record here -- I am not a gold bug. I am, however, a huge fan of commodities right now -- and gold is hovering near the top of my list. Gold has almost no industrial value, but I follow it anyway, because it is nearly a perfect metric for the anticipation of future inflationary price-increases. Why? Gold has a psychological component that it shares with almost no other thing on earth -- it literally packs eons of historical consistency and value; people have always been passionate about gold, and it has unfailingly been the ultimate measure of economic and financial stability. As such, when people are frightened, they fly to the one thing that embodies that stability in order to protect wealth, and this means that gold will react to inflation faster and more accurately than just about anything else. Further, its overall popularity means it is more liquid than other scarce metals and stones. All of these variables come together to convince me that, when the bottom falls out of the dollar and Treasuries, not only will gold keep up with prices, but it will outperform as people flock to its empirical safety. Remember: during a panic, everything tends to overshoot intrinsic value – to the upside and to the downside. Gold's universal nature will undoubtedly put it at the head of the pack, all but guaranteeing a above-average rate of return – at least until everything stabilizes. Unfortunately, however, I think we are sitting on the cusp of a colossal crisis, the likes of which we've never seen. At this point, economic stabilization seems like little more than a distant dream.

For many of the same reasons I like gold, I also like oil and agriculture. Let's face it -- getting a loan these days is almost impossible for anyone, and farmers and oil-producers are no exceptions to this troubling rule. Yes, I understand a slowing economy means slowing demand for commodities. But demand for food and oil will not simply cease; 2 billion Chinese and Indians may not be buying at the Gap this season, but they aren't about to stop driving and eating. So -- unlike gold -- oil and agriculture do have practical aspects to their demand that ensure more than a mere "safe store of wealth." As currencies falter, prices of oil and agriculture will keep pace; the fact that producers in these industries can't borrow should limit supply in a world in which demand probably won't fall all that significantly – relative to everything else. All this will almost certainly equate to better-than-average performance.

 

SHORTING TREASURIES?

Shorting long-term Treasuries at this moment may be my favorite investment of all time. I love how the Fed commits to buying $300 billion worth of 10- to 30-year Treasuries in order to keep down the long end of the yield curve, and yet those rates go up anyway. This is just more evidence that the United States government is rapidly losing its ability to manipulate the economy, as well as further testimony that now is the time to bet against the Fed – and to bet against it big. I know, I know, I'm a doomsday prophet and a conspiracy theorist. Believe me, I've heard it all. Try to remember, though -- if you can see through that fog of skepticism and doubt -- that people were also ridiculed for predicting the failures of the Roman, British, and Soviet empires. And yes, you are correct -- anyone can make a general prediction, but timing is everything. Let me be clear on this point, however: I am not making a vague prediction; I am predicting, specifically, that the dollar is going to weaken to the point of collapse – along with many other global currencies – and that it's going to happen sometime in the next two years (probably sooner). Try to bear in mind that the U.S. has committed itself to almost $13 trillion -- just to battle this financial crisis alone -- and that figure is 50% more than the government has spent on every single project, war, or undertaking since the country's inception, in real dollars -- combined.

Despite what you may or may not believe about my prediction, shorting long-end Treasuries continues to be a no-lose proposition. If by some miracle, the Fed manages to pull some proverbial rabbit out of its hat and fix this incomprehensible mess, then part of its solution, ipso facto, will necessarily be raising rates to maintain the integrity of the dollar. On the other hand, if my prediction is correct and the dollar fails, well, Treasuries are going to follow it all the way down. Yields have been hovering near all-time lows for months. There's no place to go but up.

 

HOW DO YOU GET INVOLVED?

The obvious and inevitable question is: what vehicles offer the easiest and most practical way to participate in some of these moves? Until recently, the only way the average investor could profit from such events was to use futures contracts or to take physical positions – both of which are cumbersome, complicated, and involve a great deal of maintenance. Fortunately, however, times have changed. In recent years, many companies have introduced electronically traded funds (ETFs) – some of which even offer two- or three-times leverage. There are a lot of them out there, and I again encourage you to do thorough research before diving headfirst into any investment vehicle. In my own portfolio, I am using some of these ETFs, which I have disclosed below.

 

 

Disclosures: Paco is long TBT, UGL, and DXO. He also holds U.S. dollars by necessity, pending the advent of private gold-backed currencies. Paco has been a financial analyst and a portfolio manager for 18 years. You can buy his novel Discipline wherever books are sold. Or visit www.DisciplineNovel.com. Email your questions or comments to questions@pacoahlgren.com. Copyright 2009, Paco Ahlgren. All Rights Reserved.

 

 

Nothing About this Economy Should Surprise You

"Insanity: doing the same thing over and over again and expecting different results."

-- Albert Einstein

 

The Einstein platitude above is so overused that I'm almost disgusted with myself for planting it at the beginning of this article. Almost. But then I think about how utterly applicable it is to this piteous disaster we're still calling an economy, and I really have no choice.

For nearly two decades, I have been writing about free markets and how important they are to progress – to the growth of knowledge, as the philosopher Sir Karl Popper would call it. I am by no means alone; minds far more advanced than mine -- along with groups like Cato and the Mises Institute, to name a couple -- have been defending market liberalism since long before I took my first breath. Yet, for all the effort, the arguments have met with phenomenal resistance – often ferocious and virulent. Politicians and academics have been blaming markets for our collective problems for ages, and yet I fail to see their reasoning.

Wall Street, for instance, is the favorite whipping boy for the housing crisis that has descended upon us like a poisonous fog, and yet it was created not by banks, but by government programs that all but demanded these banks loan money to anyone with a pulse. And do you know why the government did this? Because people with poor or no credit can still vote, and if you get them into houses – regardless of their ability to make payments each month – they're going to see you as a hero, and they're going to put you in office.

Now what do the banks have to do with that, except for acting as facilitators for the transactions? Let me put it another way: if you were a banker, and the government told you it was okay to lend money to people who shouldn't qualify, and told you that you would be paid handsomely for the transaction, would you say no? At best, you might say to yourself, "Is this smart?" But then you would, as everyone did, justify it by reminding yourself that if Uncle Sam says it's all right, well then it must be all right! Hey, we've all got to put food on the table!

In any case, the point of this piece is not to defend investment banks, per se, but it is rather to point out that large, centralized governments are irresponsible, inefficient monsters that destroy innovation and productivity; they are the source of all our economic woes at this moment in time (or, really, at any moment in time), and yet I firmly believe we could have done things differently -- much differently. Below are some major points that free market economists have been making for decades (or longer), and I believe that, if the world had taken them to heart, we could not only have averted this crisis, but we would be existing in an era of unprecedented prosperity.

1. F.A. Hayek – the Austrian economist, author of The Road to Serfdom, and 1974 Nobel winner in economics – observed that centralized bureaucracies lack the resources and meticulous insight to manage an economy's trillions of components. This tenet inspired the following analogy in an piece I wrote several years ago: imagine your brain trying to manage the decisions made by every cell in your body. How long do you think you would survive? Well that's what Washington has tried to do with the U.S. economy for almost a century, and we are now paying the price, yet again. Only this time, it's going to be far worse than ever before – and, indeed, may be insurmountable (see any number of my previous articles if you want to learn more about the death of the dollar and the U.S. economy).
   
2. In his milestone work Socialism, another Austrian, Ludwig von Mises – after whom the above-mentioned institute was named – proposed what I consider to be the most powerful economic axiom ever posited. It is called the Economic Calculation Argument, and it essentially states that any manipulation of price structures distorts the ability to perceive scarcity. In other words, scarcity is the product of every individual actor in an economy casting his or her vote, through transactions, for the relative value of any good or service. The value the collective places on goods and services is the result of these miniature "votes." When the government tinkers with the money supply, it necessarily distorts price structures and creates inefficiency. But more than that, it destroys any possibility of understanding true scarcity, and when that happens, our ability to discern who needs what, and where, becomes impaired.
   

   The Soviet Union -- which is inarguably the biggest joke of a planned economy ever -- perpetually failed to ascertain scarcity, and its people had to stand in lines, ad infinitum, just to get toilet paper. For my part, I thank the stars every day for the Soviet Union, because it established, irrefutably, the veracity of Mises' theory (although I do feel sorry for the people who couldn't get toilet paper).
   

   Unfortunately, other folks – like, oh, say, most academics, along with every single politician in Washington (except Ron Paul) – do not see the irrefutability of Mises' Argument. No, they have kept doing the same things, over and over, for a century, because what feels good gets votes. Who cares about the eventual consequences? And so it goes -- as the rest of us suffer day after day through this economic version of the Black Death.
   

   What is insanity again?
   

3. I don't care how fancy Ben Bernanke's helicopter is; a government cannot print money to solve economic problems. Printing money creates economic problems. It's called inflation, and it sucks. If you don't believe me, would you believe the Romans? How about the Spanish? The Portuguese? The British? What about those aforementioned "geniuses" in the Soviet Union?
   

   Do you really think the U.S. is somehow different than all those empires of yesteryear, who so recklessly manufactured their own currencies -- ultimately whittling themselves to a mere fraction of their former, majestic selves? No. The U.S. is subject to the same economic principles that every other foolish empire has had to face, and printing $12.8 trillion isn't going to do anything but ensure that our children better learn to speak Chinese. And they better learn to speak it real good, because that big groaning sound you hear in the sky – yeah that one – that's the sound of the center of economic power heading east.
   

So here we are – wallowing in the filthy muck created by generations of politicians and central bankers. You would think global governmental establishments would finally see the light, right? Surely it's time to stop this cycle! Isn't this the hour to listen? Hail Mises! Hail Hayek! Take us back to sound money and true liberty!

Well, apparently listening isn't part of the equation, because governments everywhere are
printing unprecedented sums of money. They are creating still more easy credit. They are doing all the same things – on the largest scale ever -- that got us here in the first place. Above everything else, though, they are fulfilling Einstein's famous dictum.

For the entire world is now truly and incontrovertibly insane.

 

Disclosures: Paco is long TBT, UGL, and DXO. He also holds U.S. dollars by necessity, pending the advent of private gold-backed currencies. Paco will be giving a workshop entitled The Death of the Dollar: How We Can Survive the Coming Collapse at the 21st annual Las Vegas Money Show, Mandalay Bay Resort, Tuesday, May 12, 2009, at 11:30 a.m. He hopes to see you there. Paco has been a financial analyst and a portfolio manager for 18 years. You can buy his novel Discipline wherever books are sold. Or visit www.DisciplineNovel.com. Email your questions or comments to questions@pacoahlgren.com. Copyright 2009, Paco Ahlgren. All Rights Reserved.

 

Equities Are Headed Down, but Shorting Isn’t the Answer

 

"Inflation is the senility of democracies."

-- Sylvia Townsend Warner

 

In my last article I observed that, in a poor economy, bear market traps are driven primarily by a collective flawed perception of current and future corporate earnings. I pointed repeatedly to the lagging earnings trends of the 1929 to 1932 correction, as well as to the sheer number of times reckless investors were drawn to deceptively attractive price-to-earnings ratios and high dividend yields, only to see those numbers destroyed by an ever-worsening economy. And that's exactly where we are right now – in the middle of yet another bear market rally driven by faulty earnings and dividend expectations. How do I know this? Because corporations depend on consumers, who have lost almost all ability to borrow money. The spending-spree is inarguably over.

Let me give you a working example of the sort of optimism that might get an investor in trouble. Pfizer (PFE) is a great company – a value investor's dream – sporting a history of consistent and stable earnings, well-managed debt, and strong, albeit relatively similar dividend yields to other strong large-cap stocks. After the crash last November and December, however, Pfizer's dividend yield jumped to over 9%, while it's p/e collapsed! I did all the usual research, salivating profusely, almost completely convinced that Pfizer at a price of $17 per share, was a steal. I took a significant position, and yet a little voice in the back of my mind told me to look deeper, and after doing still more research – which inspired this article, as well as the last one -- I unloaded the position, fortunately at a slight profit. Almost immediately thereafter, Pfizer reported lower earnings, and it slashed its dividend. The stock price tumbled accordingly.

Since writing my last article, I have been inundated with emails asking the same question: in light of my findings, is it time to short equities? And the answer might seem obvious – if earnings are going to fall further, and companies are cutting dividends, wouldn't the best move be to short an index or two? Things, however, are never as simple as they seem. I've said it many times before, but it might surprise you to know I actually believe the stock market is going to go up from here – if only moderately. The reason? Inflation.

From 1929 to 1932, the U.S. government was significantly impaired by the gold-standard, and wasn't able to manipulate the money supply with anything even approaching the current printing spree we're witnessing. As one reader pointed out, the government did re-set the price of gold, in dollars, in the early 1930s, but in real terms that move was so insignificant as to be non-existent -- compared to the $12.8 trillion the government is going to have to print to cover its budget for the next two years (this article should put the magnitude of that sum in perspective for you).

What this means is that a savvy investor could have shorted the market during just about any bear market trap during the 1930s collapse and fared very well – in real terms – because prices were falling as people deleveraged. The specter of inflation was nowhere to be seen. Today, however, although we find ourselves in the same deleveraging environment, inflation is a colossal threat, and it is only a matter of time before prices skyrocket.

This is why I believe the stock market will probably go up a little bit from here, in nominal terms. In real terms, however, I believe the stock market is going to do much worse than even the 90% or so that it lost from '29 to '32, and this makes our current environment so much more dangerous to those uninitiated: it's one thing to see the market falling, and to know how much money is actually being lost. It's quite another thing when the average investor sees the market rising and believes he or she is actually getting rich -- when in fact the losses, in real terms, are staggering.

The truth is, you could short the market here, and even if it goes up, you'll probably make a little money in the end -- after adjusting for inflation. But as I see it there are three problems with this strategy:

1. I have no idea how long it will take for prices to start rising (and neither does anyone else). If my theory is correct, the market will probably hover at current levels for a while.
    
2. Once prices do take off, the stock market will probably rise with them -- although at a slower rate. You'll be left in the uncomfortable position of having to battle the psychology of reverse-mathematics – constantly reminding yourself that even though it looks like you're losing money, you're not. In other words, you'll be short the market, which will start to climb with the rising prices of goods and services -- but at a slower rate. Any short positions will appear to be losers, but since they'll be beating inflation, they'll actually be making money, in real terms. Frankly, that's just confusing as hell, and it certainly doesn't sound pleasant to keep track of.
   
   
3. I still believe in the productivity and innovation that defines many U.S. companies, and eventually they're going to turn around. When they do, I believe their bull run will be as unprecedented as the horror that precedes it. Being short -- no matter how cogent my arguments for the coming storm – means betting against the aforementioned productivity and ingenuity, and that means you'll have to pick the bottom. For my part, I suck at timing markets, and I don't want to have anything to do with trying to find that nadir.
   

I think there are better strategies, including buying gold and oil, and shorting Treasuries. These positions stand to outperform inflationary pressure by a wide margin, and yet offer relatively little downside risk – at least in this environment. Yes, the time will come to offset short Treasuries, as well as to sell gold and oil, but that time is a long way off. I can't say the same for equity markets.

 

Disclosures: Paco is long TBT, UGL, and DXO. He also holds U.S. dollars by necessity, pending the advent of private gold-backed currencies. Paco will be giving a workshop entitled The Death of the Dollar: How We Can Survive the Coming Collapse at the 21st annual Las Vegas Money Show, Mandalay Bay Resort, Tuesday, May 12, 2009, at 11:30 a.m. He hopes to see you there. Paco has been a financial analyst and a portfolio manager for 18 years. You can buy his novel Discipline wherever books are sold. Or visit www.DisciplineNovel.com. Email your questions or comments to questions@pacoahlgren.com. Copyright 2009, Paco Ahlgren. All Rights Reserved.

 

The Beginning of the Next Bull Market? History and Earnings Say Probably Not.

“[It is] an ill wind that bloweth no man to good.”

-- John Heywood 

I’ve heard a lot of discussion in recent months about the future of the dollar and the economy. Some people think this is just a typical downturn – that we’ll get through it and then everything will be just fine. Housing prices will rise again. The stock market will recover. The United States will prosper. Everything will be as it was. Similarly – and more recently – there has been a plethora of talk about whether the recent rally in the stock market is the beginning of a new, long-term bull market.

I hate to yet again be the harbinger of bad news, but this is not the beginning of a new bull market, and things are not going to be as they were.

Have a look at this chart comparing the stock market collapse of the 1930s to our current downward spiral, created by Mark Lundeen:

 

Mark has consistently painted a cogent argument that we are nowhere near the bottom. If you haven’t already, you would do well to read his articles going back a year or two. He predicted everything we’re going through in a humble and patient manner. Even if you’re determined this market is going to turn around and return to “normal,” I’d think twice before simply dismissing his research. In any case, no matter what your outlook is for the future of markets and the economy, the focus of this article is the current stock market rally. And the thing that should be jumping out at you, regarding the chart above, is the red plot – explicitly, the sheer number of false rallies the market endured from 1929 to 1932.

Before we go further, I want to remind you that I found my success in the financial world as a value investor. I believe wealth-creation is a long-term prospect, and if an investor wants to do well, he or she must find undervalued enterprises that create abundant free cash flow. But more than anything, that investor must enter the position at a discount to intrinsic value. So what is intrinsic value? It is a discounted measure of a firm’s ability to create wealth for its owners, over time. And in my world, wealth is measured explicitly by free cash – loosely derived from a company’s earnings.

The problem with the current economic environment is manifold. Sure, in terms of simple aggregate stock prices, global markets have been crushed, and on the surface -- to less scrutinizing eyes -- the whole thing probably seems like a giant orchard full of low-hanging fruit. It’s simple, right? You have earnings. You have price. If the price goes down, the company is worth more, intrinsically, because the price-to-earnings ratio has collapsed. Simple, right?

The question is rhetorical, and you’ve undoubtedly guessed that my answer is a resounding no. When the market took its first harrowing dive in 1929, reported earnings remained intact, driving price-to-earnings ratios much lower. To a novice value investor, this might have seemed like the opportunity of a lifetime. Of course, we know now that it was anything but the opportunity of a lifetime; over the ensuing few years, as conditions worsened, earnings reflected the true nature of the economic environment and melted accordingly. Stocks continued to fall accordingly, with very short-lived respites offered by the painful bear market traps I referred to in the chart above.

What caused these traps? The exact same mistakes would-be value investors always make after every downward move in a collapsing market driven by a faltering economy: stocks fall, but earnings do not follow immediately, and this makes everything look “cheap.”  Unfortunately, earnings always lag the market, so when equities fall, the real economic conditions aren’t reflected by historical reporting.

Of course, in a prospering economy, this all becomes moot because earnings will continue to grow despite any market downturns. In October of 1987, for instance, the market shed 23% of its value in one day, but the economy was booming. Anyone picking up equities the day after the crash found some incredibly undervalued companies -- because earnings were increasing throughout the economy. But there is absolutely no comparison between the 1987 crash and its economy with either the 1929-1932 crash, or the 2007-2010 crash, and anyone foolish enough to even consider buying equities at this point needs to take a long, hard look at the economic conditions underpinning our current depression:

1.       The housing and credit markets are terminal. To bring it into perspective, consumers drove 67% of the economy until a year or two ago, and they got the money from their houses and credit cards. That party, however, is over, and the spending has come to a halt. Is this fully reflected in company earnings? Absolutely not, and the worst is yet to come.

2.       The depression of the 1930s was the worst economic catastrophe the U.S. has ever seen (yet), but even in the midst of that torturous environment, the nation was a net lender, and it had a huge manufacturing base. Today, the U.S. is the largest debtor nation on earth, with a relatively small manufacturing base. Whether you agree it was the best move or not – and I don’t – the United States essentially borrowed its way out of the Great Depression -- simply because it could. That, coupled with its powerful manufacturing sector of the time, allowed the country to muddle through some extremely painful years. In the current environment, however, the government’s debt-load is at record levels, and its ability to borrow is severely limited. If you believe that China and Japan are going to continue to lend to the United States at yields between zero and three percent, indefinitely, I would like to know why. Are they really so reliant on the U.S. consumer to buy their exports? And that leads inevitably to the question: what consumer? Please see my previous bullet point.

3.       In the 1930s, the United States dollar was tied to gold, thereby limiting the government’s ability to flood the market with printed currency. I have no doubt that Franklin Roosevelt and his henchmen would have loved to print money to battle collapsing prices caused by the same deleveraging forces we are seeing all around us today. Unfortunately they couldn’t – at least not the way the Fed is doing it now --  and the country was spared the runaway price-increases that would have certainly ensued if the government had been able to print money at will. Today, there is no gold standard. The U.S. government is running wild -- printing money like a child with carte blanche in a candy store -- and that money will have to be soaked up somehow when the deleveraging stops. How will the government do that? By selling Treasuries? To whom, and at what yields? Please see my previous bullet point.

When you compare our current situation to the Depression of the 1930s, the outlook is certainly grim. And yet, in terms of the stock market and its close relationship to corporate earnings, the prognosis is even worse; in the 1930s, the government’s ability to inflate the dollar was impaired, and so, at the very least, prices continued to fall – giving the consumer at least one thing to be happy about. Sure, corporate earnings fell, but at least money retained its value. In today’s economy, however, inflation is the name of the game, and runaway price-increases loom like the darkest storm on the horizon. At this point, it isn’t a matter of if, but rather when the nightmare begins; its inevitability is simply terrifying to those of us who refuse to bury our heads in the sand and trust the very government that created this hopeless fiasco in the first place.

I suppose some would argue that rising prices will be good for corporate earnings, and this will undoubtedly be so in nominal terms. But if the consumer is feeling the pain now, how is he going to feel when the prices of milk and eggs start moving up exponentially? The truth is, in nominal terms, the whole stock market might actually rise a little, but as a long-time value investor, I’m here to tell you that will not mean that wealth is being created for shareholders. If the consumer isn’t spending now, what is his budget going to look like in a hyperinflationary environment? No, in real terms, corporations are facing years of unprofitability -- thanks to the profligate and reckless actions by the United States federal government, among others -- and stock prices are going to reflect that, in real terms.

So when you’re thinking about “buying the dips,” or dollar-cost-averaging into equity markets, try to remember that we are in uncharted territory. The U.S. consumer-driven economy simply has no more fuel, and nothing will change that – at least not for many years. Likewise, the onset of inflationary price-increases is indisputable and inevitable; a country cannot wantonly commit itself to $12.8 trillion and simply print its way to its objective without suffering the enormous consequences of massive price-escalation. Further, this condition will hang in direct contrast with the economy of the 1930s, which was, to say the least, bad enough. I can only imagine how bad an inflationary depression is going to feel.

Ultimately, corporate earnings are headed for disaster, and that won’t be good for anyone. But it certainly doesn’t bode well for the prospects of true value investors.

If you want to know more about when I will be interested in equities again, see my article on the Dow-to-gold ratio.

 

Disclosures: Paco is long TBT, UGL, and DXO. He also holds U.S. dollars by necessity, pending the advent of private gold-backed currencies. Paco will be giving a workshop entitled The Death of the Dollar: How We Can Survive the Coming Collapse at the 21st annual Las Vegas Money Show, Mandalay Bay Resort, Tuesday, May 12, 2009, at 11:30 a.m. He hopes to see you there. Paco has been a financial analyst and a portfolio manager for 18 years. You can buy his novel Discipline wherever books are sold. Or visit www.DisciplineNovel.com. Email your questions or comments to questions@pacoahlgren.com. Copyright 2009, Paco Ahlgren. All Rights Reserved.

 

 

You Want Healthcare Reform? Well How About This?

"A foolish consistency is the hobgoblin of little minds."

-- Ralph Waldo Emerson

 

I've been waiting a long time to use that Emerson quote in one of my articles. Alas, it looks like I've finally found my chance.

Are there any issues more banal and worn out than healthcare reform and Bernie Madoff? There probably are, but I can't think them off the top of my head. In any case, you should probably know that I wouldn't lose a minute of sleep if I never heard the words "Bernie" and "Madoff" in the same sentence on CNBC again. The same goes for "healthcare" and "reform." But since that's not going to happen, and since these two topics are bringing me dangerously close to the brink marking the boundary between sanity and abject lunacy, I've actually canceled my cable subscription. Yes, it's true: I have decided to rely exclusively on the internet for information that I can custom-tailor to never mention healthcare reform or Bernie Madoff. Ever.

Having made my confession, however – and Bernie Madoff aside -- I nonetheless feel as though I would be remiss if I didn't at least make a small effort to put forth my own solution to the healthcare "crisis" before I permanently eradicate it from my daily media diet. I doubt anyone is going to listen to me, but in the end, that doesn't really matter. Because I do have a solution. And, in fact, it is a very good solution.

If you don't know it already, I'm going to make this as clear and succinct as possible: I loathe collectivism at all but the most local levels, and I'm not a big fan of it even there. So the idea of having to be identified by anything at the federal or state level, other than my name – like a Social Security number (for instance) – is absolutely abhorrent to me. Likewise, I think huge government programs are wasteful, foolish, and inefficient.

I know, I know. Some of you are frothing at the mouth, positively perfervid with the desire to sink your socialist fangs into my free market hide. All I can say is this: dissent if you like, but history has my back on this one, and I'm probably not going to engage you in some drawn out debate about how wonderful (for instance) Social Security is, and how it's not going to break our children. Mostly, I'm not going to argue the point because the dollar is going to fail long before Social Security has a chance to break our children, but that doesn't absolve the program from its complete inefficacy. And as for the dollar -- well, I'll resume my inexhaustible tirade about its impending failure soon enough. Don't you fret.

I'd like to preface my proposal by pointing out that there are several reasons healthcare is so expensive. First, at every available juncture, the government destroys competition in the industry as much as it can. Second, because so many people fail – or refuse – to obtain health insurance, the losses healthcare providers incur when the uninsured get sick have to be spread out among those who can pay. Third, subsidies and entitlements have inflated healthcare prices astronomically, because when the government gets involved in facilitating transactions, prices go up. If you don't believe me, take a look at the roles Fannie Mae and Freddie Mac played in creating easy money for unqualified homebuyers. Simply put, the government caused the housing bubble. Similarly, it is largely responsible for ever-increasing tuition costs. And yes, it is a major factor in the skyrocketing costs of healthcare.

I don't know how things are done in other states, but here in Texas, anyone seeking to renew his or her license plates, or trying to get a new driver license has to show proof of automobile insurance. It's the way the state makes sure everyone carries at least liability insurance on his or her vehicle, and it mostly works. So my question is this: why couldn't such a system be applied to the healthcare industry? I'm obviously not a fan of fat bureaucratic programs, but if the government has to get involved, why can it not play the role of forcing consumers to provide proof of health insurance as a prerequisite to buying goods and/or services that might not be considered… well … absolutely necessary.

Here is a short list of expenditures that might require the would-be consumer to procure such proof:

1. Budweiser. In any quantity.
   
2. Admission to strip clubs.
   
3. Spinners. (For those of you uninitiated, spinners are those absurd, excessively garish rims that continue to move even when a car is stationary.)
   
4. Pornography.
   
5. Body modifications of any sort, including -- but not limited to – tattoos, piercings, embedded fingernail art, hair extensions, liposuction, and nose jobs.
   
6. Southern Comfort.
   
7. Cable.
   
8. NFL, NBA, NASCAR, and NHL paraphernalia.
   
9. Guns.
   
10. Harleys.
    
11. Cigarettes.
    
12. Prostitutes.
    
13. Crocks.
    
14. Trunk woofers.
    
15. Anything made by Nike.
    
16. Small, purebred canines.
    
17. Any article of camouflage clothing.
    

 

Of course, there is one other possible solution to this whole mess. We could just sentence Bernie Madoff to reform healthcare. That seems fair.

 

Disclosures: Paco is long TBT, UGL, and DXO. He also holds U.S. dollars by necessity, pending the advent of private gold-backed currencies. Paco will be giving a workshop entitled The Death of the Dollar: How We Can Survive the Coming Collapse at the 21st annual Las Vegas Money Show, Mandalay Bay Resort, Tuesday, May 12, 2009, at 11:30 a.m. He hopes to see you there. Paco has been a financial analyst and a portfolio manager for 18 years. You can buy his novel Discipline wherever books are sold. Or visit www.DisciplineNovel.com. Email your questions or comments to questions@pacoahlgren.com. Copyright 2009, Paco Ahlgren. All Rights Reserved.

Some Austrians Aren’t Being Tough Enough

"A man must be big enough to admit his mistakes, smart enough to profit from them, and strong enough to correct them."

-- John C. Maxwell

The war between socialism and free market capitalism has been raging for almost 200 years – and far longer than that, if you toss aside those particular monikers and go straight to the ideological conflict that has pitted economic and financial entrepreneurs against collectivists since the dawn of human history. But never has the war been more pronounced – nor more critical – than in the current economic crisis in which the world finds itself mired.

For decades, proponents of the famed Austrian School of Economics – to which I proudly subscribe – have predicted that, as huge central governments, like the bloated United States federal bureaucracy, increase deficits and spending, attempting to control the economy, they will have to continuously find new and creative ways to manipulate debt and currency-creation in order to maintain the illusion. Indeed, many great economists have agreed that, even though the game can continue for a very long time – even decades or more – eventually the scheme will run out of resources, at which point the government will have to return to sound fiscal and monetary policy, or else print more money and destroy its currency, and by extension, the economy.

For many years all of this was largely based on theory; Keynesians and Fed proponents printed and spent with reckless abandon. And why shouldn't they? They had time and history on their sides. After all, didn't taxing and spending get us out of the Great Depression? Weren't World War II expenditures the catalysts for enormous economic growth thereafter? No, the Austrians absolutely had to be wrong, and even if they weren't, what self-serving politician in his right mind was going to ignore his "children" clamoring for someone – anyone -- to do something? That's no way to attract votes. Keynesian policies were jus t the panacea for any gloomy economy. Or so it would seem.

Unfortunately, Austrians were right – albeit patient: Government spending is not the solution. Oh, sure, it might work for a while – just like living off credit cards with no job might work for a while. But the government can only play these silly games for a time, until eventually the immutable economic law mandating that resources are indeed scarce will catch up to even the mightiest of empires. And so here we are – not just a single nation in peril, but an entire globe staring into the abyss, telling ourselves it can work again…if we only believe…

But it won't work again. With the recent addition of Fed's strategies, The U.S. government has now committed itself to $8.8 trillion in expenditures over the next two years. Some economists predict the number will actually easily exceed $10 trillion. In real terms, even a conservative appraisal still exceeds all of the major projects the U.S. has undertaken in its entire history, combined.

I'll say it again. We face two choices: we can suffer now and return to sound monetary and fiscal policy, or we can print money and inflate our problems away – postponing the suffering until a later date. Of course, if we do choose postponement, the suffering will be much more severe and much more difficult to endure. Yet the truth is we really don't have two options, because we live in a paternalistic democracy run by politicians who cannot possibly risk angering an irresponsible and undisciplined constituency, and therefore, a return to sound monetary and fiscal policy is about as likely as the sun burning out tomorrow. Sure, it could happen. But it's not going to. Thus, we arrive at the focal point of my article.

I have a confession to make. I used to be a socialist. I have read with breathless passion the dogma – from Marx to Proudhon, to Bakunin, to Chomsky. And while I have long since rejected all of it – having been persuaded initially and irreversibly by Mises' Economic Calculation Argument, and subsequently by so many others – I am luckier than most of my fellow free market advocates in that I truly know my enemy. But I have also spent a great deal of time reading and listening the proponents of free-market capitalism -- both classical and modern -- and I find myself convinced more than ever by the theoretical and practical maxims of the Austrians, that we are indeed on the verge of an economic and socio-political tragedy whose magnitude is almost unfathomable.

I find myself devouring anew the works of great minds like F.A. Hayek, David Boaz, Murray Rothbard, and David Friedman, reviewing the entreaties to reign in the federal government before it's too late. And too often these days, I lift my head and sigh, realizing the warnings no longer mean anything -- it's already too late. Beyond my resignation that it really is "different this time," and all the concomitant fear that comes with the acquiescence, I also find myself frustrated by some of the contemporary voices carrying the flag of free markets.

Case in point: Peter Schiff. Please don't misunderstand me – I have read everything I can get my hands on by Mr. Schiff, and I listen and watch his interviews with eager focus. Here is a man who, like me, predicted almost everything that is happening around us – in print, years before the fact -- and I have nothing but the deepest respect for his insight, born from deep Austrian roots. But time and again, when asked about the solution to the problem, Mr. Schiff launches into a brilliant effusion about eliminating debt, lowering taxes, soaking up excess currency, and raising interest rates. Again, it's not that I disagree with him, in that doing all these things would solve the problem. But my question is this: why on earth eat up valuable airtime discussing such moot points? The government isn't going to buy down debt. It isn't going to lower taxes. It isn't going to stop printing money. And it certainly isn't going to raise interest rates anytime soon. So are these really solutions?

Peter Schiff is a rock, and when he's under pressure on national television – taking heat from the likes of Ben Stein and Art Laffer – he exudes equanimity, and he sticks to his guns. He is an inspiration in this era of the super-status quo, driven by egalitarian-media propaganda that expects only the appropriate conditioned responses from anyone with makeup and a set of vocal chords. I admire Peter Schiff for his cool and his conviction, and I certainly don't know that I could maintain my composure in such environments. And yet, his "solutions" pack no real punch because they fail to reflect realistic outcomes in any kind of meaningful way. I am disappointed, because I think this is Mr. Schiff's only weakness.

Even Jim Rogers -- whose no-nonsense, blunt approach to the crisis has me nearly jumping out of my seat in applause – fails to present any viable strategy for the government. When a reporter asks what he would do if he were appointed Chairman of the Federal Reserve, he answers without hesitation: "I'd fire everyone. Then I'd resign." And in the midst of my laughter, I realize his strategy would be brilliant – if he were appointed Chairman of the Fed. Of course, he has about as much chance of getting that position as my 16-month-old daughter.

In my mind, the identification of the problems is now something for the history books: people like Peter Schiff and Jim Rogers – and their Austrian predecessors -- called it right, and with every passing day, they only get more right. But now is not the time to propose outlandish, unachievable strategies. We can't fix the mess the government has created over the last century; it has sealed its own fate, and the only thing we can do now is watch it unravel and collapse before us, as it delivers the final blows to our weakening currency.

But there are things we can do – realistic solutions that will become more viable as inflationary price-increases return with so much vengeance. We, as individuals, can move our assets away from the dollar, and other weakening currencies. We can invest in commodities and instruments that allow us to profit and thrive in the coming economic hurricane. We can also support politicians and business leaders who understand that we are on the cusp of a revolution not unlike the one that occurred over 200 years ago.

What will it look like? What will the outcome be? Who knows, but as with every revolution, the outcome will be extreme and radical. I, for one, would rather be a part of the new paradigm than a voice attempting to salvage the old one.

 

Disclosures: Paco is long TBT, UGL, and DXO. He also holds U.S. dollars by necessity, pending the advent of private gold-backed currencies. Paco has been a financial analyst and a portfolio manager for 18 years. You can buy his novel Discipline wherever books are sold. Or visit www.disciplinebook.com. Email your questions or comments to questions@pacoahlgren.com. Copyright 2009, Paco Ahlgren. All Rights Reserved.

 

Dow, Dollar, and Gold Parity: What Does It Mean for Value Investors?

 

Over the past year or so, I have been paying a lot of attention to the relationship between The Dow Jones Industrial Average and the price of an ounce of gold – which is commonly expressed by the Dow-to-gold ratio. On the surface, the ratio seems simple enough; if the Dow is at 10,000 and gold is at $1000 an ounce, the Dow/gold ratio is 10. Likewise, if the Dow is at 2000, and gold is at $2000 an ounce, the Dow/gold ratio is 1. But if you think about it, the relationship contains more than the two obvious components -- the DJIA and gold; the equation also employs component most people tend to overlook, which is the dollar. And once you consider the Dow/gold ratio from this perspective, the added dimension has all sorts of thought-provoking, and even frightening implications.

For an historical perspective, I've borrowed a chart of the Dow/gold ratio from a brilliant article by a talented analyst named Steve Saville, from December, 2008:

Before we delve further into the Dow/gold ratio -- and the somewhat concealed role the dollar plays in its formation -- I want to talk about the performance of the Dow, alone, over the last 80 years. Many analysts and economists have been comparing our current economic fiasco to the Great Depression, suggesting that this downturn may be as bad, or even worse than that period's. On that note, I want to point out that, in 1932, the DJIA bottomed after losing almost 90% of its value; as of the close of business on March 20, 2009, the Dow is down 49.5%. If the stock market is heading for a bottom similar to the 1930s crash, we have a long way to go; the Dow's high, in October of 2007, was around 14,150. If it loses 90% of its value, it will stand at a value of 1415. A lot of people believe that is precisely where the DJIA is headed, and philosophically, I agree. But, as with everything else in this terrifying time, nothing is as simple as it looks, and searching for an absolute value of 1415 on the DJIA could be a costly mistake.

In recent months, I've pointed out some fairly startling differences between this economy and the Great Depression. For starters, in the 1930s, the U.S. was a creditor nation; it essentially borrowed its way out of the Depression, and while I believe that was a mistake -- only prolonging the pain -- it was, nonetheless, one (very costly) solution. Unfortunately, the country's current status as the world's largest debtor nation precludes it from employing that strategy again – although Ben Bernanke, along with Barry Obama's economic toadies, would have all of us believe it can work. If you buy into that theory, however, I want to remind you that the government is printing money and easing credit at an unprecedented rate. Sure, the prices of most asset-classes are falling, but that's part of the solution, not part of the problem. The U.S. government, however, wants you to believe that the only cure to this disease, brought on by decades of inflationary money-printing and easy credit – which inevitably led to malinvestment, unprecedented economic volatility, and ultimately, several horrific economic collapses – is yet again to expand the money supply and to further ease credit until the U.S. consumer resumes his relentless and irresponsible plight to spend, rather than to save. I'm at a loss as to how anyone of a sound and rational mind can honestly believe that the solution to this type of economic catastrophe is yet more borrowing and spending. It's like saying the cure for heroin addiction is an overdose. It's preposterous.

Granted, I am a dyed-in-the-wool Austrian economist, and our definition of inflation is always the printing of money coupled with the creation of easy credit. Some of you are, of course, aching to extinguish my fire with a hose-full of Keynesian dogma, and to that I say, do your worst. But remember this: Keynesian theory – which its own author repudiated – has been around less than a century, but empires have been crushing themselves under the weight of their own reckless piles of printed money for eons. Bernanke claims he can tame rising prices when they return – and they will return, with a vengeance. But how on earth can he possibly believe he can control rising prices? How will he reel in the dollars he and his gaggle of sycophants are so capriciously printing? Will he sell Treasuries? To whom, and at what yields? Does he really think that he can simply offload trillions of dollars of debt to the world at constant low rates? If so, he's a fool; if he sells bonds, he's going to drive their prices down hard, and that can only mean increasing yields! How is that going to help "tame" rising prices?

Here are a few more differences between the 1930s and our current calamity: in the 1930s, the U.S. had a significant savings rate. Today that rate swings between negligible and negative. In the 1930s, the U.S. had a huge manufacturing base; it exported far more than it imported. Today, the U.S. is, for the most part, a service economy. Its automobile industry – once world's paradigm – is now crumbling under the weight of debt, bureaucracy, and union demands. Everything from computers to apparel is made by foreigners. Until recently, the U.S. consumer bought those manufactured goods with the money he or she borrowed from houses and credit cards – creating an economic house of cards. The house, however, has now imploded; the U.S. consumer is tapped out and cannot drive nearly 70% of the economy as it once did. And, to continue the comparison, in the 1930s, the U.S. dollar was backed by gold, which is no longer the case.

That brings me to perhaps the most important disparity between the Depression and our current situation. In the 1930s, because of all the factors I just mentioned, the United States found itself in a state of sustained falling prices. The government couldn't print money at will – it had to adhere to the gold standard to which it was obligated. Yes, the Great Depression was horrific, but at least prices fell, and continued to fall. Today, the vast sums of money the government is printing, coupled with the unprecedented easy credit it has put in place, ensure that falling prices are only a temporary phenomenon; indeed, the government is trying to create inflation! And as bad as the Great Depression was, I don't think any of us can imagine how much worse it would have been if the country had had to face 25% unemployment and rising prices. It's almost unthinkable.

Almost.

In the early 1930s, after the stock market hit its nadir, it rebounded to the tune of 150% in about a year. That would suggest that a savvy investor who gets in at or near the bottom of this bear could stand to make a fortune on the rebound. Is the stock market going to lose 90% of its value? I believe it will lose that much, or maybe even more. Does that mean a DJIA of 1415? Probably not.

Let's talk about the Dow/gold ratio again. If you look at the chart above, you can see that a ratio around 1 or 2 normally signals a bottoming of the Dow, as well as a top for gold. I say "normally" in the context of the last 80 years, in which the U.S. government has manipulated the economy and its currency successfully, time after time. Unfortunately, because of all the factors I mentioned earlier in the article – the country's status as the world's largest debtor nation, its status as a service economy, its savings rate, et cetera – the government has finally painted itself into a proverbial corner from which there is no escape. Skyrocketing prices are inevitable, which means – if you let thousands of years of history be your guide – gold is going much higher.

In nominal dollars, I do not believe the DJIA is going to lose 90% of its value, but in real terms, I believe it will probably lose considerably more than that. If we differentiate this economy from the 1930s in terms of the direction of prices, and we agree that, unlike the 1930s, rising prices are inevitable, then the Dow/gold ratio could approach 1 (or even go lower) even if the DJIA maintains its current level, or goes higher! In fact, if Bernanke is unable to "tame" rising prices caused by his inflationary mischief, it's very likely gold could surpass its real-dollar peak over $2000 in the early 1980s by a tremendous margin.

So, in the 1930s, because prices fell sustainably and continuously, the DJIA did lose 90% of its value, in real dollar terms. But if inflation causes explosive price increases this time, it's likely that, in real terms, the Dow will lose 90% or more of its value without actually falling much beyond current levels. And remember – the CPI is not the true measure of price-increases. Keep your eye on gold, as well as on things like gasoline, eggs, milk, and other agricultural products; these are the true measures of costs in our economy, and when those prices begin to increase rapidly, you will know Bernanke has failed.

As far as returning to stocks, well, my theory goes something like this: we need a way to calculate the real-dollar loss of value in the DJIA, as it relates to impending inflation, as measured by gold, and what better way to do that than the Dow/gold ratio? As bearish as I am on the U.S. economy right now, I still believe U.S. companies will be among the most innovative in the world once this all shakes out. To illustrate my point, consider some of the great German companies that survived world wars and the destruction of the Weimar mark: BMW, Bayer, and Daimler are among many more that withstood incomprehensible political and economic changes.

I am a value investor, and I believe earnings have a long way to fall before we're finished with this debacle. Nonetheless, I'll be watching the Dow/gold ratio carefully. Once it approaches 1 – whether that means a DJIA of 7000 or 700 -- I'll be looking at stocks very carefully.

 

Disclosures: Paco is long TBT, UGL, and DXO. He also holds U.S. dollars by necessity, pending the advent of private gold-backed currencies. Paco has been a financial analyst and a portfolio manager for 18 years. You can buy his novel Discipline wherever books are sold. Or visit www.disciplinebook.com. Email your questions or comments to questions@pacoahlgren.com. Copyright 2009, Paco Ahlgren. All Rights Reserved.

 

And You Thought It Was Bad Before?

On top of the $8.5 trillion dollars the U.S. Federal Government has obligated itself to spend in the foreseeable future, now the Fed has also committed to spending another $300 billion to buy long-term Treasuries over the next 12 months. That's $300 billion. That's just under one-third of a trillion dollars. And where will the Fed get this money?

The pundits would have you believe that taxation is the only option to raise this vast sum of capital, but the reality of the situation is that unless these pundits are utterly incapable of doing basic arithmetic – which they aren't -- they are simply trying to scare you. And perhaps rightly so, because there is only one way the U.S. government can fund $8.8 trillion in spending, and taxation is only a small part of the "solution."

To illustrate the mathematics of what I'm talking about consider this: there are about 304 million people in the United States, which means that the government would have to extract $29,000 in tax revenue from every man, woman, and child to come up with such a staggering sum of money. Even if the government didn't spend one dime beyond the $8.8 trillion, and taxed everyone at the same rate, it would still have to extract $29,000 from every human being in the U.S. in order to cover the debt it is creating.

As an aside, I had to perform these calculations in a spreadsheet, because my BA II Plus wouldn't allow me to enter that many zeroes. And I still made a mistake, which a reader promptly pointed out. These numbers are hard to understand, much less work with, and that's what makes this so terrifying.

Over the years, I have collected a fairly impressive collection of skeptics, adversaries, and opponents who delight in criticizing my "radical" theories, and I'm sure that contingency will be out in droves to respond to this article. But before you naysayers get to firing on all eight cylinders – wearing the letters off your keyboards with furious strokes of merciless rebuttal -- I'm anxious for you to consider the cold, hard math I've just laid in your lap. Consider that a large portion of those citizens are retired, or children, or people otherwise incapable of or disallowed from working, and that $29,000 per person starts to get bigger very fast. How on earth can the U.S. government hope to squeeze that much money out of its citizenry? 

Of course, the question is rhetorical, and since this is my article, I'll just go ahead and answer it. The U.S. government plans to "deal" with this unprecedented load of debt through the inflationary destruction of the U.S. dollar. It cannot tax enough to service the debt, so it will print the money.

But there's a part of the equation that leaves me scratching my head and chuckling a little, in a wry, disturbed fashion -- sort of like the way I chuckle when I see a dog chasing its own tail – and it's this: the United States government will print all of this money, and then it will turn around and loan that money to itself. That would be like me taking a paycheck, having a lawyer draw up loan documents, signing the check over to myself, and making monthly payments back to me. Now why would I do something like that? Absurd.

Perhaps the most troubling aspect to the whole sordid mess, however, is something I've brought up before: Chinese and Japanese people are not stupid. They know the U.S. cannot hope to suck $29,000 out of each and every warm body within its reach and domain without creating massive inflation. So, yet again, I pose this question: why would the Chinese, the Japanese, or anyone else for that matter, continue to lend massive amounts of money to the U.S. government, at absurdly low rates, if the only possible outcome is steep inflationary price increases and interest rate explosions?

The simplest answer is usually the best answer. They won't. Unemployment will continue to rise, the American consumer will continue to falter, credit card defaults will race skyward, and the Fed will print insane amounts of cash. Foreign governments will get wise to the situation and stop lending, and the Fed will face rapidly rising prices while trying to keep interest rates low. But how will it attract capital if it doesn't increase yields? Oh the conundrum…

For my part, I predicted the Fed would finally buy the long-end of the yield curve – although I didn't think it would be this aggressive. Nonetheless, I lightened my short position in Treasuries significantly at the end of January. I believe the herd will follow Treasuries higher for a while, but sometime in the next 3 to 6 months, shorting Treasuries is again going to continue to be the position of the century.

The other day, I was watching CNBC's Smart Money, during which several of the network's elite pondered the "mystery" of gold's advance in tandem with stocks. They batted the question around like a beach ball for a minute or two before there was a pronounced silence. Then one of them tentatively said, "Could it be because people are scared that inflation is coming back?"

Do you think?

 

Disclosures: Paco is long TBT, UGL, and DXO. He also holds U.S. dollars by necessity, pending the advent of private gold-backed currencies. Paco has been a financial analyst and a portfolio manager for 18 years. You can buy his novel Discipline wherever books are sold. Or visit www.disciplinebook.com. Email your questions or comments to questions@pacoahlgren.com. Copyright 2009, Paco Ahlgren. All Rights Reserved.

 

How Long Will It Take the Dollar to Fail?

"You cannot afford to wait for perfect conditions. Goal setting is often a matter of balancing timing against available resources. Opportunities are easily lost while waiting for perfect conditions."

-- Gary Ryan Blair

 

I have always made it a policy not to try to time markets, and while my outlook for the dollar is bleak, I don't feel comfortable making an exact prediction about its demise. Having said that, in December -- when the Fed implemented zero-interest-rate-policy and announced its intention to employ quantitative easing -- they galvanized my conviction that the dollar and Treasuries are doomed, and I started building a public case against the United States Government and its ability to sustain its decades-long policies of borrowing and printing. Nevertheless, when I predicted Treasuries would fall, I didn't expect the 30-year bond to gain more than 100 basis points in less than two months! But after that surprise, my time-horizon for the life of the dollar has shrunk considerably. I still think the Fed might try to defend the long end of the yield curve, but every single day, my faith in its ability to maintain low yields wanes, and I increasingly believe things are going to unwind sooner rather than later.

I am not an alarmist, and I used to roll my eyes at people who talked about burying guns, potable water, and canned food in the backyard. But if hyper-inflationary price increases are coming – and I certainly believe they are – buying durable goods now is not only smart, it's necessary. Anything that lasts and provides future utility is going to be a good investment, and if I have a choice of buying a can of beans now for 89 cents, or five years from now for $12, well, it doesn't exactly require a financial calculator to establish how good that rate of return is – even if the things I buy merely keep pace with rising prices as a whole.

A lot of people will call me an alarmist for my previous statement, but it really just boils down to the same questions I've been asking for weeks now: do you believe the United States can continue to borrow at the same pace it has for decades? Do you believe the number of dollars in the system, along with the unprecedented easy credit the Fed is creating, won't lead to runaway price increases? For me it's like Pascal's wager: If I'm wrong, I can always eat canned goods later -- laughing at my miscalculation a little harder with each subsequent forkful of tuna. But if I'm right, my family may be able to weather an extremely nasty storm in relative comfort.

Another thing to remember – something I pointed out in a recent article – is that it is far more important to look at the dollar versus commodities than it is to look at the dollar versus other currencies. Quarter-hour updates on financial news networks discuss the "strength" or "weakness" of the dollar, but this metric is misleading; it is a measure of the dollar against a basket of other currencies, not against commodities. And even the government's gauges of the dollar's efficacy – like CPI – are so misleading and vague that I just don't trust them. In any case, it may be that, as prices begin to rise against the dollar, they may also be rising against other major currencies, and the dollar could show relative strength against those currencies – if it is not falling as fast. Still, copious printing and easy credit will cause prices to rise, and any other assessment of dollar "strength" will be an illusion. In other words, when you're trying to ascertain the value of your currency, don't measure it against the yen, measure it against milk and eggs at your grocery store.

Every presidential administration in the 20^th century conspired – wittingly or not -- to destroy our currency. It has been like a subtle cancer – not readily apparent on the outside, but slowly eating away at the body from within. Now, at the zenith of this crisis, just when the government should be tightening credit, strengthening the currency, encouraging saving, cutting taxes, and reducing spending, the Obama Administration is doing just the opposite: it is taxing precious capital, along with the most productive and innovative members of our economy – thereby redistributing wealth to the least productive and innovative members of our economy. It is increasing spending to the tune of $8.5 trillion over the next two years, while encouraging unprecedented printing and easy credit. Our government is relying on the continued generosity of our lenders, namely China and Japan, but I have made cogent arguments that those countries are not likely to continue to support our voracious and insatiable appetite for new capital at current yields – especially capital that will be allocated and invested poorly.

I have said this before, but it warrants repeating: we were a creditor nation in the 1930s, with a massive manufacturing base. Not that I think it was the correct solution, but we borrowed our way out of the Great Depression. Today we are the largest debtor nation on earth, with a relatively small manufacturing base. Jim Rogers claims to be the worst market-timer on earth, and I disagree with him only in that he can't be worse than me. As such, I can't tell you exactly what day the dollar will collapse – or if it will even be that sudden. But one thing is for sure: the cancer has metastasized, and there is no hope of recovery; my instinct tells me that the sheer lack of vision, coupled with the absence of any substantive acumen in Washington is going to ensure that the failure comes sooner, rather than later.

 

Disclosures: Paco is long gold, UGL, DXO, and TBT. He has been a financial analyst and a portfolio manager for 18 years. You can buy his novel Discipline wherever books are sold. Or visit www.disciplinebook.com. If you have questions or thoughts, leave a comment or write to Paco at questions@pacoahlgren.com. Copyright 2009, Paco Ahlgren. All Rights Reserved.

Banning Derivatives

"Knowing a great deal is not the same as being smart; intelligence is not information alone but also judgment, the manner in which information is collected and used"

-- Dr. Carl Sagan

 

When I was much younger, I knew an extremely intelligent neurosurgeon. I can't tell you his intelligence quotient off the top of my head, but he was an eloquent, deep thinker. He would regale us with stories of his time in college – challenging his history and philosophy teachers. Or he would tell us about his experiences in Vietnam as a medic, imparting some of the deep epistemological changes those experiences produced in him.

When I was a teenager, I discovered that my math courses gave me more trouble as they increasingly advanced in their scope, and eventually I decided to solicit my doctor friend for help. As a financial analyst, I now consider myself mathematically skilled, and in fact I have a profound passion for the discipline. Yet I still marvel at the memories of this doctor's acumen – how quickly, indeed how gracefully, he could pick apart and solve the problems. But it was more than that; he had a way of describing the processes to me that helped me understand not just how to solve the problems, but how to understand them. He was one of the smartest people I have ever known. And he made a lot of money as a neurosurgeon.

I lost touch with him when I left El Paso to begin my own adventures, but when I was in my early-twenties, I heard the doctor had been financially ruined. Apparently he had gotten involved with commercial real estate throughout Texas, and the subsequent market collapse wiped him out. About two years later, news came that his misfortunes had taken an enormous toll on his health, and that he hadn't been able to continue his career as a surgeon. His condition declined until he finally died relatively young -- in his late-forties.

Why am I telling you this story? To illustrate a crucial point: sometimes smart people venture from their areas of specialty and do stupid things. The man I'm telling you about was a great surgeon, but he was a terrible real estate speculator. Please don't think I'm being insensitive; I miss the doctor, and I was sad to hear of his tragedy. But that doesn't change the fact that he deviated from his expertise, undoubtedly driven by a misapplied confidence that came from his success as a surgeon.

As bad as it is to see one person suffer so much from the consequences of his own miscalculation, there's an even more dreadful form of this "over-confident intellect" disease – with exponentially more far-reaching consequences: it happens when doctors, lawyers, scientists, or captains of industry abandon their professions to seek public office, and the problem derives from the fact that we gravitate like lemmings to their charisma and sagacity, allowing them to make decisions for all of us in areas far outside their realms of specialty. This is the tragedy of democracy but it is a mistake we willingly make, over and over, to our collective detriment. Are politicians stupid? Some undoubtedly are, but most are not. Does this mean they make good decisions? No, it does not.

Case in point: a proposed ban by Minnesota Congressman Collin Peterson on about 80% of all credit default swaps. I'm not ignorant of the role CDSs played in the current financial crisis, but I'm also not oblivious to the fact that CDSs also play an important role in creating liquidity and facilitating price-discovery. I'm sure Congressman Peterson is a smart person, but his proposal is preposterous – just like the short-selling ban that the government imposed on the markets in October. Politicians, however, are not the only leaders in society who – with good intentions or not -- try to foist upon us these sorts of ridiculous plans.

I consider Warren Buffett to be one of my most important role-models, and I probably know more about him than I do any other person in history -- alive or dead. When I was younger and I began gravitating toward finance, I became fascinated by Buffett and the people who influenced him – like Ben Graham, Phil Fisher, and Charlie Munger. I read all the Berkshire-Hathaway annual reports, and meticulously picked apart every single book I could find offering insight into methodology of this brilliant investor and his ilk. I adopted their principles to find a great deal of success for myself and my clients in subsequent years.

My respect for Warren Buffett, however, has its limits. I'm sure I will be castigated for saying it, but in other areas of thought, Buffett is a borderline fool. Economically and politically, he is a rabid leftist, often condemning the very system from which he has profited so handsomely and for so long. He has condemned futures and options markets, for instance, and even proposed a 100% capital gains tax on any security sold within a year of purchase. I understand that Buffett's acumen as an investor is nonpareil, but how on earth can he not see the damage his propositions would do to liquidity in markets, and ultimately to the economy as a whole?

I have never understood why derivatives speculators are so vilified. Yes, it's true, they have been responsible for extreme and unwarranted moves in markets – like the technology and oil bubbles. Nonetheless – and I apologize for being trite –what goes up does come down, and the same speculators who cause these problems in the first place are invariably punished for their folly. Warren Buffett's ire isn't required to elicit their penitence; the market backlash is quite sufficient.

The thing that seems to elude people like Buffett is the fact that speculators do create tremendous liquidity in markets – dramatically narrowing spreads, and encouraging price discovery. Supply and demand do not cross at some constant, absolute point in space and time as your high school economics teacher would have you believe; the intersection is an amorphous, dynamic point, floating evasively through markets -- teasing us, but never revealing the precise scarcity of a particular good or service.

In subatomic physics, it is impossible to ascertain both the velocity and position of a particle; whatever you use to measure the particle actually changes its position and speed. We can know one or the other, but not both. Likewise, the very price structures we use to gauge the scarcity of goods and services necessarily change the nature of supply and demand with every new transaction. We can't know market equilibrium, we can only approach it. The liquidity provided by speculators is exactly the mechanism we need to get as close as possible to knowing market equilibrium, and yet these speculators are denigrated by people whose intelligence we respect, simply because these critics do not fully understand the nature of markets.

Perhaps most surprising is that some of these critics, like Buffett, remain ignorant despite having immersed themselves in the system. But it illustrates that deviation from an area of expertise by only a very small amount – in Buffett's case, from understanding corporate wealth creation, to understanding the mechanics of liquidity – can generate colossal erroneous conclusions. Now apply that to large deviations – say a doctor who decides to become a real estate speculator, or worse, say, a career politician who decides to start a crusade against derivatives. You start to see how real damage can be done.

Imagine a world in which children dictate terms to their parents, and have the power to fire them if they don't get results the children demand. That's the way democracy works; but as flawed as it is as a system for producing substantive change, the negative consequences of group-think are often compounded by the fact that our leaders are often so intelligent they fail to recognize the limits of their own abilities. Sometimes "smart" just isn't enough, and when you couple ego-driven intelligence with irrational demands from a constituency of spoiled brats -- wielding the power to destroy political careers -- the problems snowball.

If Warren Buffett's and Collin Peterson's ideas genuinely stem from their ignorance of the consequences, then they really are just fools to be pitied. But if they make these absurd and even dangerous proposals with the full knowledge of their consequences to our collective well-being, then they are evil and they should be stopped before they can affect the kind of change that would cause massive price distortions – especially in an economy that is already struggling to survive.

 

Disclosures: Paco is long gold, UGL, DXO, and TBT. Paco has been a financial analyst and a portfolio manager for 18 years. You can buy his novel Discipline wherever books are sold. Or visit www.disciplinebook.com. For more information about his real estate business, visit www.CentralTexasValue.com. If you have any thoughts or questions, please leave a comment or write to Paco at questions@pacoahlgren.com. While he can't guarantee he'll get back to everyone, he will do his best! Copyright 2009, Paco Ahlgren. All Rights Reserved.

How Treasuries and ETFs Work

I have become so comfortable writing about Treasuries and the dollar recently, I have forgotten that not everyone is as intimate as I am with some of the terms and abstract thoughts I use. In the last week, however, I've been inundated by requests from people asking me to explain some of these concepts in more detail, so I have decided to periodically highlight questions from readers and try to expand on that particular idea. If you would like me to clarify something, please don't hesitate to leave a comment, or write to me at questions@pacoahlgren.com.

A few days ago, a reader contacted me regarding TBT -- which is the ProShares Ultra short long-term Treasuries EFT. Michael asks:

"How come the TBT is only up 22% YTD, while the 30-Year Bond's Yield has increased 31%? Moreover, ProFunds has a Mutual Fund (RRPIX) that is supposed to be 1.25X leveraged to the 30-Year, and that Fund is only up 18%!"

This is a fairly common problem people have when analyzing exchange traded funds – especially those that are leveraged like TBT. And while this particular conundrum can entail some complex math, I'm going to try to offer a simple, general explanation.

Before we get started, it's important to note that bond prices move inversely to bond yields – that is to say, when bond prices go up, their yields go down, and vice versa. Most confusion stems from the fact that change in yield does not correspond exactly to change in price. Here's something from an article at leftbusinessobserver.com that illustrates my point:

"Say the U.S. government sells Treasury bonds when prevailing market interest rates are 8%. So, a bond with a face value of $1,000 on issue would pay $80 a year in interest - usually in two half-yearly installments of $40. But if market interest rates were to rise to 10%, then who would want to buy such a bond? So, the market price of the bond would have to fall to a level where that fixed $80 annual payment were the equivalent of a 10% annual yield - in this case, the price would have to fall to $800, so that the annual $80 payment would equal 10% of the purchase price of the bond. (Obviously, this matters only if the holder of the bond wants to sell it in the open market; if he or she wants to keep the bond to maturity, the price fluctuations exist only on paper.) Since bond prices are usually expressed at a percent of face (or "par") value, the price of the bond would be quoted at 80."

In this example, the bond's yield increased 25%, but the bond's price fell only 20% -- due to the fact that correlation between yield and price movements isn't absolute. If you look at it from that perspective and you're willing to do a little research, you should be able to figure out the way it works. Here's a page at learningmarkets.com that teaches how to calculate a bond's yield, given various inputs. That should be a good place to start!

Another thing you need to remember is that TBT is designed to approximate, inversely, the changes in prices (not yields) of longer-term Treasuries -- with maturities of 20 years or more. Also remember that the change in TBT is designed to achieve twice that of the change in the underlying bonds – again, inversely. If you take the time to calculate an average price-change of long-term Treasuries over a given period, and you compare that average to the inverse price-change of TBT (multiplied by two), they should roughly mimic each other.

There are other considerations: changes in the publicly-traded market price of TBT (or any ETF) differ slightly from in-house, managed changes in the securities' net asset value (NAV) -- although the two prices do move very closely. In order to maintain an appropriate NAV, however, ProShares must react to changes in markets and manually maintain their positions. In other words, the change in NAV isn't automatic, and while the managers undoubtedly try to mimic their targets as accurately as possible, none of this is an exact science. Finally, don't forget that ProShares charges a management fee.

I hope this helps!

 

Disclosures: Paco is long gold, DXO, and UCD. He holds no TBT. Paco has been a financial analyst and a portfolio manager for 18 years. You can buy his novel Discipline wherever books are sold. Or visit www.disciplinebook.com. If you have any thoughts or questions, please leave a comment or write to Paco at questions@pacoahlgren.com. While he can't guarantee he'll get back to everyone, he will do his best! Copyright 2009, Paco Ahlgren. All Rights Reserved.

Voting and Spending Our Way Into the Fiery Depths of Hell

"A democracy is nothing more than mob rule, where fifty-one percent of the people may take away the rights of the other forty-nine."

-- Thomas Jefferson

 

"Democracy consists of choosing your dictators after they've told you what you think it is you want to hear"

-- Alan Coren

 

Lately, I've been predicting some pretty catastrophic stuff – like the United States defaulting on its debt, and the failure of the world's major currencies. And every day that passes seems to bring us closer to the inevitability of those predictions.

None of this makes me happy, by the way; I would really like to be wrong this time.

At any rate, I have received a great deal of gratitude and praise for my theories, but I have also been inundated with comments like, "You're stupid," and "You're immature," and "No way," and "Gold is bad," and "Go back to Russia." And things like that. Which is all fine, I guess.

Look, I've been writing for a long time, and yes I think it's reasonably safe to say that some of my theories are radical. And, of course, if a person decides to promote radical theories, he better be ready to absorb some heat for it. Luckily, over the years I've pretty well inured myself to the barrage of criticism that descends upon me like a swarm of ravenous mosquitoes every time I publish something, and I guess I owe my proverbial calluses to a simple maxim: popular people get elected because they regurgitate the status quo, whereas dissenters get ridiculed because they challenge it. Now, does this mean dissenters are always right? Of course not, but I'm hard-pressed to think of one technological, medical, social, or academic innovation inspired or created by mere popularity. And I find it equally difficult to count the number of breakthroughs that have erupted from the minds of dissidents.

"But," you say, raising your eyebrows and sticking your finger in the air. "Einstein was popular." And that's true. But it doesn't diminish the veracity of my conclusion; popularity is rarely an ingredient in progress, and even then, it's not causal. I would wager that Einstein's popularity (or lack thereof at the time) didn't inspire his special theory of relativity.

Every day, I watch Barak Obama speak and I find myself as impressed with his style and eloquence as everyone else seems to be. But then I hear the "substance" of his messages and I cringe. For hundreds of years, classical economists have been trying to save us from ourselves, warning us that -- regardless of their intentions -- governments don't solve problems, they create them. So why do political leaders keep making such bad decisions? And more importantly, why do we keep putting so much faith in our elected officials?

It's simple, really. Most people make poor decisions, because most people are like children. Allow me to illustrate my point by asking you a simple question: which is better for the human body – broccoli or ice cream? Now, if we put 1000 children in a cafeteria, and we give each of them one bowl filled with broccoli, and another bowl filled with ice cream, what do you think is going to happen? And what if we perform the same experiment every day for a year? Would the results differ? Probably not.

Now let's talk about some common behavior exhibited by "adults." Adults smoke. They drink too much. They abuse drugs. They don't educate themselves. They play video games all day. They talk on their cell phones while driving. They spend incomprehensible amounts of time, money, and energy watching pornography. Yes, adults do lots of stupid and unproductive things.

I'm in quite an analogous mood right now, so I wonder if you might indulge me as I offer yet another hypothetical. Let's say the economy is suffering one of the worst recessions in a century. And let's say you're a dyed-in-the-wool free market economist with an I.Q. upward of 160. Let's also say you want to be elected to the office of President of the United States. Are you going to tell people that, in order to get out of the recession, the government must do nothing? Are you going to tell people that it's better for the government not to print money? Are you going to tell people it's better for the government to reduce its debt? Of course you're not – at least not if you actually want to get elected. Why? Because people want ice cream, not broccoli.

If you want to be a politician, you must lie. You must promise the people that the government will do something – even if you know that anything the government does will only cause more damage. For the last century, this is precisely the recipe that has caused policy maker after policy maker to implement programs that have damaged economies and currencies time and again. And the resultant peaks and troughs are neither purely cyclical, range-bound, nor predictable. Debt has increased exponentially. Productivity has collapsed. The charade has been maintained through burgeoning easy credit and an ever-expanding amount of currency. The economy is a top, forced to spin faster and faster by politicians eager to be elected, but eventually the laws of physics are going to tear the entire thing apart. The conditions we face are unprecedented on so many levels, and I am afraid the catastrophe is looming.

I certainly welcome any criticism I get, because approaching the truth is far more important to me than defending a broken theory. Yes, I want to be wrong, but more importantly, I want to know why I'm wrong. And yet I fear I am not, because the old rules aren't working anymore, and most of the counterarguments fail to provide much substance.

So I will continue to dissent, because it is a dangerous time to be an empiricist.

 

Disclosures: Paco is long gold, DXO, and UCD. He's getting excited about the recent rise in Treasuries, but he hasn't acted on that excitement yet. Paco has been a financial analyst and a portfolio manager for 18 years. You can buy his novel Discipline wherever books are sold. Or visit www.disciplinebook.com. Email your questions or comments to questions@pacoahlgren.com. Copyright 2009, Paco Ahlgren. All Rights Reserved.

What Will Replace the Dollar?

Recently, I've devoted most of my writing to a narrow range of topics, including the current unprecedented rate of inflationary activity by the Fed, and the looming failure of the dollar. The issues have brought a lot of debate from those who agree, as well as from those who think I'm crazy. Yet despite support or opposition, three questions seem to come up more than any others:

1. Will the collapse be an absolute failure of the dollar and the U.S. economy, or will the dollar retain some value?
   
2. Regardless of the answer to the last question, will some other form of currency compete with, or even replace the dollar completely?
   
3. What am I doing to prepare for the events I predict? Am I shorting the dollar, or is there a better way to capitalize on the move?
   

Before I begin answering some of these questions, I want to point out that most of my critics tend to cling to the notion that the economic and military dominance the U.S. has enjoyed for the last century are immutable conditions -- that is to say, the U.S. and the dollar will last forever. Ergo, I point to any number of empires that have fallen prey to the exact same form of arrogance and aggression -- including (but not limited to) Rome, Spain, France, England, and the Soviet Union. Moreover, if I were forced to predict an outcome based on either the immutability of the U.S., or the immutability of basic economic principles, I would vote irrevocably for the latter. Every single one of the aforementioned defunct empires can thank inflationary money-creation for much, if not all of its downfall. The United States is proving to be no wiser, and it is extremely naïve to think that 50 quasi-independent entities – each sporting its own constitution and government – will sit idly by as Washington flies the dollar into the ground.

I don't want to digress too much into the likelihood of mass secession, having visited that topic ad nauseam last week. But what I should point out, in pursuit of an answer to the first question above, is that I do not subscribe to any theory postulating absolutes. While I do believe the dollar is on the verge of a tragic, extreme, and irreversible downward course, I do not believe it will simply disappear from the face of the earth as a medium of exchange. It is much more likely the dollar will collapse and then level off as a weaker monetary unit. It will not retain its status as "global reserve currency."

And that brings us to the next question: if the world flees from the dollar, what will it run to?

Those of you who read my articles regularly undoubtedly consider yourselves quite blessed to be regaled by my relentless assaults on the U.S. dollar. I despair, however, that my aggression against the greenback might offer the impression I am partial to its weakness. Let me assure you I am not; every major economic bloc on earth is implementing the exact same irresponsible policies of zero-interest-rates, quantitative easing, and massive government stimulus that cause me to fear for the dollar's future, and I am equally appalled by the prospects of all the world's major currencies – including the euro, the pound, and especially the yen. Indeed, even Switzerland -- once the world's last bastion of sound monetary policy – is now threatening to implement quantitative easing!

But there's yet another interesting variable in this equation.

The Chinese and other countries have been playing an interesting game with the U.S. for decades: they keep their currencies weak in order to make exports more attractive to the U.S., while at the same time lending the U.S. vast sums of money. The U.S., in turn, uses this borrowed money to buy cheap finished goods from these countries. The countries then use their profits to lend the U.S. yet more money. And so the cycle continues. Until now.

As I've noted so many times recently, U.S. creditworthiness is all but dead. The American consumer is tapped out. There are few people left to buy Chinese goods. Why am I bringing this up? As the dollar, the euro, and the yen start to give ground, the Chinese, for instance, will feel obligated to drive Renminbi lower in order to re-ignite exports. The whole thing is a tinderbox just waiting to explode. So if every major currency on earth faces the same fate as the dollar, what will people use as a medium of exchange when the bottom falls out? My answer is as simple as it is predictable: gold, silver, and other precious metals.

I know some of you are upset right now. I can almost hear you cracking your knuckles above your keyboard, preparing to launch into a vicious tirade about how abjectly stupid it is to think people are actually going to buy milk, eggs, and cereal with gold. What will they do -- chop Krugerrands into wedges, like modern Pieces of Eight? I suppose that is a solution – it certainly worked for the Spanish, whose coins were the "reserve currency" in the new world for a long time. But in our modern technological society, using coins – or even fractions thereof – is completely unnecessary, if also impractical.

I am not a futurist, and I am not willing to predict with any degree of purported accuracy the exact form currencies will take once the illusion of fiat money finally and irrevocably comes to the world's complete attention. In my book Discipline, however, I posited a scenario in which the world's major currencies fail, only to be replaced by private currencies backed by precious assets. In the book, the world's major powers try desperately to stop the flight from their inefficient, monopolistic currencies but because of the proliferation of credit and debit cards, the transactions in the new currencies are transparent and easily facilitated. Of course, this leads to the next question: what, exactly are these governments going to do -- punish their citizens for wanting to use a stable medium of exchange in response to a failed promise? Are these governments really going to hold guns to their citizens' heads, proclaiming, "Use our currency and starve, or use a private currency and go to prison."

Again, my prediction came in the form of a novel; maybe it will accurately represent the outcome, and maybe it won't. But is it so farfetched to think that the managers and purveyors of the SPDR Gold Trust ETF – which currently holds more gold than most sovereign nations – couldn't quickly and easily issue some type of certificates that might quickly and efficiently facilitate transactions, at even the grassroots level? Further, couldn't this fund quickly and easily supply debit or cash cards to the public?

Perhaps your response to my musings is to say, "It would never catch on," in which case my reply to you is this: have you seen the speed with which things like iPods and MySpace go viral? Do you really think that, if the world's major currencies were failing, people wouldn't flock to any form of stable money as quickly as possible? What would you do? If dollars were melting in your pocket, and someone offered you a liquid medium of exchange that just about everyone was accepting – backed by all the stability and consistency of precious metals – which would you choose?

We've addressed the first two questions I started this article with, so let's get to the third: if you want to prepare for a collapse in the dollar, should you short it, or is there a better way benefit? The answer is that the only real way to short the dollar is simply not to own it. You can certainly short dollar futures if you like, but when you do that, you're shorting the dollar against specific currencies, and we've already established that all the other major world currencies are going to fall with the dollar. Even the dollar index is tied to other currencies.

As an aside, here's an interesting thought to ponder regarding the Dollar Index: the major currencies with which the dollar index is calculated could all be sliding with the dollar – relative to assets, goods, and services in the global economy -- and yet the dollar index could actually be going up, if the dollar is stronger than those other currencies. Just think about that. Every day on CNBC Rick Santelli refers to the Dollar Index as a true gauge of the dollar's strength, but in reality, the dollar might be weakening tremendously against assets, and if you only watch the Index, how would you know?

Anyway, if we assume the dollar is weakening with all other major world currencies, what do you do in response? Well, if you don't already know my thoughts on Treasuries, I've written plenty recently about how far I think they have to fall as faith in the U.S. government and the dollar wanes. Certainly, once it becomes clear the Fed can no longer realistically defend the long end of the yield curve, shorting Treasuries is going to be the play of a lifetime, so keep that in mind when you're trying to figure out how to prepare for failing global currencies.

In one of my recent articles, I also pointed out that in times of rising prices caused by the expansion of the money supply, it isn't so much the case that assets are becoming more valuable, due to demand. No, it is much more accurate to say that the currency is becoming less valuable. When you begin to think about it in those terms, it becomes easier to consider how you might prepare against currency collapses. Think about the things that people will consistently need or want in precarious economic times – especially times of rising prices. Historically we know that precious metals have done well, but commodities in general also do well. Agriculture tends to keep pace. Also, as silly as it might sound, anything durable that you know you're going to use in the future is an excellent hedge against inflation. If you know the currency is going to be worth half as much in a year, and you know your infant son is going to need diapers in a year, then diapers are a good investment in today's currency – not only because you have use for the good, but also because you free up future, higher disposable income for investment.

Another idea? If you can maintain an income that rises with prices, being a debtor at a fixed rate is a great position to be in. Your salary is increasing, and yet your mortgage payment, for instance, is not.

One more thing to think about: while the historical consistency of precious metals is important, the psychological aspects of gold give it an edge as an investment in times of rising prices. Silver and palladium are certainly rare and precious, but they don't seem to have the same cachet – and indeed the poetic impact – as gold. How many country songs, for instance, have been written about palladium? What I'm trying to say is this: when gold rises, it tends to rise more than other precious metals simply because people are more passionately drawn to it.

Now let's talk about something like oil for a moment. In real dollars, the price of oil has averaged somewhere around $25 a barrel over the last several decades. Is demand for oil going to pick up? Of course; populations are increasing, and China and India are becoming industrial powerhouses. Is the supply of oil going to diminish? I would argue that it probably isn't going to diminish as much as environmentalists would have you believe – especially with the onset of new technological innovations which improve the efficiency of extraction – but it is a finite resource, so I will give some credence to the argument that it is becoming scarcer. Therefore, all things being equal, the price should rise based on nothing more than the principles of supply and demand – and probably sooner, rather than later.

But what will happen when major currencies start to collapse? The price of oil will increase accordingly, right? Actually, no; the price of oil will likely inversely mimic the slide in currencies, but it should also increase beyond that to account for ever-increasing demand. To wit, I don't believe the historical average price of $25 per barrel – even in real dollars – adequately reflects the demand for oil we will face in coming decades. The same argument could be applied to agricultural and commodity securities as well. So I'll say it again: the best place to be when the dollar falls is anywhere but dollars. If you really want your portfolio to shine, however, you need to find the investments that will outpace rising prices, and that means agriculture, gold, durable goods (that you'll need anyway), and fixed-rate debt. And, of course, there's always gold.

But if you can get in on the ground floor of a private, gold-backed currency, well, that might just turn out to be the best investment ever.

 

Disclosures: Paco is long gold, DXO, and UCD. Unfortunately he also holds U.S. dollars by necessity, pending the advent of private gold-backed currencies. Paco has been a financial analyst and a portfolio manager for 18 years. You can buy his novel Discipline wherever books are sold. Or visit www.disciplinebook.com. Email your questions or comments to questions@pacoahlgren.com. Copyright 2009, Paco Ahlgren. All Rights Reserved.

 

Chinese to U.S.: You Want How Much?

 

Let's start this article with a somewhat scaled-down description of current account balance:

"[If the current account balance is] positive, it measures the portion of a country's saving invested abroad; if negative, the portion of domestic investment financed by foreigners' savings."

Now let's move on to a link a reader sent me today of current account balances around the globe (thanks Mano):

https://www.cia.gov/library/publications/the-world-factbook/rankorder/2187rank.html

Note the first country on the list. Now note the last country on the list. Now ask yourself this: do you really believe the U.S. is going to be able to continue to fund operations by borrowing money?

Fine. Let's look at it another way. Do you really think the Chinese are so stupid and gullible that they're going to continue to lend the U.S. money, despite its syphiloid current account balance?

Listen to me. I took the first level Chartered Financial Analyst exam, and I passed it. But I don't really know to this day how I passed it. I sat in an Auditorium in San Francisco, California, sweating like a hot goat for six hours. I punched numbers into my calculator and the screen returned "Hahahahahahahaha!"

No. Really. That's what it said.

Do you know what else happened in that auditorium? I'll tell you. Between hot flashes, bouts of nausea, and general moments during which I no longer knew my own name, I looked around. A lot. And do you know what I noticed? Chinese people don't sweat during CFA exams. They don't get hot flashes. They don't forget their identities. They don't look around at stupid Americans. No. Do you know what they do? Math. Real good math. And then they finish the exam -- like, 45 minutes early -- and they leave. That's what they do.

You need to listen to me. Chinese people are decidedly not stupid. They're curve-killers. They make it (nearly) impossible for dumb white people (like me) to sneak past 70. So don't sit there and try to tell me the Chinese are going to keep lending the U.S. money. Because they aren't. They invented market capitalism, and they do it better than anyone else -- even when they're claiming to be communists.

Still not convinced? Okay. How about this: are you one of those people who believes a person can finance a $2 million dollar house with no money down, no job, and no tax returns? Well, I've got news for you. You can't. Things have changed. And that rock you're living under? Yeah. That one. Well it requires 20% down too. And you can't finance it without tax returns either.

[Author leans forehead on hand, supported by elbow on table, purses his lips, and stares at computer monitor. He gently shakes his head and rolls his eyes in anticipation of deluge of negative responses from dollar-loyalists, flag-waivers, and apple-pie-eaters tomorrow. Author then sighs audibly and begins to type again.]

Guess what everybody? Sound economics and finance are back. And they're real mad at the United States. Real mad.

 

Disclosures: None. Paco has been a financial analyst and a portfolio manager for 18 years. You can buy his novel Discipline wherever books are sold. Or visit www.disciplinebook.com. Email your questions or comments to questions@pacoahlgren.com. Copyright 2009, Paco Ahlgren. All Rights Reserved.

An Inflationary Depression

I received this from a reader a few days ago:

"You say your biggest concern is that the Fed will not be able to sell Treasuries without driving yields higher if inflation comes back. But wouldn't the Fed want to make yields higher if inflation comes back? Wouldn't they want to discourage borrowing and investment by making yields higher?"

As you probably know by now, I don't believe there is a distinction between price inflation and monetary inflation; I believe that all inflation is defined as an increase in the money supply -- including credit. In other words, general price increases are the result of inflation -- whether from printing excess money or by easing lending rates to the point that credit expands. Either way you look at it, the way the Fed typically deals with the problem of rising prices is to decrease credit by increasing target rates, and/or by selling Treasuries -- thereby decreasing the number of dollars in the system. The latter has a second benefit (if you can call it that): as the Fed sells Treasuries, it increases yields, further discouraging investment.

This whole game is predicated on a thriving economy, with low unemployment and high consumer confidence. Why? Because if the economy is doing poorly, and the Fed starts increasing interest rates and selling Treasuries, it will only discourage borrowing and investment -- and that's the last thing an ailing economy needs. The term used for such such conditions -- that is, a sluggish economy with rising prices -- is stagflation. This is precisely the type of environment the United States experienced in the late 1970s and early 1980s, and this is why I've said so many times recently that Paul Volcker -- then Chairman of the Federal Reserve -- was luckier than he was skillful when he restricted rising prices by driving the Fed's target rate above 20%. And, of course, stagflation was what Ben Bernanke feared more than just about anything in 2008, when inflation (his definition) went over 5%, at the same time the economy began to slow.

Stagflation is the Fed's worst nightmare because -- as I illustrated above -- it is extremely difficult to combat. On one hand, the Fed needs to stimulate a weak economy, and the way it does that is by lowering rates and increasing the money supply. On the other hand, the Fed claims its primary objective is fighting rising prices, which it typically does by raising rates and decreasing the money supply. So you can see the problem stagflation poses.

In recent weeks, a lot of data has suggested that credit is easing and that banks are starting to lend again. It's important to note that the Fed has printed more money than ever in history, and the only thing keeping that money from causing massive price increases is that its velocity is low -- that is to say, the money isn't getting into the hands of consumers and producers; it's staying in the banks.

But if credit is loosening, that deluge of money is going to hit the economy hard at exactly the same time that credit begins to expand again. And when this happens, prices are going to go much higher. But as I said in my article yesterday, this environment presents a huge problem: demand for goods and services has collapsed, and when the tidal wave of money and credit hits the system, the resultant rising prices aren't going to derive from the fact that assets are becoming more valuable to people, but rather, from the fact that the U.S. dollar is becoming less valuable. The economy will still be sick, and yet prices will be rising.

So what will the Fed do? It can't lower rates; they're already at zero. It could buy Treasuries, but that would require printing yet more money, further deteriorating the integrity of the dollar. And now we get to the most interesting -- and frightening -- part of the stagflation conundrum: as the economy continues to suffer and the Fed considers new, creative ways to ease, it will also simultaneously have to consider raising rates and selling Treasuries in order to restrain escalating prices. But even if the Fed decides that restricting trumps easing, it can't sell Treasuries because doing so would drive interest rates higher, further dampening investment and borrowing -- and that would only do more damage to the economy.

Oh, what to do...

Most pundits incorrectly believe government stimulus is going to re-ignite prices only after the economy has recovered, and that the Fed will therefore be able to play its game with the same old rules -- combating rising prices by easing. I totally disagree, however, because of the three factors I've cited so many times in recent weeks: first, the U.S. is now a debtor nation, with unprecedented obligations to foreign governments. Second, its manufacturing base has all but disappeared. And finally, the consumer is broke with no savings and no credit. All of this will contribute to further deterioration of corporate earnings and dividends, and unemployment will climb higher still. The economy simply cannot recover quickly from these circumstances -- if at all.

I'm highly confident that rapidly rising prices will return sooner than any economic recovery; indeed, the reason I believe the economy likely won't recover at all is because the Fed will have fewer resources at its disposal than at any other time in history, at precisely the point it will face the worst stagflation in U.S. history.

I know many of you don't want to hear it, I'm more convinced of the U.S. dollar's demise than ever. A lot of people have been asking me what we can do about it -- decrying my predictions as meaningless because I offer no accompanying solutions. Well disparage me no longer, because as individual investors, there's a lot we can do -- namely getting on the opposite side of the dollar and Treasuries.

But as a nation...? No, there's nothing that can be done. More than at any other time in history, Washington needs to get out of the way, and yet Washington is interfering on an unprecedented scale. But maybe you still believe our beloved politicians can get us out of this mess.

I'll tell you what. Why don't you hold your breath while I count to 8.5 trillion.

 

Disclosures: Paco is long gold. Paco has been a financial analyst and a portfolio manager for 18 years. You can buy his novel Discipline wherever books are sold. Or visit www.disciplinebook.com. Email your questions or comments to questions@pacoahlgren.com. Copyright 2009, Paco Ahlgren. All Rights Reserved.

What If Stocks Were Priced in Gold?

 

"Everything has its limit -- iron ore cannot be educated into gold."

-- Mark Twain

 

Several charts have been floating around the Internet for some time showing showing the historical Dow Jones Industrial Average, priced in terms of gold. The simplest explanation entails thinking of the Dow divided by one ounce of gold; if the Dow is at 5000, and gold is at 500, then Dow-to-gold is 10. But it's important to remember as you're considering this ratio that the Dow is calculated in terms of dollars. So essentially, when we determine the Dow-to-gold ratio, it's not just a simple ratio of gold to shares in the Dow, but rather it is a three-part ratio -- Dow, expressed in dollars, to an ounce of gold.

Wouldn't it just be easier to express gold in terms of dollars, or the Dow in terms of dollars? Well, those are certainly useful ratios -- and we use them all the time -- but what we're really going after when we look at a historical Dow-to-gold chart is how well the Dow has performed, relative to the dollar, and relative to gold. What have inflationary pressures done to the Dow, in terms of gold and the dollar, over the past century? How have the three components moved in the various historical boom-bust scenarios? The results are interesting.

Let's shift gears for a moment. Just off the top of your head, what would you expect stocks to do in periods of inflation? The dollar loses value rapidly, right? And that means prices of goods and services move higher, presumably with wages. So wouldn't it stand to reason, intuitively, if corporations were making more money as prices increased, profits would increase too? And if profits increase, shouldn't share prices go higher in response?

It turns out that inflationary price increases are bad for the stock market, and no period in history establishes this more concretely than the late 1970s and the early 1980s. Interest rates and prices soared, along with the price of gold, but stocks were flat. I want you to think about what I'm saying here: prices in general were going up, and yet the stock market was not. What this means is while stocks, in nominal terms, looked to be relatively stagnant, in real terms they were getting crushed. This is why the Dow-to-gold ratio is so significant as an indicator of relative value.

There is an elegant, simple truism that comprises every single transaction between buyers and sellers, and yet most people don't even think about it: whenever you buy something, you are selling something else. When you buy corn, you are selling dollars. When you buy a Ford, you are selling dollars. If you are in Mexico and you buy a chicken, you are selling pesos. Of course, if you came from the U.S., you first sold dollars, bought pesos, and then sold pesos to buy the chicken. I know most of you already understand this concept, but I'm trying to emphasize that even when currency is used, every transaction is merely a trade; that is to say, the transaction is nothing more than negotiation that results in the exchange of two things -- whether goods, services, or currency.

With that in mind, consider this: when prices rise because of inflation (printing of money), it isn't so much that goods and services are getting more valuable -- rather it's much more accurate to say the currency is simply getting less valuable relative to everything else. If the dollar collapses, for instance, and the cost of a loaf of bread goes from $1 to $20, and at the same time a share of Microsoft goes from $20 to $30, then Microsoft is severely underperforming -- in inflation-adjusted dollars. A loaf of bread will cost you 20 times what it used to -- not because it is more valuable, but because the dollar is less valuable. Meanwhile Microsoft is worth only 50% more. Relative to the dollar, shares of Microsoft are actually losing money -- in a big way.

If  you look at a chart of inflation from 1978 to 1982, you'll notice a huge spike. If you look at a chart of the Dow Jones Industrial average during the same period, you'll see that stocks traded sideways in a fairly well-defined range over the same period. But that doesn't tell the whole story; if you adjust for the meteoric rise in prices during that five-year period, the stock market actually performed much worse than the nominal dollar fluctuations presented in the historical chart. In other words, the price of just about everything was going up dramatically, but stocks were not. So if you adjust prices back to "normal" levels, and adjust stocks accordingly, the picture for equities would have been horrible.

Now for the pièce de résistance...

Here is a series of charts of historical nominal gold prices (not adjusted for inflation), in several different currencies -- the first of which is U.S. dollars. Take a look at the spike in the price of gold from 1977 to 1981. Now, if we go back to our original chart above, showing the Dow Jones Industrial Average, in direct relation to an ounce of gold (Dow-to-gold), you can see that the ratio went roughly 1:1 in 1980 -- at the peak of the inflationary price surges. To clarify, the Dow was at about 750, as was gold.

But didn't we say that, relative to rising prices, the Dow actually underperformed dramatically? So if you bought gold in the mid-1970s, not only was your investment skyrocketing, but the stock market -- which was flat in nominal dollars -- was actually doing very poorly relative to rising prices. Bear in mind that both the Dow and gold were priced in terms of nominal dollars at the time; they essentially "cancel out" -- that is to say, relative to rising prices, gold also failed to perform as well as the nominal dollar-price. Still, it did offer an excellent hedge against rising prices -- and even outperformed during the period.

What does all this mean? Well, for starters the average Dow-to-gold ratio over the last century has been about 9.5, and we are currently at about 8.5. So you're probably thinking we're oversold and due for a correction. In other words, the Dow-to-gold ratio is probably going higher, right? Well that was my first conclusion too, but actually on closer examination it turns out that's probably not right at all.

For much of the last century the dollar was tied to gold, and while the relationship was never perfect -- and the U.S. government betrayed the union many times, in many different ways -- there was at least some relationship, which helped pull the ratio down. Eventually, excessive inflationary printing caught up with the government in the 1960s, and it became clear it wouldn't be able to honor redemptions against the dollar at the price it had fixed. Nixon essentially defaulted on the U.S. promise to redeem dollars for gold by taking the U.S. off the standard in the 1970s -- and this, more than anything else, allowed inflationary pressure to drive general prices into the stratosphere. This was the moment the Dow-to-gold ratio approached 1:1. To fight rising prices, Paul Volcker, the Fed Chairman at the time, pushed the Fed's target interest rate past 20% and barely saved the U.S. economy from collapse.

For most of the next 20 years, gold fell and stock prices rose. Meanwhile, the U.S. government capitalized on the lie it had created and printed more and more money. Who really cared? Everyone was making money in the stock market, and prices remained relatively stable. In fact, every time prices failed to act "correctly," the Fed simply changed the rate at which it would lend to banks. But the illusion of the monetary policy game couldn't last forever; people used easy money printed by the government to buy assets they couldn't afford throughout the economy -- especially houses. Finally the pressure was just too much, and everything started unraveling in 2007. But the gold market seemed to understand the game couldn't last, and around 2000 it started a slow, steady rise.

Relative to everything, the number of dollars in the system in early 2009 is almost incomprehensible. Once de-leveraging reaches its nadir -- and it's coming soon -- those dollars are going to hit the economy and drive prices much higher.

What have we learned about stocks in such periods of rising prices? Not only do they fail to perform, but adjusted for inflationary price pressures, they actually underperform. General prices and unemployment will continue to rise. The consumer will continue to be unable to consume. Corporate earnings and dividends will continue to collapse as a result. Stocks are going lower -- probably much lower.

And what about the price of gold? It will almost certainly continue to increase -- not only because people will flock to its long historical stability and consistency, but also because there are simply so many more dollars (and yen, and rubles, and euros) in the world. Remember, the U.S. isn't the only country printing innumerable sheets of currency. And in that context, remember also that inflationary price increases have almost nothing to do with increased demand, but rather they are the result of currency devaluation and destruction -- through printing.

I just want to share two more charts with you. The first should give you a little perspective -- it is a historical chart of gold, in both nominal and real dollars. Notice the real price of gold in 1980 (in 2007 dollars) was $2272 per ounce. If I'm correct about inflation and the fate of the dollar -- and I'm confident I am -- then we are nowhere near the historical high in gold. But I don't think we're merely going to re-test that high -- I think we're going to blow through it as the dollar loses value.

In the 1930s, as corporate earnings and dividends disintegrated, the Dow lost nearly 90% of its value from peak to trough. The U.S. was a creditor nation with a huge manufacturing base. The dollar was tied closely to gold. Since its peak in October 2007, the Dow has lost less than 50% of its value. The U.S. is a debtor nation with a relatively small manufacturing base. I can't say it enough: we borrow profusely, we manufacture very little, and we consume gluttonously. Nonetheless, the consumer has now lost almost all his purchasing power, and corporate earnings and dividends are going to suffer massively as a result.

In 2007, the Dow peaked at about 14,150. To give you some perspective, an 85% drop in the Dow from peak to trough would put it at about 2100.

I know its easy to imagine the Fed has magical powers. I've fantasized about such things myself at times of extreme weakness -- that maybe the Fed will "somehow" figure out a way to fight and defeat the unprecedented evil specter of inflation it is foisting on its unsuspecting children. Sometimes I do believe that our Lord and Savior Barak Obama will wave his charmed "unicorn horn of change" and all will be well again. Likewise, at times I feel like I could let Uncle Ben Benanke take me just about anywhere in his helicopter of prosperity. My faith in the reverend John Maynard Keynes runs deep, as I hope, and hope, and hope. I find myself gleefully clicking my heels together and repeating, "the dollar is almighty, and the Stars and Stripes will prevail." And when I am in this wonderful place, I have confidence that someday soon, we'll all be buying houses with no money down, and with no jobs. Our driveways and backyards will once again overflow with boats, motorcycles, and sports cars.

Then I think about the 1930s. And suddenly I am wide-awake.

Let me ask you a simple question, and I want you to actually think about it. Do you really think we can't get to the 1930s again? Do you really think that we're going to return to the exuberant excess of the past few decades? If so, let me disabuse you of the notion: the United States was in much better shape, economically, going into the Great Depression than it is now. Prosperity is not coming back to the U.S. as we know it. We are in a lot of trouble.

Is a Dow-to-gold ratio of 1:1 so incomprehensible? Again, it has happened before -- several times. But I'll even take it a step further: what about a Dow-to-gold ratio of .5? Or less? I promise you, if the Fed fails to soak up all the dollars it's putting in the system, that's exactly where we're going. And what, you may ask, does the Fed use to "soak up dollars?"

I'll be glad to tell you that too. When the Fed needs to take dollars out of the system, it sells Treasuries (which means it buys dollars). The problem is, the U.S. debt-load is astronomical. Who, exactly, is going to buy that debt from the Fed? And at what interest rate? Remember, if the Fed is desperately trying to take dollars out of the system, there can be only one reason: it is scared of rising prices caused by inflation. But if the Fed floods the market with Treasuries, it will achieve exactly the opposite effect it's looking for -- it will cause rates to rise, probably dramatically. Do you really think the Chinese and the Japanese are going to buy Treasuries at a 2% yield if the Fed is panicking and trying to buy dollars to stop an inflationary price explosion? If so, you're delusional. Chinese and Japanese people are smart. They're not going to fund an inflationary dollar at 2%. Ever.

In the past it might have worked. Of course, in the past, the U.S. money supply was much smaller, and our ability to borrow was much stronger. But those days are gone.

As if I haven't terrified you enough, the last thing I'm going to leave you with is really scary. It is a link to an excellent article by Mark J. Lundeen, whose insight into this economic catastrophe has been stupefying since long before all of this even started. Embedded in the article is a chart that shows historical dollars-in-circulation, relative to U.S. gold.

With that, I think I'll let you do the rest of the math. Sleep well.

 

Disclosures: Paco is long gold. Paco has been a financial analyst and a portfolio manager for 18 years. You can buy his novel Discipline wherever books are sold. Or visit www.disciplinebook.com. Email your questions or comments to questions@pacoahlgren.com. Copyright 2009, Paco Ahlgren. All Rights Reserved.