October 26, 2008
by David Chapman
"This crisis, however, has turned out to be much broader than anything I could have imagined"
"Those of us who have looked to the self-interest of lending institutions to protect shareholders equity - are in a state of shocked disbelief"
~ Alan Greenspan, Federal Reserve chairman 1987-2006 - October 24, 2008
Shocked - well, we are shocked that Mr Greenspan is shocked. The former Fed chairman who was revered as a god by Wall Street now has the chutzpah to say he is shocked by what has taken place. He went on to admit that he was "partially" wrong to resist regulation of some securities. Some securities? Which ones? Most securities except for the stock market are not regulated. Except for the Sarbanes-Oxley Act of 2002, most securities regulation in the USA dates back to the 1930s.
Mr Greenspan, we are shocked that you could have been so naive for so long. In a world of unbridled deregulation and laissez faire capitalism, allowing interest rates to remain low for so long while pouring oodles of money into the financial system was like throwing gasoline on a fire. It would end in an unmitigated disaster.
The disaster is now upon us. We too are shocked at how quickly this happened. We are shocked that no sector has been spared. We are shocked that so many smart people could ultimately be caught with their pants down as the train crashed. We include ourselves in that. Over the past year there had already been two train wrecks. The first one was rather mild lasting through July/August 2007. The second one was nastier starting in October 2007 and finally bottoming in March 2008. But the third one that started in May 2008 was the train wreck of all train wrecks and it took with it the areas that had been largely unscathed and even thrived during the first two. There were no areas of safety except holding cash. When the train crashed it took everything and everyone with it.
In the space of barely a month the Dow Jones Industrials and the S&P 500 have returned to 2002 levels. The NASDAQ was lucky; it fell back to mid-2003 levels, at least for the moment. The TSX Composite was even luckier: mid-2004. The TSX Financials that had been falling steadily for months in its last gasp was back at 2005 levels. Ditto for the TSX Energy Index that had been the major leader for the TSX Composite. The TSX Gold Index was suddenly back at 2004 levels. And for the poor souls on the TSX Venture Exchange - well it was back to 1999/2000. The 1987 stock market crash only knocked the Dow Jones Industrials back to 1986 levels. Hardly the disaster this one has been.
In the space of a month or so, Wall Street has turned into a barren canyon with taxi cabs and expensive restaurants looking for customers. Elsewhere it is just shellshock. The Alberta oil patch that had been darling of Canada (and of the TSX Composite) has seen oil barons reduced to hoping that gasoline stations will go back to actually using people and not just "self-serve". Okay we exaggerate (well maybe not), but the plain truth is that senior companies like Suncor (SU-TSX) have lost 63 per cent of their value since the May highs, and that many intermediates and juniors like Oilexco (OIL-TSX) are down roughly 80 per cent or more during the same period.
The Gold and Materials sector has been pummelled as well. The Gold Index topped last March and since then Barrick Gold (ABX-TSX) has fallen, like Sunoco, roughly 63 per cent. Many junior producers and especially the junior exploration stocks are down 80 per cent or more. Potash (POT-TSX), the star of the materials/agriculture sector, has fallen 65 per cent since topping in June. It has all happened so quickly. Does that mean the agriculture boom is over? Absolutely not. It just means that Potash was hard hit been thrown out like every other stock. Creative destruction at its worst.
So if Mr Greenspan is shocked, we don't know what it says for the rest of us. It seems the world has gone into cathartic shock. If so where is the defibrillator? The bad news this past week just kept coming - Goldman Sachs to throw out 3,200 employees, Wachovia setting a bank record for a loss, dismal retail sales figures in the US and Britain, Japan's trade surplus down 94 per cent, and GM, Ford and Chrysler all on the brink of bankruptcy. The only question is which will fall first. Maybe all three? The big three reduced to a pile of rusty cars. And the coming Christmas season? Fogetaboutit! The Grinch has already been here.
Even Kirk Kerkorian has bailed on Ford (losing hundreds of millions of dollars in the process and proving that even smart investors get their heads handed to them sometimes). Entire countries are now teetering, with both Iceland and Pakistan either bankrupt or on the brink of it. Behind them is a growing list of countries in trouble - Hungary, Ukraine, and a potential host of Latin American and Eastern European countries. While some countries such as Iceland primarily matters to its 300,000-odd inhabitants (its GDP is estimated to plunge at least 10 per cent in the next year) the collapse of a country like Pakistan would matter to the world, given its political instability.
Everyone should actually feel lucky. No word as yet that any country is headed in the direction of Zimbabwe, a country once one of the richest in Africa but now on the brink of chaos and starvation. Zimbabwe is the post card child for the absolute worst case scenario. Grant you years of economic sanctions coupled with the rule of a ruthless dictator mismanaging everything have brought Zimbabwe to its knees.
So what is Greenspan's legacy? Setting aside the rapid monetary growth, his real legacy is debt. And it is the massive growth of debt that is primarily behind the massive monetary growth experienced over the past few decades. Using the Flow of Funds Accounts of the United States, total debt grew from $8.7 trillion in 1987 (when Greenspan took over) to $29.2 trillion in 2006, an astounding 236 per cent increase. By comparison GDP has only increased roughly 197 per cent during the same period.
Consumer or household debt that was $2.8 trillion back in 1987 rose to $13 trillion under Greenspan and is now over $14 trillion. Federal Government debt of $1.9 trillion in 1987 is today over $5.3 trillion. But that number officially reported on the Flow of Funds is merely the public portion of the US Debt. The total US Federal Debt is now over $10 trillion. The public portion of the debt is all of the debt held by US States, corporations, individuals and foreign governments, whereas the total debt adds the debt held by Social Security and intergovernmental debt obligations. Nothing is said about the unfunded liabilities that could raise this mountain of debt to $56 trillion and counting.
The official debt is expected to grow sharply as it excludes the debts of Fannie Mae and Freddie Mac, the obligations to bail out AIG (who keep coming back for more), the debt that will be required for the $700 billion bailout (that could easily surpass $1 trillion), or the debt that will be required to be raised to take equity positions in banks, or the $500 billion plus to bail out money market funds. Add to this the debt required to fund ruinous wars in Iraq and Afghanistan and you have the makings of potential $1 trillion budget deficits. All of these followed years of tax cuts and other giveaways that ensured that the United States of America would not only be the most indebted nation on earth, but may well become the most spectacular bankruptcy ever. To counteract this massive increase the time to raise taxes to offset this debacle has probably been passed.
The US bankrupt? Some might call that an exaggeration and possibly it is. But warnings have come in the past from the IMF and there has been talk (but we suspect no action) on possible downgrading of US debt. The world (G20 to be exact) is meeting in Washington next month over what some hail could turn into a new Bretton Woods agreement. Don't expect much. The US will not wish to give up its economic leadership role just yet. A larger crisis will have to develop. The US with an official debt to GDP ratio around 72 per cent (and rising quickly) is not in the league of many other nations just yet. Japan has a debt to GDP ratio of almost 200 per cent. But at least it is a meeting of the G20 which includes the US's main creditors (China, Saudi Arabia and Japan). At G8 meetings only Japan is present and they never complain about the US's mountain of debt.
So what would be that larger crisis? The only one left on the table is the collapse of the US dollar (and the bond market). The recent rise in the dollar has been nothing short of astounding. Of course, the explanations come easy. When you are collapsing all you can do is unwind and bring what is left back home. And that is essentially it as hedge funds and others unwind positions in foreign currencies (carry trades in anything else - foreign debt, stock markets, commodities, gold, etc) and repatriate the proceeds. The yen carry trade is also being unwound, and that has resulted in an even more spectacular rise of the Japanese Yen.
All this has left those of us who believed that gold would be the ultimate hedge scrambling for explanations. It has fallen 30 per cent from its high last March and baby gold (silver) has fallen even more: almost 60 per cent. Compared to the stock market (S&P 500 down 42 per cent), gold has outperformed. No consolation, it seems. Many who had preached the virtues of gold have received vitriolic e-mails, hate mail, and who knows maybe even death threats. Such is the pervasion of fear and revenge.
In the midst of this one has to ask: would I rather hold US dollars or gold? We know what we would still choose. Gold is a hard currency with a 3,000-year history and no liability, and therefore it will never default. The dollar is a paper currency with a 200-year history and $10 trillion of debt behind it (or $56 trillion depending on how you count). It is an IOU whose value can only fall over time.
As we know the current Fed chairman Ben Bernanke is continuing the policies of Alan Greenspan, as all these bailouts and debt writing attest. If printing money was the solution to every financial crisis we would all live in a state of Nirvana and no country would ever go bankrupt or default - they would just print more money. The reality is the opposite. History is littered with the defaults of governments dating all the way back to the Greeks and Romans. Even the US has defaulted when Nixon closed the gold window back in August 1971.
Gold's current problems are temporary. The US dollar's problems may be terminal despite this short-term move into the sun. This is not a healthy rally. If the unwinding of bad investments in order to repatriate to your home country what is left is healthy, then we truly have some fine beach properties in the northern muskeg for you.
While gold has been falling in US dollar terms it has been rising in a host of other currencies. Or at least, not falling. Our chart of gold priced in euro in Canadian dollars shows that the price has stayed at or near record highs. We even briefly went to new all-time highs before pulling back again. Grant you it is a pattern to watch carefully because we failed to maintain those new highs. But in other weaker currencies such as the Mexican peso and Brazilian Reals, gold remains at or very near record levels.
The US economy is clearly in trouble, as a host of recent numbers seem to indicate. Still no official recession has been pronounced. But economic numbers of late including the weekly employment claims, the Philly Fed Index, Leading Indicators, Consumer Sentiment and retail sales are all pointing to an economy under severe stress. One in six homeowners are either in foreclosure or have seen the value of their house fall below the size of their mortgage. Car sales are plummeting, as witnessed by the severe problems of the US big three. Even Toyota has recently experienced a downturn in sales.
If the export sector was the saviour for the US economy, given the weakness of the dollar that advantage is rapidly disappearing with the dollar's rapid ascent. In Canada, exporters who were complaining about the high value of the Canadian dollar are breathing a sigh of relief with its recent collapse. The other side of that coin, though, is that anyone who adjusted to the high Canadian dollar or hedged their positions is now suffering huge losses as a result of the fall of the Canadian Dollar. The Australian dollar - another commodity currency - has been even harder hit.
The problems in the US economy, the fact that the US (and Europe) is moving into overdrive to bail out the system by issuing debt or outright printing money and monetizing the debt, all point to higher gold prices down the road. Well over 40 per cent of US public debt is held by foreigners (primarily China, Japan and some petro Mid-East countries primarily Saudi Arabia) and they will be unhappy to see the US try to monetize its debt away. That is a default in all but name. But as we are sure to see at the G20 meetings in November, the US is not ready to be told how to manage its affairs by foreign debt holders. As we noted above, it will take a bigger crisis to get us to that point, and that crisis has to be one of confidence in the US dollar.
We continue to see signs of a two-tier gold market. The official one is where the price has generally been falling. The unofficial market of coin dealers and even the mints have been cleaned out, have difficulty accessing product, and what they have on the shelves goes for a high premium. Central banks have stopped leasing gold. Gold lease rates for one month a month ago were 0.7 per cent and today are 2.7 per cent. Silver lease rates have jumped from 0.6 per cent to 1.2 per cent. Further, there has been some talk of a default on the December gold contract. This would occur if it someone tried to take delivery rather than rolling contracts. John Embry of Sprott Asset Management has discussed this possibility. That the paper price of gold has been dominating the physical gold market is an anomaly that cannot continue forever.
The stock market has already had a vicious decline. There is no law or certainty though that the decline will not worsen. An interesting chart we saw demonstrates the potential dangers in this market. The chart from www.chartoftheday.com is of the Dow Jones Industrials adjusted for inflation since 1925. It is interesting to note that the highs of 1966 were barely above the highs of 1929 on an inflation-adjusted basis. The DJI peak seen in 2000 was barely double the 1929 high and not even 30 per cent above the 1966 peak.
On the downside, the collapse from 1966 to 1982 saw the DJI back at levels seen from 1935 to 1945. The current DJI is now, on an inflation-adjusted basis, below the lows of 2002. The bottom of the long-term bull channel is down somewhere around 4,000-5,000. That would suggest that ultimately the DJI could roughly halve from today's levels. It might not happen, but these long-term charts offer an excellent perspective on where markets go on the upside and where we could go on the downside.
There is a clear double top on the chart of the DJI. The projected target is at least 5000. The real nightmare is a 1929-1932 scenario that was almost straight down. A more likely scenario though is the 1966 to 1982 collapse that saw numerous strong rallies that of course ultimately failed. Our leaning is that scenario and it is during these rallies that investors will get an opportunity to restructure and prepare for the next collapse. But the reality is when the collapses occur they could be swift and vicious as we have just witnessed.
There are baby bears, papa bears and mama bears. 1998, as scary as it was, was really only a baby bear. In retrospect the 1987 stock market crash was also only a baby bear. The 2000-02 tech wreck/dot-com bust was a papa bear. Today's bear has all the characteristics of being a mama bear, a rare creature last seen in the 1930s and the 1970's. If it is, we have Alan Greenspan to thank. Alan - we are shocked by your gift.
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