Monthly Archives: October 2008

Lending won’t stop if banks go under.

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The Journal has a story about a venture-funded alternative lender called On Deck Capital that extends credit to small businesses, many of whom don’t qualify for bank loans at the moment. Interest is high, at 18+ percent, but that sounds about right considering the risks of lending to small companies in this environment.

This business model reminds me of person-to-person loan companies such as Prosper Marketplace, Inc., where savers are matched with lenders through an auction process.

No fractional reserve lending.

The beauty of these lenders is that they can’t create money out of thin air like the banking cartel. Every penny they lend out was earned and saved by someone, either the investors in the venture fund that backed On Deck or the very individuals who find borrowers on Prosper.com. These companies do not create fake credit like banks, but simply fulfill the proper role of intermediaries.

No moral hazard.

The president of Chemical Bank, George Gilbert Williams, credited “the fear of God” for the bank’s continued ability to satisfy withdrawals with gold coin through the panic of 1857*. Without the FDIC or Fed to bail anyone out, lenders have to be very careful about each loan. In such a free-market system, lenders’ fear of losing their own money prevents bubbles from being blown. Without the explicit or implicit promise of bailouts, there is no need for them.

Market rates.

If all the fractional reserve banks in the world were to fail tomorrow, and the Fed and FDIC were abolished, all kinds of new lenders would crop up, offering everything from high-yield consumer credit to asset-backed trade loans to mortgages. The interest rates would be set by market forces, which is to say that they would be high at the moment to reflect risks. Only very strong borrowers could secure loans, and the weak would have to de-lever or fold.

Savings encouraged.

Without the fear of inflation, but with strong deflation, savings would be encouraged. More and more of those savings would be lent out as the bust ran its course and risks were better balanced against rewards, in no small part because asset prices would be much lower.

Unfortunately, nobody seems to understand such simple logic these days, and Bernanke’s models say that inflating away savings to prop up the insolvent is the way to prosperity. We’ll see who is right.

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*Page 112, Money of the Mind, by James Grant.

Real credit vs. fake credit.

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The essence of why bailouts will only deepen our problems is that real credit cannot be created out of thin air. This counterfeit operation is what caused the bubble to begin with, and by trying to put out a fire with gasoline, Bernanke, Congress and Obama are going to burn down the whole city.

Frank Shostak, the Chief Economist at M.F. Global, knows a thing or two about economics, which is not something you can say about many of today’s economists. The Mises Institute website publishes this essay of his on credit, which illustrates the critical identity between savings and investment, and the proper role of banks in an honest system.

Central-bank policy makers have said that the key for economic growth is a smooth flow of credit. For them (in particular, for Bernanke) it is credit that provides the foundation for economic growth and raises individuals’ living standards. From this perspective, it makes a lot of sense for the central bank to make sure that credit flows again.

Following the teachings of Friedman and Keynes, it is an almost-unanimous view among experts that if lenders are unwilling to lend, then it is the duty of the government and the central bank to keep the flow of lending going. …

It is true that credit is the key for economic growth. However, one must make a distinction between good credit and bad credit. It is good credit that makes real economic growth possible and thus improves people’s lives and well-being. False credit, however, is an agent of economic destruction and leads to economic impoverishment.

Good Credit versus Bad Credit

There are two kinds of credit: that which would be offered in a market economy with sound money and banking (good credit); and that which is made possible only through a system of central banking, artificially low interest rates, and fractional reserves (bad credit).

Banks cannot expand good credit as such. All that they can do in reality is to facilitate the transfer of a given pool of savings from savers (lenders) to borrowers. To understand why, we must first understand how good credit comes to be and the function it serves.

Consider the case of a baker who bakes ten loaves of bread. Out of his stock of real wealth (ten loaves of bread), the baker consumes two loaves and saves eight. He lends his eight remaining loaves to the shoemaker in return for a pair of shoes in one week’s time. Note that credit here is the transfer of “real stuff,” i.e., eight saved loaves of bread from the baker to the shoemaker in exchange for a future pair of shoes.

Also, observe that the amount of real savings determines the amount of available credit. If the baker had saved only four loaves of bread, the amount of credit would have only been four loaves instead of eight.

Note that the saved loaves of bread provide support to the shoemaker, i.e., they sustain him while he is busy making shoes. This means that credit, by sustaining the shoemaker, gives rise to the production of shoes and therefore to the formation of more real wealth. This is a path to real economic growth.

Money and Credit

The introduction of money does not alter the essence of what credit is. Instead of lending his eight loaves of bread to the shoemaker, the baker can now exchange his saved eight loaves of bread for eight dollars and then lend those dollars to the shoemaker. With eight dollars, the shoemaker can secure either eight loaves of bread (or other goods) to support him while he is engaged in the making of shoes. The baker is supplying the shoemaker with the facility to access the pool of real savings, which among other things includes eight loaves of bread that the baker has produced. Note that without real savings, the lending of money is an exercise in futility. …

The existence of banks does not alter the essence of credit. Instead of the baker lending his money directly to the shoemaker, the baker lends his money to the bank, which in turn lends it to the shoemaker. …

Despite the apparent complexity that the banking system introduces, the act of credit remains the transfer of saved real stuff from lender to borrower. Without the increase in the pool of real savings, banks cannot create more credit. At the heart of the expansion of good credit by the banking system is an expansion of real savings.

Now, when the baker lends his eight dollars, we must remember that he has exchanged for these dollars eight saved loaves of bread. In other words, he has exchanged something for eight dollars. So when a bank lends those eight dollars to the shoemaker, the bank lends fully “backed-up” dollars so to speak.

False Credit Is an Agent of Economic Destruction

Trouble emerges however if, instead of lending fully backed-up money, a bank engages in fractional-reserve banking, the issuing of empty money, backed up by nothing.

When unbacked money is created, it masquerades as genuine money that is supposedly supported by real stuff. In reality, however, nothing has been saved. So when such money is issued, it cannot help the shoemaker, since the pieces of empty paper cannot support him in producing shoes — what he needs instead is bread. But, since the printed money masquerades as proper money, it can be used to “steal” bread from some other activities and thereby weaken those activities.

This is what the diversion of real wealth by means of money “out of thin air” is all about. If the extra eight loaves of bread aren’t produced and saved, it is not possible to have more shoes without hurting some other activities — activities that are much higher on the priority lists of consumers as far as life and well-being are concerned. This in turn also means that unbacked credit cannot be an agent of economic growth.

Rather than facilitating the transfer of savings across the economy to wealth-generating activities, when banks issue unbacked credit they are in fact setting in motion a weakening of the process of wealth formation. It has to be realized that banks cannot relentlessly pursue unbacked lending without the existence of the central bank, which, by means of monetary pumping, makes sure that the expansion of unbacked credit doesn’t cause banks to bankrupt each other.

We can thus conclude that, as long as the increase in lending is fully backed up by real savings, it must be regarded as good news, since it promotes the formation of real wealth. False credit, which is generated “out of thin air,” is bad news: credit which is unbacked by real savings is an agent of economic destruction.

Fed and Treasury Actions Only Make Things Worse

Neither the Fed nor the Treasury is a wealth generator: they cannot generate real savings. This in turn means that all the pumping that the Fed has been doing recently cannot increase lending unless the pool of real savings is expanding. On the contrary, the more money the Fed and other central banks are pushing, the more they are diluting the pool of real savings. …

If the pool of real savings is still growing, then doing nothing (and allowing the interest rate to reflect reality) will allow the recession to be short lived and economic recovery to emerge as fast as possible. (At a higher interest rate, various bubble activities will go belly up. As a result, more real savings will become available to wealth generators. This in turn will work towards the lowering of interest rates.)

We suggest that decades of reckless monetary policies by the Fed have severely depleted the pool of real savings. More of these same loose policies cannot make the current situation better. On the contrary, such policies only further delay the economic recovery.

By impoverishing wealth generators, the current policies of the government and the Fed run the risk of converting a short recession into a prolonged and severe slump.

If Princeton and the rest weren’t run by fools and knaves, this is the kind of thing they would be teaching, not Bernanke’s brand of institutionalized theft.

I recommend reading Shostak’s whole essay. Click around the Mises site while you’re there. It is a wonderful resource for real economics, the kind that can make you money. The Rothhbard and Mises files would be good places to start.

Silver, platinum, palladium say gold needs to fall.

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This spring, as gold topped out at over $1000 per ounce, platinum hit $2250, silver breached $20, and palladium reached $579. The ratios at the time were roughly 1:0.45, 1:50, and 1:1.75, respectively, about where they had been for the last several years.

Here are the five-year charts from Kitco, in order of descending pain:

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I expected gold’s increase in relative value, since the other metals are considered more “risky” assets and depend more on industrial demand, but these ratios are looking a bit extreme. The one that jumps out at me is platinum priced only 10% higher than gold, at a level where gold was trading just two days ago!

With the deflationary carnage that has taken place in the rest of the precious metals (and base metals), gold’s grip on the $800 level is looking more and more tenuous. I have been figuring on $600 for some time, but now I am thinking that $400 is not out of the question. $400 sounds nuts, but there is a massive phase shift underway, in which cash is going from a hot potato to the one thing everyone needs but nobody seems to have.

That said, gold has been increasing in value against everything but dollars and yen, and to a lesser extent, euros, pounds, Swiss francs and some other currencies. It has been acting like a currency in this deflation, though one in need of a correction. In that regard, a fall to $400 would coincide with much more extreme dollar-denominated declines in almost all other assets.

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For more on this shift, see:

Bond sell-off just a correction. Bailouts will not stop deflation.

Don’t worry about the Fed printing… yet.

‘Defensive stocks’ is an oxymoron.

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If you don’t like stocks, why own any of them? Sure, you would be ahead if you had switched from Crox to Merck last fall, but Merck has still been cut in half in the last 12 months. Even Wal-Mart, Costco, Monsanto, Toyota and Honda have been among my better shorts this fall. In a bear market, earnings and multiples contract for all companies, not just the high fliers.

JP Morgan just came out with a list of 16 stocks to hold in a two-year “global recession,” which seems to be the new euphemism for depression. From Bloomberg:

The list merges the strongest convictions of its 78 stock analysts with a “top-down” view that the banking crisis threatens global growth, Thomas J. Lee, chief U.S. equity strategist at the New York-based bank, said in a telephone interview.

“There is growing demand from clients for core holdings that outperform in a global recession,” Lee said. “Every week that passes that credit markets remain challenged, there’s incremental damage to the macro economy.”

The companies are:

3M Co.
Baxter International Inc.
Colgate-Palmolive Co.
CA Inc.
Devon Energy Corp.
General Mills Inc.
Gilead Sciences Inc.
Google Inc.
Hewlett-Packard Co.
McDonald's Corp.
Merck & Co.
Monsanto Co.
Nucor Corp.
Philip Morris International Inc.
Union Pacific Corp.
Visa Inc

I have created a Yahoo! Finance portfolio of these companies, and I am going to track their performance over the coming months and years. I give them extremely low odds of outperforming a 2-year Treasury bond, and about even odds of beating the Dow. To be more specific, I bet they fall by an average of 50% over the next 24 months, even from today’s prices, which are about 25% lower than 2 months ago.

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Disclosure: I happen to be long Union Pacific puts, and I recently sold my Nucor and Monsanto puts.

Gold: Wait ’til you see the whites in their eyes.

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Gold fever

Retail investment demand for gold (and silver) has exploded since this summer, even as the exchange price has fallen well off its highs. Coins and small bars have become unavailable for sale anywhere near the spot price. Even Krugerrands, of which 46 million ounces exist, are fetching a $100 premium on Ebay.

The largest bullion coin mints are running flat out to meet demand. The Austrian Mint has more than tripled production of Philharmonics, and the South African, Australian, and the Canadian mints are doing their best to meet demand for Krugers, Kangaroos and Maple Leafs. The Indian postal service has even started selling small coins. How has the US Mint reacted? It has suspended production of Eagles and is rationing other coins. There’s a head-scratcher: an opportunity for huge seignorage profits falls in their lap, and they say, “Eh, why bother… this extra demand is a pain. Let’s take a break.”

Retail investors are suddenly rushing into gold as the severity of the financial crisis becomes common knowledge. It is actually a very encouraging phenomenon. It shows that there are still quite a few people who do not trust banks and governments, and may understand that their leaders are desperately trying to inflate away their savings to prop up a broken banking system.

Resist the urge

All of these reasons for buying gold are good ones, and nobody should be without some right now, but as someone who already has a bit, I am doing my best to resist the urge to load up at these prices. With little old ladies and pensioners withdrawing wads of cash and trotting to coin shops, to buy now would be to join the crowd, and that sends up a big red flag in my contrarian mind.

I am sticking to my guns and holding onto my GLD puts, and only nibbling at bullion on dips. The technicals on gold are just awful right now, with choppy trading on the backside of a nearly vertical peak that took the metal up 300% in six years. All commodities, from oil to base metals to grains, are in a nasty bear market. Also, with central bankers flooding the system with new digital and paper currency and the stock market in a full-on panic, the conventional ‘fundamentals’ could not get any better for gold, yet it remains 20% below its high. If it is struggling to hold $800 now, what will happen when things calm down in a few weeks?

Will demand be the same after stocks have played out the final wave of this crash (not the same thing as the end of the bear market) and the newly nationalized banks start lending to one another again (if not to others)? What about when CPI has showed a couple of months of solidly negative numbers? Won’t the cold, low-velocity reality of deflation set in? When the prices of everything from Wal-Mart sweat shirts to snow blowers to gasoline are significantly lower than last winter, will people be so afraid to hold cash?

The little old ladies are the last into an investment theme and the last out. Wait for them to trudge back to the shops just when the strongest phase of deflation is over and the printing and spending and new lending programs just start to take effect. Then call Brink’s.

Stocks are very expensive. Mr. Market is still in denial.

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Bottom line: Declines in earnings and mood could result in an 80% drop in stock prices from here.

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The S&P 500 is still priced at over 15 times last year’s earnings ($66 as reported*). Since the late ’90s, corporate earnings have been as inflated as the rest of the economy by cheap credit. From 2003, they spiked up even further, way out of line with long-term trends, largely due to inflated financial profits from the real estate scam and consumer-related and other income from society-wide profligacy. Here’s a 20-year chart:

Click image for larger view. Source: Techfarm

Mean reversion

To make matters worse, in the optimism of the bubble environment, investors extrapolated the recent pace of earnings growth out into the distant future, completely forgetting that growth is mean-reverting. This long-term mean in the US has been about 6% (good luck keeping that up under socialism). Earnings growth will always revert to a mean in a market economy simply because excess earnings attract competition. In an economy with government-supported fractional reserve lending, the downside of the credit cycle will also undercut earnings (and generate large losses).

2006 S&P 500 earnings of $81.51 were an extreme historical anomaly, so applying a 19-handle to them was insanity. If Mr. Market hadn’t been so hopped up on the energy drinks popular at the time, he would have thought long and hard before paying more than $8 for 2006 earnings, especially because stocks were hardly paying any dividends at all.

The first two quarters of 2008 came in with $15.54 and $13.17 in earnings, respectively. If you assume that each of the remaining quarters will be worse than the last by $2 (pretty optimistic if you ask me), you come up with a final 2008 figure of $49.

Mood swings

When thinking about what to pay for those earnings, you want to think about what kind of mood Mr. Market will be in next year. Somehow, I don’t think he’ll be quite as optimistic as of late, since the aftermath of that tuarine/caffeine cocktail can be a downer. After such a frenzy, his mood typically declines for years and doesn’t turn up again until he has put a sub-10 multiple on recession year earnings.

Looking at past episodes, the odds are strong that Mr. Market pays less than $12 for each dollar of 2008 earnings by the end of 2009: an index value of 588 using our ’08 estimate.

But then 2009 earnings aren’t looking so rosy either: even sell-side analysts are predicting that they will be lower than this year’s. Extrapolating a decline of $1 per quarter from our $9.17 estimate for Q4 ’08, you get $27 per the index for 2009. This happens to be about what the 500 earned in the mild recessionary year of 2002. Think next year will be worse? Adjust accordingly.

Whatever your own ’09 estimate, keep in mind that Mr. Market will be downright angry with stocks’ performance and extremely cynical by the time 2010 rolls around. If history is any guide, by the end of 2010 he might not even pay $8 for those earnings. That would be an S&P 500 value just north of 200.

Got LEAPs puts? You can bet on earnings and Mr. Market’s mood out to December 2010 with options on SPY.**

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*S&P provides a big Excel spreadsheet of such figures here (download).

**See disclaimer. I own a ton of these.

Optionality pays off.

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In the Goldilocks spring of 2007, by allocating 2.5% of one’s equity portfolio to December 2009 1000 strike puts on the S&P 500, a manager could have greatly reduced, if not eliminated the risk of the (then 4.5-year-old) bull market topping out over the next 30 months. The puts, even if not purchased at ideal prices, could very easily have appreciated by a factor of 10 as of today’s close, or even 20 if purchased on dips and sold last Friday.

At approximately $130 each, they could still easily appreciate by another two or three times by expiration if the bear market deepens.

It goes to show that it can pay to worry, even if you don’t have enough conviction to take decisive measures like liquidating a portfolio and going to cash (or short) while a bull market is still intact.

You can also insure against missing out on gains.

The same strategy can be applied on the long side. Suppose the Dow falls under 3500 by mid-2010 (actually, plan on it). Most people would by then have a perhaps unhealthy fear of stocks, just as they had an unhealthy attachment to them 18 months ago (and still do). The market could be approaching a turning point by then, but few will have the conviction to dive in with a significant portion of what is left of their capital.

In this case, our worrywart manager (who has since seen the light and bailed out of his stocks), if he gets another contrarian hunch, could risk just a few bucks for, say, December 2012 calls at 5000 on the Dow. Since he is still 97.5% in cash, if the market continues ever further into the abyss (distinctly possible this time), it is no big deal, but if stocks sport a classic recovery rally, the manager could get himself a very nice portfolio return.

The key to the lopsided risk-reward balance is to act contrary to popular sentiment when it has been running in one direction for several years. At such times, optionality on counter-trend moves is dirt cheap. I suspect that such an options strategy could generate very satisfactory long-term returns without ever risking more than three percent of principal.

You would not even have to own options all the time. You would just start buying puts after say, a three year and 40% gain in the S&P, and add to the position on rallies as the bull market matured, never allocating more than perhaps 1.5% of assets per year. Your sell trigger for the puts could be the moment the S&P records its first 20% decline.

Some inverse could of course be applied when the S&P is deep into a bear market. Bears often don’t last as long as bulls, so perhaps you would start to buy long-dated calls at the two-year mark or after a 30% decline.

That said, this particular bear is of the sort that hibernates for 300 years and couldn’t care less what all the other little bears have been doing while he was asleep. I am going to be very patient about waiting for him to exhaust himself, and may not to waste any ammo on him at all, but hunt the smaller game in Asia.

File under Western Civilization, Decline of: Krugman wins Nobel

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The market has been severely hamstrung for decades, and now that it is fainting from loss of blood, its vampire captors point to it and say, “see, markets need to be restrained or else they fail.”

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I won’t actually comment on Krugman, other than to say that he is a socialist, and like many of his breed who do not actually implement collectivist scams (as opposed to Raines, Paulson, Mozillo, Congress, et al.) but provide intellectual support for them, he seems to have a soul, albeit a lost one.

Anyone who understands the principles of the market and defends them in public these days must feel the way I do: that we are simply narrating the decline. You can’t argue with history. You can just put it down as you see it, now in the hope of carrying a few embers of common sense through or out of the West as it enters some kind of dark age.

It is astounding that after recently observing Hitler, Stalin, Mussolini, Mao, Peron, Castro, Chavez and a hundred other tin-pot dictators destroy or hobble their nations through various forms of collectivism, the entire West is now leaping headlong in that same direction, with hardly a second thought. No credit is given to the principles of individualism, private property and freedom of contract, nor the great market economy that created the prosperity these societies are so eager to squander. The market has been hamstrung for years, and now that it is fainting from loss of blood, its vampire captors point to it and say, “see, markets need to be restrained or else they fail.”

This episode will play out over generations, and it will end with tens of millions dead and the end of the very civilization that codified respect for the individual.

The end of the Enlightenment means the end of freedom and the end of freedom means the end of centuries of increasing living standards, from food and health care, to travel and communication, to privacy and personal security.

The West is simply finished. It’s best hope is balkanization, in case any regional pockets of common sense remain, though I can’t think of any that are physically and culturally strong enough to withstand the violence to come. Perhaps Switzerland, for a while.

A massive rally is straight out of the 1929 playbook.

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Below is a table of highs, lows and closes from October 23rd to November 14th, 1929, courtesy of Yahoo!. (Unfortunately, their date function is stuck in 1969, so you have to count up from the bottom.)

Key dates:

  • September 2nd. Pre-crash high water mark: Dow 381.
  • October 25th, Black Thursday. From the previous close of 305, down 11% in early trading, a swing into the black, and a close down 2%. (eerily similar to last Friday).
  • October 28th, Black Monday. Down 14.7% intraday, 13.5% at the close.
  • October 29th, Black Tuesday. Down 18.5% intraday, 11.7% at the close.
  • October 30th and 31st: Huge two-day rally, 19%.
  • November 13th: Bottom for 1929: Dow closed at 198, down 48% in 10 weeks. It then rallied to 294 by late April, before declining to 41 by July 5, 1932.

Here’s a visual aid (wider time frame):

Source: sharelynx.com

Look at the rally from the 29th, Black Tuesday, to the 31st: 19% by closing values, and 33% intraday. So far in the Panic of ’08, we are up 11% from the close and 21% intraday from last (Black) Friday.

The rally in ’29 was a wave four bounce within wave three, and it failed spectacularly. I’m not saying this wave four of three bounce will end in exactly the same way, but I think we have yet to see the lows for this fall: