Where are we in the secular (post-2000) bear?

Mish Shedlock’s investment management company, Sitka Pacific, provided this chart in their September letter (as a non-client, I only get delayed copies):


One lesson to be learned here, which they get into in the letter, is that prices bottom before valuation multiples. In the bears of the 1910s, ’29-early 40s and ’66-82, inflation appeared late in the game. BTW, this meshes with Kondratieff theory, where inflation leads to disinflation to deflation then inflation again, with asset values moving in tandem.

So, be prepared to buy in this coming wave down, if we get a nice drop over the next year or so, because select equities could be a nice hard asset to own through the turmoil in the currency and sovereign debt markets, which is likely to spread to the US, UK, Germany and Japan by later this decade.

Deflation explained in two simple charts

The charts below come via Mish’s post today on why it doesn’t matter that Bernanke wants to eliminate bank reserve requirements. The quick answer: Greenspan already did that in 1994 when he allowed overnight sweeps on checking accounts to free them from reserve requirements just like savings accounts. In this era, banks lend first and look for reserves later.

Anyway, way back in 2007 I first became convinced that this would be a deflationary depression because of this simple equation: there was $52 trillion in outstanding debt in the US, and only (at the time) $850 billion in base money (all the “cash” that the Fed had created since it was founded in 1913). As defaults and write-downs started to reduce the amount of debt, the Fed was likely to create new money to bail out banks and monetize deficits. It was plain to see that the difference in scale betwean the two pools, debt and cash, would tip the scales in favor of deflation, along with a shift in attitude towards frugality and a new respect for the value of a dollar.

Well, here we are in 2010, and the Fed has indeed created a fresh $1.2 trillion, but the debt pile has stopped growing over the last year, even taking into account the massive issuance of treasury debt. This chart comes from Karl Denninger:


I suspect that if properly marked to market, the private debt figures (household, business credit and financial instruments) would be considerably lower. There is a lot of pretending going on at banks, since they do not want to take write-downs. How much of that household credit card and mortgage debt will really be paid off?How much of those financial instruments are junk (and even investment-rated) bonds that will be defaulted on in the next few years? How many business loans are in arrears or just barely being made?

On the other side of the equation, here is the base money supply since 1999:


If reserve ratios mattered, wouldn’t debt have at least doubled (or more if you believe in the multiplier effect)? The fact is, nobody who can handle a loan wants one, and nobody who wants one can handle it.

Credit conditions and risk appetite are what drive lending, not reserves. Banks simply don’t hold reserves anymore, which is why bubbles get so out of hand and why they are always a few bad loans away from bankrupcy. If bankers’ asses and depositors’ funds were on the line like in the 1800s, you better believe banks would hold reserves. Depositors would sniff out those that tried to scimp, and take their funds elsewhere, nipping any trouble in the bud. Busts were frequent and localized, and freed up capital for productive hands. That’s why that era produced the greatest improvement in living standards and real GDP growth of 3-4% while prices were steady to falling for decades.


Here’s another chart that shows our state of debt saturation from Nathan’s Economic Edge. GDP no longer grows with debt — this is the point of no-return where interest can no longer be serviced with production, so the whole thing starts to collapse.

Mish in the morning (audio)

Here’s a wide-ranging interview of Mish Shedlock on King World News.

A few take-aways:

Even if the US economy adds a steady 100k jobs a month, unemployment will be flat at 10% indefinitely.

The depression is masked by food stamps, extended unemployment benefits and a million census workers.

The best thing for underwater homeowners is often to just stop paying the mortgage — odds are you can stay in your house for ages while saving up to rent the equivalent for less than the monthly mortgage payment.

Chris Christie of NJ is the only decent governor in the US. He’s cutting spending in a real way, taking on the unions and municipalities and cutting programs.

If consumer spending is really up, sales tax receipts should be up, but they are not, even though many states have raised their rates. Same store sales are only up because stores are closing, driving more business to those that remain. Those that are closed aren’t counted.


There’s much more on Greece, Iceland, unions, pensions and deflation.

Almost every city and state is bankrupt.

Mish has been swamped lately, posting what seems like at least two stories a day about the insolvency and incredible stupidity of state and local governments.

See these stories for examples:

School Crisis in Nevada: Governor Seeks to Cancel Collective Bargaining With Schools Because the State is Broke

Economically Illiterate Quote of the Day 2010-02-03: This Quote Concerns the LA Budget

Neil Barofsky Promises Handcuffs; Police Pay Dispute In Miami; Workers Protest In NM; California Muni Bond Outlook, Other Potpourri

During the boom, as tax receipts increased, it became the norm for state and local governments to inflate their budgets by five, eight or ten percent per year, mainly in the form of guaranteed pay raises and defined benefit retirement plans for goverment workers, as well as excessive hiring for jobs that have no use or would be better left private.

I can’t tell you how many times I’ve read about little towns paying mid six figure salaries for cops who’ve only been on the force for 5-10 years, or 100-200k for firemen or mid-level admininstrators. Even secretaries for city executives often make 80-150k, and most of these people get to retire with guaranteed cushy benefits at a much earlier age than in the private sector.

Many public employees belong to what have become the most powerful unions in the country. Their pull with politicians delivers fat pay raises and insurance benefits that almost nobody else gets these days. It used to be that government jobs were the worst — where the class idiots ended up working, but now it seems like the joke is on the high-achievers, since government unions have become the best racket in town.

The Ponzi is over.

What all of this has lead to is states taking on incredible amounts of debt to cover these costs, while counting on increased tax reciepts forever. Now that the real economy is hurting and taxes are down, governments find themselves struggling pay. They are using all kinds of gimmicks to keep the game running, like accelerated tax payment schedules, higher fees on car registration, public transit, toll roads and the like, and installing more of those Orwellian traffic cameras.  They are also making a big stink about how essential services like schools (better left private anyway), police (too many bullies with war toys), fire (better all-volunteer) and trash pickup (why on earth not fully private?) will be cut unless they pass tax increases.

These threats are all nonsense — governments always cut the stuff that people notice in order to show how important they are to daily life and to trick the public into assenting to taxes, when the real problem is the outlandish pay of the tax-feeders. Think about it: do you get more from your government than 10 years ago? Better roads, more frequent trash pickup, cleaner parks, better schools, safer streets? I doubt it, but I bet your state and local governments are spending twice as much as they were in 2000 (7% spending increases for 10 years doubles the budget).

The gimmicks aren’t going to last. The debt is unpayable unless the federal government covers it (since the feds have a Fed to buy unlimited debt with funny money), and I doubt that this is going to happen. It is just not a priority for the individuals who control Congress and the White House. They need the Treasury’s last bit of credit to keep the wars going, backstop the next round of banking losses, and to keep the unemployment, medical and social security checks flowing (if entitlements are halted, things will get ugly).

Cities can declare bankruptcy, and they have from time to time. States cannot declare bankruptcy, but they can sure default.

Joe Q. Investor is certain that bonds are safe.

This whole situation seems lost on the investing public, which piled into municipal bonds during 2009′s credit binge. After all, stocks are too risky! Municipal and low-quality corporate debt is likely to be one of history’s major crashes, and these markets seem to be rolling over already. Debt investors looked into the abyss in 2008, but in this climate of record complacency, people have forgotten how little is backing up these securitized promises.

This is not an easy sector for retail investors to short, but there are some instruments available. I’m either short or planning to take short positions in the following ETFs: HYD (high-yield munis), JNK (junk corporates) and LQD (investment-grade corporates). This is not a short-term play, but with patience this market should roll over big time.

Here’s a chart (click the image for a larger view):

Source: yahoo! finance


A pure play on wider credit spreads could be made by also going long Treasury debt at durations that match the average in these bonds. IEF is a 7-10 year Treasury ETF, TLT is 20-30 year T-bonds, and of course there are very liquid futures markets in 2, 5, 10 and 30 year Treasuries.

Summer school

There are still a lot of people out there who didn’t absorb last year’s course on the credit cycle, particularly the chapter on inflation and deflation. To remedy this gap in your elementary economic education, before buying resource stocks or saying that any market will go to the moon on Fed-powered rockets, you are required to read this refresher by Mish Shedlock. An except is below:

…there are practical as well as real constraints on what the Fed can and will do. Nearly everyone ignores those constraints in their analysis.

Congress in theory and practice can give away money. Indeed, Congress even does that to a certain extent. Extensions to unemployment insurance, increases in food stamps, and cash for clunkers are prime examples.

However, those are a drop in the bucket compared to the total amount of credit that is blowing up. Take a look at the charts in Fiat World Mathematical Model if you need proof.

The key point is it is the difference between Fed printing and the destruction of credit that matters! As long as credit marked to market blows up faster than handouts and monetary printing increase we will be in deflation. Deflation will not last forever, but it can last a lot longer than most think.

Also ponder this missive from the dean of Deflation U, Robert Prechter:

“The Fed’s balance sheet ballooned from $900 billion just five months ago to more than $2 trillion, by buying outright, or swapping the pristine credit of U.S. Treasury debt for the questionable paper held by troubled banks, brokerages and insurance companies. One of the marketplace’s most strongly held beliefs is that the U.S. dollar is on the verge of an imminent collapse and gold is set to soar because of the Fed’s historic and irresponsible balance sheet expansion… We agree about the irresponsible part, but not about the near-term direction of the dollar and gold. Our forecast is being borne out by the dollar, which has soared straight through the Fed’s most aggressive expansion to date. Just as Conquer the Crash forecasted, the Fed is fighting deflation but, as the book says, ‘Deflation will win, at least initially.’ The reason is that there are way more debt dollars than cash dollars, with about $52 trillion currently in total market credit. As this enormous mountain of debt implodes, it is swamping all efforts to inflate. Of course, the Fed has explicitly stated that it will keep trying. Its initial effort was akin to trying to fill Lake Superior with a garden hose. But $2 trillion still won’t do the trick of stemming a contracting pool of $52 trillion. The only real effect is that taxpayers get hosed. Obviously not all of the $52 trillion is compromised debt, but the collateral underlying this mammoth pool of IOUs is decreasing in value, placing downward pricing pressure on the value of related debt, which won’t show up in the Federal Reserve figures for many months. A reduction in the aggregate value of dollar-denominated debt is deflation, which is now occurring. Eventually the value of credit will contract to a point where it can be sustained by new production. At that point, the U.S. dollar may indeed collapse, as gold soars under the weight of the Fed’s bailout machinations. But deflation must run its course first. In our opinion, it has a long way to go…”

Also consider an oldie from yours truly  (Some Basic Points on Inflation and Deflation):

#1 The business cycle is the credit cycle.

#2 Inflation is a net increase in money and credit, not just prices (mainstream opinion) and not just money (common misconception among contrarians).

#3 Deflation is a net decrease in money and credit.

#4 There cannot be both inflation and deflation at once.

#5 The central bank and the government bring about inflation by absolving banks of the responsibility for their actions. 9:1 fractional reserve lending would not be rewarded in a free market devoid of FDIC insurance and a central bank to print the money to pay for it and other bailouts for bankers.

#6 Price increases themselves are not inflation. If you have a fixed expense budget and your grocery and energy bill goes from $500 to $700, you must cut back $200 somewhere else (for instance, many are deciding to forgo eating out).

For points 7-11, click here

Also see, Why Bailouts will Not Stop the Depression

Want to fight the bailout? Check in with Mish.

Not all libertarians are as cynical* as I am. Like giving money to Ron Paul’s campaign (which I did, because it was always about the message, not winning), fighting the bailout may be futile in the end, but at least you can look back and say that you made the effort.

Mish is on top of a massive campaign to do the right thing, with resources and guidance for contacting congresscritters, many of whom are reporting that this is the biggest public response that they have ever seen. If you are of a mind to make some noise, head over there.

Mish has drawn up an open letter to Congress with suggestions for removing some of the road blocks that government has placed in way of the market, which would allow our financial system to right itself with no handouts. Passing such a bill would be the most sensible thing Congress has ever done.

Also consider pointing your Congressional ‘representatives’ to Fund manager John Hussman’s plan, which involves more government involvement (so it stands a better chance with Congress than Mish’s, since it gives them something to do, not undo), but is far more sensible than the Paulson plan.


*My own belief is that educating yourself and others about fractional reserve banking and other scams, while protecting your own assets or even making money on the short side, is good for everyone. It leaves more capital in sane hands and preserves knowledge that can be redeployed at home or elsewhere, whether in the coming years or many decades from now. That’s not cynicism, but realistic hope. Civilization will flourish again, sometime, somewhere, hopefully on earth, hopefully among humans, and hopefully in my lifetime.

Trading note: I’m not buying the anti-dollar rally.

Crash Proof vs. Conquer the Crash

I was thrilled to see Peter Schiff on Bloomberg TV this afternoon, since I knew he’d be all fired up and really let loose on the bailout. I was not disappointed, as he advised Americans to get all of their assets out of the country, and, maybe in a slip, ended by saying “get out of America.” He and I couldn’t agree more on politics (Ron Paul) and about the future of the land that used to be America — currency failure, war, Fascism, and all-around ugliness — and I used to basically believe his investment thesis (get out of the dollar ASAP!) until Mish and Prechter’s more nuanced analyses won me over to the deflation first then inflation camp about 12 months ago.

The crux of the matter is the difference in scale and pace between the Market’s deflation and the government’s inflation, and fact that the bankers’ credit inflation machine is broken.

Dollar carry trade still unwinding.

I turned bullish on the dollar vs the euro and pound a few months ago, and have been short-term bearish on oil, gold and other commodities since this spring. Shorting oil and gold last June was as contrarian as you can get — that is, contrary to the contrarians, since their views on a dollar flameout had become mainstream (see Mainstream Contrarianism Crushed).

Since then, commodities have tanked across the board as America’s script made a huge breakout rally against everything on the other side of the dollar carry trade. After a move like that, you have to expect some retracement, and that is what we have been getting for the last few trading days, as oil, gold and the Euro have each made up roughly half of their losses against the dollar.

Play it again, Bob.

I am still going against the grain here and using this as another chance to make the very same play. Anti-dollar sentiment feels almost as strong as this spring, as you would expect on the news that hundreds of billions to trillions more of our government’s notes to pay nothing will be issued to finance this bankers’ coup. The reason for my position is partly trading psychology (the WSJ reports that “Large speculators were net short more than 40,000 contracts in the euro and 49,000 contracts in the British pound, the most negative they’ve been on those currencies in the last 52 weeks”) and partly the fact that the carry trade has a lot further to unwind, since dollars were being handed out in buckets for so long against so many asset classes. He who sells what isn’t his’n must buy it back or go to prison, and there are still buckets and buckets of dollar debt out there that must be repaid or go to money heaven. Either way, it increases the value of the surviving dollars as people desperately need them to pay off debt and keep the lights on.

The US government will have the strength to enforce its legal tender laws for some time to come, if it can do nothing else, so the dollar will still be good for all debts public and private. And now that people are going broke left and right (broke means no money), those who still have some dollars safe in Treasuries or mattresses will find that they can get more and more for them, commodities included, at least through this initial phase of the depression.

Gold: don’t leave home without it.

The speed and magnitude of the bailout at this early stage of the depression is surprising, even though nothing about the substance of Paulson’s (and by Paulson, I mean the cabal that he represents) actions surprises me in the least. It will be interesting to see if these programs can speed us through deflation in a year or two, rather than the two to five years I had been assuming (Japan’s deflation lasted nearly a decade, but they were not as hell-bent on destroying their currency as Paulson and Bernanke are ours). At any rate, when the next inflation comes, it is the big one, so I would not want to risk being completely without hard assets at any time from now on.

Disclaimer — I have no idea how, if at all, Prechter and Mish are playing the dollar and commodities or anything right now, so just because I cite their ideas here don’t assume mine are in sync with theirs. And, as always, don’t trade like me! Don’t trade at all! It’s too dangerous out there. I’m not an investment advisor, and I may have long or short positions in any of the securities, commodities or currencies mentioned on this site. See disclaimer page.

Real interest rates are positive

Strong Incentive to Save

Mish knocks it out of the park with this one. Not only are inflation-adjusted rates positive, they are actually above average on a historical basis, and with stocks and other risky assets tanking (see charts below), there is a very strong incentive to save money in Treasuries.

Home prices are crashing and those prices are not adequately reflected in the CPI. Instead, the single largest component of the CPI is “Owners Equivalent Rent“. OER is a process in which the BEA estimates what it would cost if owners were to rent the homes they own from themselves. I do not believe this to be a valid construct of prices.

By ignoring housing prices, the CPI massively understated inflation for years. The CPI is massively overstating inflation now.

In normal times with rents in sync with home prices, it did not matter much if one used OER or actual home prices. It’s a remarkably different story now. We have just seen the biggest housing bubble in the history of the world. At the peak of insanity, home prices were 3 standard deviations above rental prices and 3 standard deviation above wage growth.

Now, the important factor is that home prices are crashing, with quite a big drop still needed to get back to historic norms. With that in mind, housing can be expected to be weak for quite some times.

The treasury market seems to have figured all this out quite nicely. Pundits screaming “treasury bubble” clearly have not.

Case-Shiller vs. Owners Equivalent Rent

Case-Shiller shows that home prices have declined 15.4% over the past year. Currently, OER is the largest component of the CPI at nearly 24%.

A CS-adjustment (substituting Case-Shiller for OER in the CPI) would knock 3.7% off the CPI (15.4 * .24).

We must also take into account the reported OER was +2.6 vs. a year ago. It’s affect on the CPI is (2.6 * .24) or .624 of the reported 5.6%. Rounding to the nearest tenth, another .6 needs to be subtracted from the adjusted CPI. (5.6 – 3.7 – .6 = 1.3)

This would make the CS-CPI +1.3% instead of the reported 5.6%

Prices are a Trailing Indicator of Credit Expansion (aka Inflation).

As Mish always explains, CPI looks in the rear view mirror, not out the windshield, so let’s look back for a minute. What has driven up the price of housing, education, clothes, food, entertainment and travel? The quick answer is credit, easy credit extended by an inherently corrupt banking system. Bankers had been bailed out so many times that they finally lost all sense of decency and respect for lending standards. That easy credit made people feel rich, in no small part because it inflated investment assets, so people weren’t worried about higher grocery prices.

Now that credit is unavailable and investments are crashing, suddenly $4 bread feels a little excessive. If credit is the fuel for price increases, and investment assets lead the way, then the outlook for lower consumer prices is very good. Let’s gaze out the windshield and see how good:

We know what the mortgage market looks like, but here’s total bank credit (roughly $9.5 trillion):

Source: St. Louis Fed

Ok, other than the sharpness with which credit stopped expanding last year, this doesn’t look like much yet, but credit has gone flat after the greatest rise in history. And actually, the reason why bank credit is flat and not down since mid-2007 is that companies have been frantically drawing down existing credit lines and stuffing the cash in the money market (why M3 soared), since they know they’re going to need it and rightly suspect that those lines will soon be withdrawn.

Credit is Withdrawn, Asset Prices Fall

Real estate is ultra-sensitive to credit, so it was the first sector to turn, back in 2006:

Source: Standard & Poors

Stocks of course turned last year, and now commodities have turned:

Source: Bloomberg

That includes the grains…

(All grain charts from the Chicago Board of Trade)

…and the metals. We all know gold and silver are down, but here’s a peek at the base metal index from Kitco. Party’s over:

Treasury Rally is No Conundrum

So, where’s an investor to hide? My advise is to invest in the future: stop investing.

That’s what Treasury buyers are doing. Treasuries are set to continue their bull market, and I bet they will make a rally for the history books in the next 12 months. Here’s the 30-year:

Source: Chicago Board of Trade


Don’t trash cash. It’s the new, new thing.