GOLD IS MONEY PART 1

I wasn't intending to write this topic for several months, as I was planning to wait for my entry point for buying gold and silver, but events of the past several weeks have convinced me otherwise. With this entry I want to clarify my position on owning the precious metals and lay out my strategy for the long-term.

First off, let me start by saying that ALL predictions around the timing and price of commodities or any other asset class need to be taken with a big grain of salt. Regardless of the relentless descent of the economic fundamentals that we are now witnessing, financial markets will do what they do, which is to rise sharply, fall sharply, meander sideways and otherwise move in such a way as to confuse and torture as many investors as possible. The market is a casino, if you stay at the table long enough, eventually the house will get its money back.

That said, I believe, based on my deflation thesis, that there will be an entry point for gold and silver that is significantly lower than these current levels, and I am willing to play my hand that way. From the 2001 low of ~$250 to the recent high of $1000+ dollars, gold has risen 300% in what I believe is the "first wave" in a long-term secular move. Furthermore, based on the chart pattern and Elliot Wave analysis, I believe that we will see a deep pullback to roughly $500 per ounce (+- $50), which would be a 62% Fibonacci retracement.

I know, there are many who believe that gold is a "safe haven" and therefore will continue to rise, as the world stock markets fall. However, that common belief is also predicated on the view that the U.S. dollar will continue to sink inexorably into oblivion. In a deflationary environment, however, there will be a shortage of U.S. dollars and the dollar (beyond all expectations) will rally. Also, contrary to the "safe haven" theory, when global stock markets sold off hard into their January panic lows, gold fell in synch with the stock market. Therefore, one must surmise that this rally in gold is just another product of the credit bubble and the overall rise of all commodities. Once the commodity bubble bursts, gold will come down with everything else.

There is a somewhat risky assumption built into my prediction however, and that is in assuming foreign creditors will continue to sponsor the U.S. debt ponzi well into a deflationary downturn. If they don't, and there are reasons to believe they may not, then the U.S. dollar would collapse and gold would soar. Back in October, the Chinese raised the specter of using the "nuclear" option of selling off their U.S. dollar holdings. At the time, they were obviously just playing political games, but if they do eventually liquidate their U.S. holdings, then the only safe place in this country will be a bunker in Montana with 10 years worth of food and 100,000 rounds of ammunition.

Which gets us back to the title of my post, that in the long run gold is the only true money. They say money doesn't grow on trees, but in fact it does. Paper comes from trees and therefore there is literally an endless supply of "money". Paper currency has no intrinsic value; it has only notional value, based on the faith and trust people have in the Government issuing it. Once that faith and trust is lost, the value of paper currency will be lower than 4-ply toilet roll, and gold could easily be at $4000 an ounce (bread will likely be over $8 per loaf - maybe we should stockpile bread...).

How do I reconcile my short-term belief that gold is not currently a "safe haven" vs. my long-term belief that gold is the only money worth owning? Easy, based on the fact that most people still have faith in the U.S. dollar as their primary currency. Trying to determine when widespread recognition of the fallacy of this faith occurs, is obviously difficult to predict. For my part, as indicated above, I will trust the technical (chart-based) road map for determining my entry point for gold, unless I see something event-driven that changes my mind - which could occur at any time...

To be continued...

No ROI (Return on Intelligence)

One of the most difficult aspects of living in this current era is the debasement of intelligent thinking. As I have indicated, below, we are deeply entrenched in the DISINFORMATION age, which brings with it all manner of deception, dishonesty, and anti-intellectualism. As the financial crisis unfolds, the public's desire for "simple" answers will only increase, and intelligent "grey area" debate will give way to "black or white" George Bush-style uninformed posturing. Further exacerbating the problem will be the mass media's relentless decline into the abyss of ignorance e.g. "Reality TV", "Fox (Faux) News"; a race for the bottom with the ever-descending lowest common denominator. As people's optimism for the future fades, they will "tune in" and "tune out" in ever-increasing numbers.

Due to the triumph of the marketing-based pseudo-economy over the engineering-based economy, the premium on intelligence has basically disappeared. Not too long ago being intelligent and increasing one's knowledge was an edge in work and in private life. Reading books other than those written by Danielle Steele and Michael (pseudo-scientist) Crichton, was considered a worthwhile use of time. Under the "marketing based" economy however, those rules have changed, and intelligence is now deeply discounted to the point of having a negative return on investment. What edge can intelligence have, when there is no one around to understand what the hell you are saying? Actually, I think there are plenty of smart people still around, but how can meaningful discourse compete with Britney Spears' latest escapades? I may sound like a snob to say all of these things, but I for one miss the kind of straight talking, critical thinking that made the United States a strong nation in the first place.

It begs the critical question: What will come back first - a strong economy based on sustainable fundamentals OR the premium on intelligence that promotes R&D, and enables competition with the rest of the world? I submit that it will be impossible to achieve the former, without the latter.

Return on Intelligence (ROI), Rest in Peace...

China Leading The Way...Down

Overnight the Shanghai Composite broke down 5% to a new multi-month low of 3411. This puts the index 44% off of its peak reached last October.

On a percentage basis, the Chinese stock market has lost considerably more value than either the U.S. or European stock markets. Granted, the Chinese market far outperformed those other markets in the past 5 years, however, the parabolic path of the Chinese stock market (up and down) is eerily similiar to that of the Nasdaq circa 2000-2002.

It was just over one year ago (February 2007), when the global markets had a mini-crash in reaction to the Shanghai Composite losing 10% in two days. That turned out to be a non-event, as the Shanghai Composite went on to more than double in value in the ensuing 9 months.

Therefore, it's very interesting that the Shanghai Composite has now shed 44% from peak to trough, and yet this time, there has been very little commentary on this fact...After all, we've been told time and again that the Asian markets have "decoupled" from the U.S. economy and therefore won't be affected by the U.S. slowdown.

The fact that the Chinese stock market is underperforming the U.S. stock market tells me that someone of intelligence out there understands that the Chinese economy is highly leveraged to the U.S. economy, and that the path of least resistance for both markets is down...

MORAL FAILURE

So far I have explained at length the various economic root causes for this historic economic breakdown that we are witnessing, many of which are due to the mismanagement of the United States' economy.

Beyond the relative decline of one country however, the current "Globalized" economy was doomed to fail regardless, as much from MORAL failure as economic failure.

From a moral standpoint, the vast majority of people on this planet do not get paid under the current "pyramid" model, nor do they stand any reasonable chance of ever getting paid. One of the central tenets of a successful Ponzi Scheme is that the people at the bottom of the pyramid must absolutely hold faith that they too will one day attain an improved lifestyle. This is why trade barriers have been falling around the world, as country after country has put its faith in the globalized pyramid scheme.

Unfortunately, as we are now witnessing in real-time, the Westernized lifestyle is not SUSTAINABLE, to say nothing of being SCALABLE. The model is not sustainable because it is massively resource intensive i.e. 5% of the World's population (U.S.) use roughly 25% of the current output of natural resources. Simple mathematics indicates that this model can only be maintained if U.S. incomes rise as fast or faster than prices of natural resources. With the explosion of commodity prices in the past several years (e.g. oil has increased 1000% since 1998), this is clearly not the case.

If the model cannot be sustained across the current base of consumers in North America and Europe, then the scalability of this model is not even remotely possible, as the 5%/25% figures above make it mathematically impossible for the majority on this planet (or even a decent sized minority) to ever achieve a Westernized consumption-oriented lifestyle.

Once the leaders of the various developing countries around the world actually wake up to this most obvious fact, then the trade barriers will go back up and the global Ponzi will be officially over - for good.

Where does that leave the world economy? It means for one thing that the race is on to find the next great source of energy, as it's not possible for oil to be the same enabler of growth in the next century that it was in the past century. In fact, those economies rigidly tied to the use of fossil fuels, will inevitably experience sub-optimal growth. More importantly, however, for developing and developed nations alike, there will be a forced migration to an entirely new economic model and away from the Westernized lifestyle. Some of the key aspects of this new economic model will be (among others):

- Reduced resource footprint / end of the mass consumption based life style
- Quality of goods over quantity. Renewed emphasis on reusability and repairability
- Shared services: public transportation; rent vs. own etc.
- Focus on quality of life vs. wealth and material aggregation
- Focus on community life over individualistic lifestyles
- Reduced role and size of Government

Needless to say, for those in the developing world who already practice most of the habits described above, the adjustment will be relatively easy. For those in the developed world, the adjustment will be wrenching, difficult, AND LONG OVERDUE.

PONZI ECONOMICS

According to Tim Ferris, author of "The 4-Hour Workweek", thanks to overseas (aka. sweat shop) outsourcing (my adjective, not his), the profit margins for a typical direct sale product are > 50%. In addition, up front investment costs are minimal (as low as $1,000 - $2,000) and all other costs are variable (based on number of units sold), which makes the model infinitely scalable. For a successful product, that makes the potential return on investment practically infinite, while the downside risk is minimal. As good as that all sounds, one look at the numbers explains who gets paid according to this new model, and who does not:

From page 186: Splitting the Pie: Outsourcer Economics

Revenue (per unit sale price): $92.25

Expenses:

Product Manufacturing: $10
Call Center: $3.32
Shipping: $5.80
Fulfillment: $2.35
Credit Card Fees: $8.14 (includes returns, bad credit etc.)
Royalties: $2.40

Total Expenses: $32.01

Profit: $60.94

NOTE: this does not include advertising costs, which vary depending on the method used. In the Pay-per-click internet model, advertising costs would also be variable.

Key observations about this model:

1) Net profit is phenomenal at 66%

2) The cost of the product itself is only $10. This includes all of the raw materials to manufacture, the cost of labour, all plant-related fixed costs and the manufacturer's profit.

3) Even if Labour is 50% of the $10 (i.e. $5), the cost of labour could double and still not materially impact the final NET profit margin. However, due to hyper (read: destructive) competition among overseas manufacturer's, neither the labourer nor the outsource manufacturer has any pricing power to raise the $10 price.

4) The numbers above explain how S&P 500 profits have increased by double digit percentages each of the past several years. Traditionally, the only way to increase profit margins was to increase productivity (output per employee), either by improved technology/automation or more efficient processes. A big chunk of that $60 profit used to go into the pocket of American workers. Under the outsource model the American 'Consumer' still pays the same final price and the entire increase in margin accrues to the owner.

Since it's abundantly clear who DOES get paid in this model, let's consider who doesn't get paid in this model:

1) The foreign worker making 50 cents per hour, 70 hours per week

2) The American manufacturing worker who now wears an orange bib and makes $8/hour at Home Depot (oh right, he just lost that job too thanks to the declining housing market...)

3) The environment, since there is no room in this model for any type of sustainable environmental practices

The last takeaway I would make is that of all of the costs above, the only piece that isn't already at rock bottom is the profit margin itself. There are many optimists saying that the stock market can't fall, because P/E ratios are at reasonable levels; however, as the above model shows, the market is priced off of historically inflated and unsustainable profit margins. As the economy slows, the first thing that will come down (indeed, the only thing with room to come down) are these generous profit margins - fortunately (or unfortunately, depending on how you look at it) there is a very long way to fall...

MELTDOWN

We are on the verge of the long awaited financial meltdown. Here is roughly how I see things playing out from here:

1) Stock market tanks (Timing: One day to 3 months, most likely 1-6 weeks): the market has been in denial for a long time, but time is running out ...

- The stock market is the key as it directly represents investor/consumer confidence - once it goes, everything else will collapse like dominoes

Strategy: Cash and/or Index puts

2) Credit market seizure (Timing: One day to 3 months, most likely 1-6 weeks in conjunction with stock market tanking): The credit crisis has been slowly spreading and panic has been contained. I expect things to come unglued very soon...

3) Fed Panics and Drops Rates to Near Zero (Timing: One day to 3 months, in conjunction with credit/stock market tanking)

Strategy: Avoid exotic derivatives (due to counter-party risk). Avoid long-term Treasuries, Corporates or Munis

4) Commodity Market collapse (Timing: One day to 3 months, most likely 1-6 weeks in conjunction with stock market tanking): The commodity market has been the last refuge for investors. I expect that last leg of the stool to be kicked out any day now

Strategy: Stay out of the way

5) Liquidity Trap (Timing: 6 months to 12 months, in conjunction with Fed panic)

6) Widespread Bank Failures (Timing: 1 month to 18 months). Once the credit market goes into seizure, the crisis will soon spread to the banks. People will be SHOCKED AND AMAZED at how fast banks will close...

Strategy: Hold $10k - $20k in hard cash. All other cash funds only in FDIC insured deposits (no more than $100k at any one bank)

7) Massive Layoffs (Timing: Now for next 2 years). Today's job report was worst in five years (100k jobs lost in private sector). It's all downhill from here...

8) Real Economy Collapses (Timing: 3 months for next several years).

9) Deflation takes hold (Timing: 3 months for next ~2 years). Asset prices and goods and services prices deflate

10) Government Gets Desperate (Timing: 1 - 2 years)

Strategy: BUY GOLD (bullion, coins, futures, CEF, GLD etc...)

11) Hyperinflation (Timing: 2 to 5 years - hard to predict)

Strategy: BUY MORE GOLD (bullion, coins, futures, CEF, GLD etc...)

12) Crime and Anarchy (Timing: Now for the foreseeable future): Crime rates are already starting to tick up...

Strategy: TBD...

Filet Mignon

In earlier posts I made mention of the fact that traders have been selling puts into each decline. That seems to me to be risking dollars to make nickels. Above is a snapshot of the Shaeffer's Open Interest (put/call) Ratio for QQQQ which shows this ratio is at it's lowest level in the past year. The current SOIR is 1.25 and the 1 year rank is 1% meaning that 99% of the time the ratio has been higher. On the 2 year chart the SOIR ratio is in blue.

Selling puts into a decline is risky business. Essentially you are providing downside risk insurance to other investors (and/or removing your hedges) on the premise that there won't be continued downside.

For the past 4 years this strategy has been working great, but it's one of those things that works great until that one day when it blows up in your face. It's kind of like eating Filet Mignon every day - it's a great idea for a long time and then all of a sudden comes that heart attack...

The Boy Who Cried Black Swan

The concept of the "Black Swan Event" was introduced in Nassim Taleb's book, "Fooled By Randomness". Borrowing from Wikipedia, the definition of a Black Swan event, is a "large-impact, hard to predict and rare event beyond the realm of normal expectations".

The term "Black Swan" is intended to indicate something rare, as in the occurrence of black swans in nature.

While it's easy to agree that such events occur, I do not agree with all of Taleb's conclusions regarding these events. One of his key assertions in the book is that the markets are random (why not, the text books say so) and all trading success in the markets can be ascribed to luck - that is of course except his own proprietary trading system. (As an aside if you are thinking of reading his book, this guy has the ego the size of the Grand Canyon, which makes it a difficult read).

His key point regarding Black Swan events, is that any trading strategy that works today or even for a few years, will eventually be wiped out a by a Black Swan event, because these, after all, are "unforeseen events".

My problem with this theory is that I don't believe Black Swan events are all that rare. Apparently the Asian currency crisis in 1987, the LTCM debacle in 1998, and 9/11, are all examples of Black Swan events. And yes, these financial crises all had different and unpredictable causes, but the outcomes were all relatively similar: the markets - stocks, commodities, risky bonds etc. all declined in unison, while "safe" treasuries rallied. If you tell me that a major selloff can happen three times in 5 years, then I probably should have a contingency plan to deal with such an occasion. The fact that millions of traders have survived all three of these recent events, tells me there is something wrong with his wipe out theory.

In addition, in order to define something as "rare" you need to have a time frame in mind, otherwise the use of the term could be completely erroneous. For example, on a day-to-day basis, a currency crisis is very rare, but over the course of a century, currency crises are relatively common occurrences.

Why waste my time or worse yet your time with all this? Simply because I know weeks or months from now, Taleb will be doing the talk show circuit telling everyone that this current crisis is a "Black Swan" event. There is no way it could have been predicted. Those (like me) who say they predicted it, are statistical anomalies - lucky fools. Unfortunately for Taleb, his theory cannot be proven. It is academic bullsh*t, no different than saying that a pro baseball player who hits home runs every night is a statistical anomaly - skill plays no role. I get it that Depressions don't happen everyday, however, from a historical perspective, they are not uncommon. There is no Great Power in the history of this planet that has ever borrowed its way to prosperity, and the United States won't be the first. Yes, trying to time the exact timing and sequence of the decline is/will be difficult, but the outcome is still inevitable.

For anyone to say that the current credit/economic fiasco was impossible to predict is like me quitting my job, maxing out my credit cards, mortgaging my house and then saying bankruptcy came out of nowhere.

My advice to Taleb is to put down his Monte Carlo simulator and pick up a copy of Paul Kennedy's Rise and Fall of the Great Powers, which is a must read for anyone who wants to put current events into historical context. From this book it is apparent that "Black Swan Events" are not very uncommon at all i.e. what the United States is experiencing now (competitive decline, depletion of the treasury, financial engineering, hubris, strategic overreach, energy shortage) has occurred to many other "Great" nations over the past 500 years.

The Boy Who Cried Wolf...
Which brings me to my other key point, that there is a line of specious reasoning making its rounds in the Mainstream Media which is the notion that something that hasn't happened so far, can't happen. After all, we've had debt and deficits for 30 years, no? We've survived the S&L crisis, the 1997 crisis, 1998 LTCM crisis, 9/11, so why should this time be any different? Those "perma-bears" have been crying doom and gloom for years now!

This line of reasoning is so specious that it falls strictly under the category of DISINFORMATION. It brings to mind the chain smoker who smokes for 20 years and thinks that he is invincible. Let me put a question back to these same cheerleaders: If massive debt and deficits are such a good idea, then why stop at giving out $1200 stimulus checks? Why not make it $60,000 per family - how about $6,000,000? Oh right, that's just crazy talk. Everyone knows that $1200 is the optimal amount...

One last thought for those who lump all bearish forecasters together as "perma-bears" and "stopped watches" in order to deride the messenger and ignore the message. The fact that the "Boy" was early in his forecast did not affect the outcome. In the end the boy was right: The wolf came, and it ate everything...