Saturday, November 27, 2010

Point of no Return

This week's edition of the The Economist featured an article on Japan and its demographic (ageing) crisis.

Voodoo Economics
Not surprisingly, the article missed out on by far the most important point regarding Japan and a key point that is instructive for all nations currently running deficits.  The point is that once a country starts running structural deficits to fund operating expenditures, it soon becomes mathematically and politically impossible to ever pay off the debt.  Economists like to point to the ability of countries to "out grow" their debt and deficits via Supply Side Economics.  A third grader is smart enough not to believe such a load of rubbish, but not so today's average economist/politician/bankster.

One can easily construct a financial model to indicate the impact to the Japanese economy were it to even attempt to start paying down its debt.

 - Current Federal debt at 200% of GDP (which it is)
 - Average Duration of debt: 30 years (this is a VERY generous assumption)
 - Average interest rate on debt: 1% (The rate on JGBs fluctuates, but is currently very low)

Now we see why it was so easy to ignore this problem in Japan for so long.  With interest rates at 1%, the conventional wisdom is that "Debt Service Costs" are extremely low, so there is no harm in taking on more debt.  Unfortunately for the purveyors of this "load", there is more to debt service than simply the current interest i.e. principal.

Plug the above figures into Excel and now assume that all of this debt needs to be paid off in 30 years time.  In this model, we are solving for the Payment (a blend of principle + interest) i.e. the true debt service cost and the one that would have saved "The Economist" from devoting a lengthly article to evading the simple truth.

Over 30 years, as a percent of GDP, the payment is: 8%  !!!

Wait, it gets worse.  Obviously in order to pay down debt, a country needs to first stop accruing new debt i.e. first eliminate the annual recurring deficit.  Japan's fiscal deficit for 2010?  10%

The Bottom Line for Japan:
In order for Japan to START paying down its current level of debt over a 30 year period it would have to incur a 16% hit to GDP immediately and that figure will only grow into the future.  (NOTE: 2% of GDP is interest and already included in the deficit).

U.S. Example:
Variables for the U.S.:
 - Current Federal debt at 100% of GDP 
 - Average Duration of debt: 20 years (average duration is currently 5 years, so this is very generous)
 - Average interest rate on debt: 3% 
 - Current annualized deficit for 2010: 10%

Level of GDP that would be removed by paying off debt over 20 years:
[Ongoing debt service cost, amortized over 20 years: 6.7% of GDP] 
Including 10% Deficit: ~14% (after taking out the 3% interest due to double-counting) 

Keep in mind, both countries are applying unprecedented fiscal and monetary stimulus at this juncture and yet there is minimal growth in either country i.e. no sign whatsoever that either country could possibly remove the bulk of stimulus while at same time maintaining a positive economic growth rate MUCH LESS pay down a $1 of debt.

Definition of Recession is Totally Bogus
Officially, according to NBER, the U.S. is out of recession, and has been since June 2009.  Of course, that is totally bogus because the "official" definition of recession does not take into account fiscal deficits, so it is meaningless.  Whether, the deficit was at 0% or 10% of GDP (as it is now), the U.S. would still be deemed to be out of recession.  Currently, as I write, GDP growth is running at ~2% year over year, so in reality, the true economy is running at a negative 8%.  When a country can borrow 10% of its GDP and then declare that the economy is "growing" at 2%, that's the trifecta - bad math, denialism and stupidity all rolled into one.

Legacy of the Baby Boomers
That 14% represents the hole in the economy left behind by the most greed-addled, self-indulgent generation in world history.  Not only are the Boomers spending the wealth inherited from their parents, they've underfunded and raided their own 401k retirement funds, bankrupted Medicare and Social Security, and on top of all that left A GAPING 14% SMOKING CRATER where the economy used to be, for their children and grandchildren to inherit.

As I have said before, GAME OVER, MAN.  We just need Wall Street and the morons with the fancy degrees to wake up and smell the fucking napalm.

Saturday, November 20, 2010

Roadmap for Collapse Part II

In the first installment of the Roadmap, I discussed the market implications of the collapse.  With this installment, I gaze further into the abyss to discuss the potential economic outcomes of the collapse.   For this purpose, I created the hypothetical decision model (below).

As you see, I divided the map into three main areas: reflation (economic normalcy), deflation (price, asset, economic), hyperinflation (mainly price).

As far as assumptions, I suppose the fundamental assumption is that without Government stimulus (fiscal/monetary) the economy is not self-sustaining and therefore would quickly succumb to the deflationary forces of the total debt burden.

Therefore, the pollyanna scenario of a self-sustaining economy without ongoing fiscal and monetary intervention is not represented in this model, and I assume anyone reading this blog in the first place, gets that.  

Most likely scenario: Deflation then Hyperinflation
As depicted by the blue lines and as described vividly throughout my posts, I expect another even stronger market event than the one we experienced in 2008, which would be extremely deflationary.  Those who believe it would not be deflationary, forget that both oil and gold tanked during the turmoil two years ago.  Where I indicate that a policy is "blocked", I mean politically blocked.  Given the newly elected Republican-dominated Congress, the likelihood of either the Gov't or the Fed continuing to add "stimulus" unfettered, is highly unlikely.

As you see, I have represented a "Default" scenario under which the U.S. Gov't repudiates its debts, as a potential scenario, given the new political backdrop - a scenario I thought highly unlikely until recently.  I still think that an outright default is unlikely, making the "middle scenario" of MASSIVE fiscal stimulus combined with massive monetization, essentially devolving into de facto currency printing (via FDIC payouts, stimulus checks etc.), as the most likely scenario.

Less likely scenario: "Status Quo", leading directly to Hyperinflation
This is a very popular scenario these days, causing the big run up in gold.  In order to believe this chain of events, you must make certain unlikely assumptions:
1) Assumes no adverse market "event" similar to 2008, which as indicated was extremely deflationary
2) Assumes that an inevitable backup in interest rates, would itself not cause the economy to stall and the markets to collapse
3) Assumes there would be no political intervention in the current stimulus trajectory and that fiscal and monetary stimulus would continue unfettered (seems very unlikely)

Pollyanna (impossible) scenario: Self-sustaining economy and removal of all stimulus
This scenario is extremely unlikely, given:
1) Overall magnitude of Government stimulus, now baselined into GDP
2) No sign of sustainable economic growth, especially in a low/no leverage environment
3) Massive outsourcing which has caused long-term secular unemployment and removed entire industries and skillsets from the U.S. economy i.e. the unemployed have skills that are no longer in demand in the U.S.
4) Massive debt overhang that will continue to put deflationary pressure on the economy
5) Unresolved Social Security and Medicare deficits

Threading the Needle->All paths lead to hyperinflation...Eventually
While, as indicated in the model, all paths lead to hyperinflation, it could take some time to get there.  Keep in mind, there are a whole lot (most) of other countries that will go bust before the U.S., which in the "short-term " will increase deflationary pressures and demand for U.S. dollars as a safe haven.  Any country that does not issue debt in its own currency (i.e. entire Euro area and Eastern Europe) will highly likely default.
A U.S. default, were it to eventually occur would "collapse" the U.S. dollar - relative to what, is the question i.e. other currencies would be similarly debased.  Relative to gold and silver is the likely answer.  Inevitably, what is left of the already-weakened banking system would be obliterated.  That part of the economy supported by borrowing and lending would be gone, along with a substantial negative economic multiplier.  Residual private debts and fixed contracts would be a crushing weight on the economy and likely lead to the "Weimar" scenario of printing currency to eliminate the residual debt burden.  I do not believe any Government on the planet has the will power to keep from printing its way out of a deflationary depression on the order of magnitude we will face, while confronting mass social unrest on an unprecedented scale.
Printing and distributing enough physical currency to even partially offset the amount of derivative "money" in the credit-based system, will not be a trivial ordeal...As one would expect in our Fractional Reserve Banking Model, physical currency currently represents only about 10% of the total "money supply" (M3).  So imagine a world where (even temporarily) the majority of money in circulation, is eliminated  i.e. a cash-only economy - the Euro too, long since having been abandoned.  In this scenario, inflation would build over time, likely very slowly initially and then accelerating.

Timing is Everything
All of this is highly speculative, as the scale of monetary collapse described above will be unprecedented and accompanied by substantial geopolitical strife and domestic anarchy.  Sequence is hard enough, timing is impossible to predict accurately, however, I see the overall scale of the model below in the 3-5 year range, perhaps ten years maximum.  Some things will likely occur faster than expected, whereas other phases will likely drag out much longer than expected.

Invest at your Own Risk
Therefore, given all of the potential paths and scenarios, it's not at all clear how one would successfully navigate a crisis of this magnitude.  Surely some amount of hard cash, gold, rice and ammunition is in order.  For the time being, I still like U.S. Treasuries (all durations) here.  I would also view a (large) pullback in gold as an initial buying opportunity with the goal of scaling in to a substantial position eventually...

For those in Canada, I like 3+ year duration Government of Canada bonds, which you can buy through a brokerage account (NOT Canada Savings Bonds, which are totally illiquid - can't be traded).

Friday, November 19, 2010

Waiting for Godot, in the Pet Sematary

"Clowns to the left, and jokers to the right...Stuck in the Middle with you"- Stealers Wheel

Ho Hum, just another week in the markets:

- Just another European economy on the brink of insolvency 
- Just another brawl between Central Bankers regarding Mercantilist policies
- Yet again, the same fucktard Fed, excoriating U.S. Gov't deficits, while at the same time financing these deficits by printing more U.S. dollars.  That is like a crack dealer telling his customer he has a drug problem.
- The Chinese angry at the U.S. over the fact that inflation is running between 4-10% (depending on who you believe), yet continuing to peg the Yuan to the U.S. dollar to ensure ongoing trade imbalances (guaranteeing inflation).
- And note the accompanying asinine comment from Faber, telling us that the underlying issue is [beleaguered] American consumers borrowing too much, even as their jobs and incomes are systematically being eliminated i.e. nothing to do with China's currency policy !

I could not make up this much self-contradicting stupidity if I sat down for hours and tried...
Overall, on the "left", we have the usual Tools and Fools trying to propagate the illusion of recovery via yet another Fed prop, QE2.  We have had umpteen Fed actions these past few years now: interest rates at 0%, monetization of mortgage debt (MBS), no less than three rounds of monetizing public debt - QE1 was round 1, then the Fed started rolling MBS security repayments into Treasuries starting this past August, now another $600 billion just in time for Wall Street bonus season, what a coincidence!  Nothing but desperate fools thinking that more cheap money can solve a debt problem brought on by cheap money.  Let's see, if we can only make crack cocaine cheaper, then we could solve the drug problem...that's the ticket !!!  Anyone who defends Monetary policy at this point is an Intellectually bankrupt jackass .  Book smart morons, indicative of the comfort seeking class of Baby Boomers (not all, surely) who lack the intellectual honesty and courage to face reality, much less gaze into the fucking abyss.

On the right -  well, you know, Palin & Co's. demented hillbillies, hellbent on creating the new Fascist state, that surely-be-to-God will rise from the ashes.  An American Taliban that will dispense with the liberal nihilists and Limousine liberals with a sweep of the hand.

Wait for it!  Be patient, it's coming....Rome was not burned in a day...

According to the latest EWT, the markets are at a sentiment extreme exceeding the 2007 high, despite being 20% lower in price and attending a punk, Pet Sematary version of the "Goldilocks" economy, that is rolling over by the minute...

Stuck in the Middle With You. 

Sunday, November 14, 2010

Roadmap for Collapse Part I

[Last Update: 11/14/2010]

The Global Ponzi Scheme is Going SUPER NOVA
Under "QE2", The Bernanke Fed has committed an additional $600 billion to buy up Treasury bonds and further leverage the system.  With each purchase, the Fed pushes investors further and further out on the risk curve.  To that point, risk markets around the world - stocks, bonds, commodities, gold - went parabolic this week.  The Hang Seng (Hong Kong) is gapping up vertically !  We are reaching end game.  Like a dying sun, the global credit-based Ponzi Scheme is actually accelerating, as it goes SUPER NOVA, first expanding outward in one last gasp of frenzied speculation, only to ultimately collapse inward upon itself.  It will be a crash heard around the world, as investors wake up to the fact that they are all on the same side of the boat holding too much risk.

Fool me Six Times, Shame on Me...
We have all seen this movie before - Nasdaq 2000, the post-9/11 boom/bust (~2002/2003), the Housing market debacle (2005/2006), the Commodities melt-up/melt-down (2007), the Lehman/subprime fiasco (2008).  Each of these debacles, was aided and abetted by trade imbalances and cheap money (Fed policy).  In the aftermath of each crash, the Fed was able to rescue the economy by applying even more monetary stimulus than the last time (in conjunction with ever increasing government spending).  Therefore, investors have been lulled into a sense of confidence that the Fed is infallible and can fix any economic problem.  Yet, only a total fool would assume that they can keep the Ponzi pyramid intact forever.  Applying additional monetary easing to solve a debt problem is like drinking to solve an alcohol addiction.
One should bear in mind that the vast majority of money managers are not concerned with the Fed's exit strategy.  Their only concern is what happens between now and 12/31 bonus time.  As for individual investors, everyone rides the market bullet train thinking they can be the first off before it crashes.   Amazingly, even Bill Gross, Manager of the world's largest bond fund, admitted this week that the Fed's policies are "somewhat of a Ponzi Scheme !!!"  

Why Bernanke is either really stupid, a Tool for Wall Street, or most likely both...
The Fed's hopeless goal right now is to propagate the illusion of recovery long enough for a real economic recovery to take hold, essentially the game plan for every recession since WWII.   After all, when the stock market is going up, that gives the illusion of recovery.  Aided and abetted by 30 years of outsourcing and globalization, the Fed has long been able to manipulate interest rates to encourage consumption and debt, without generating hyperinflation.  Back in the 1950s total debt levels were at 50% of GDP, now total debt is at 360% of GDP i.e. 7 times higher.  Unlike all of those previous economic recoveries we are now post facto millions of jobs having been outsourced while having overall debt levels at 360% of GDP, so this time, there is no underlying economic fuel (new businesses, jobs) to sustain the economy.  Essentially, the Fed is just pouring gasoline on a dying fire.  Yes, there is a short-term burst of monetary "stimulus" that juices the stock market, but the real economy just keeps rolling over.  Only a delusional optimist assumes that the debt pyramid will continue to grow and that lenders will accept new debt for repayment of old debt (aka. Ponzi borrowing) indefinitely, into an imploding economy.  When confidence collapses and lenders realize that the goal is return of capital (principal) not return on capital (interest), then the markets will collapse,  DEFLATION will take hold BIG TIME, and the Fed will be totally impotent.

The Financial Liquidators (America's "Best and Brightest")
Beyond the failed monetary and fiscal policy contributions to this ongoing fiasco, the deeper underlying root cause is apparently something no one wants to discuss let alone confront.  Over the past ~30 years, a new culture of financial "liquidators" took control in the U.S. and securitized/monetized all aspects of the Supply Chain from design and engineering through manufacturing.  These financiers who became ubiquitous not only on Wall Street but in every major Corporation, displaced the predominant culture of engineers and scientists who had presided over the ascendancy of the U.S. as a manufacturing and engineering powerhouse.  The Financial Liquidators have neither the training nor the inclination to design, build or create anything.  Instead they have presided over the fevered process of selling off the entire U.S. manufacturing base and the Middle Class along with it.  Schooled (and willfully ignorant) in the Anglo/American pollyanna bullshit of Ricardian comparative advantage, and therefore conveniently naive with respect to export mercantilism, they were fully empowered by the fiat currency regime imposed by Richard Nixon and Milton Friedman.  What would have happened had the gold standard been maintained, is that the recurring trade deficits would have brought about a run on gold reserves, thus preventing the Idiocracy of the day from outsourcing their entire fucking country.  These were the key reasons - to accommodate ongoing trade imbalances, as well as to enable Friedman's Monetary policy to become the Ponzi scheme of choice -  why the gold standard was dropped in 1971.

Essentially these short-sighted greedbots were not willing to accept lower returns on capital for even one millisecond to allow U.S. manufacturing to retool vis-a-vis foreign competitors.  Leveraged buyouts, securitization, outsourcing, offshoring, union busting are the tools of the trade for the liquidators.  A class of salesmen, and speculators v.s. engineers and investors.  Self-nominated "dealers" of industry who have inevitably created a self-cannibilizing economic pyramid scheme.  A pyramid scheme that has foolishly liquidated its own customer base.  Clearly, America's current cohort of "Best and Brightest" are neither the best nor the brightest, nor have they been for quite some time.   The self-aggrandizing schools that are spawning these newly minted jackasses need to be held accountable, to say nothing of the entire economics profession which is morally, intellectually, and soon-to-be, quite literally bankrupt.

Of course, this is what the average person in America already knows, so all we are doing is standing around waiting for Wall Street to realize the party is over.  Will they make it to 12/31 bonus day before the day of reckoning?  They did last year, but as we've been told - Past performance is no guarantee of future results...

For those looking to protect their assets through a deflationary credit collapse.  I still recommend Treasuries, as explained here (invest at your own risk):

The Treasury ETFs:

SHY: 1-3 year maturities ("safest" with respect to interest rate movements)
IEI: 3-7 year - probably the best compromise between long and short-term
IEF: 7-10 year - these are the bonds the Fed is buying :-)
TLT: 20+ year - most volatile/speculative, but most upside if yields fall (i.e. deflation)

-------------------------MARKET SUMMARY ------------------------------

Key fundamental Risks:
Fiscal AND monetary stimulus starting to wear off:
- The economy is slowing despite unprecedented Fiscal and Monetary intervention
- Fiscal and Monetary policy are now one and the same i.e. the Treasury writes a check and the Federal Reserve prints the money. There is no longer any difference between these two policy approaches.
- Yet despite all of this unprecedented "stimulus" the economy is still heading lower which can mean only one thing - the Ponzi scheme is ending.

Key technical risks:

1) Mutual fund cash levels at historic lows

2) Excessive speculation in Emerging Markets (Bombay Sensex), Metals (Silver/gold) and growth stocks Apple, Baidu, Netflix, TravelZoo...all in vertical blowoff mode

3) Market at most overbought level since October 2007 top (Based on the "Open Trin")
- Open Trin is a smoothed moving average of the Trin (ARMS Index)

4) Bullish investor sentiment (AAII) at highest level since October, 2007 all-time top

5) Stocks having highest correlation since 1987 (not a good time to be buying stocks)

7) "Safe" haven bonds uptrending (yields falling) - indicating flight to safety and liquidity
- 2 year Treasury yields at lowest level ever...


The below chart indicates the market's position from a long-term Elliot Wave standpoint.  According to EW Theory, the market is viewed to be correcting the past ~80 years of rally since the 1932 low.  Corrections generally take an a-b-c pattern.  The "a" wave is the first wave down, in this case the decline from 2000-2003.  The "b" wave is a correction of the "a" wave, in this case the rally that lasted from 2003-2007.  Note it is very unusual for a "b" wave to actually retrace an entire "a" wave, however, when that occurs it is deemed to be particularly bearish for the "c" wave which as one would expect, comes as major surprise to those who believe that the worst is over.  We are now in wave "c", which itself will be comprised of 5 wave segments (wave "a" and "b" were also comprised of 5 segments).  Therefore, wave "1" down was the decline from 2007 that lasted through the Lehman crisis and bottomed in March 2009.  Wave 2 is just now completing, as we see with a parabolic spike higher ~1200.  That will bring to bear the third wave of wave "c" which will be the strongest wave of the entire secular bear market and eventually bring the market back down to multi-decade lows.  After wave "c" a new stock market rally can begin.

As always, take market predictions with a grain of salt, especially with regards to timing. I am highly confident the above scenario (or something similar) will play out, but the timeframe for each of the declines and counter-trend bounces is highly speculative.

For those who deride Elliot Wave Theory as "financial astrology", I would be careful.  Granted, their short-term charting is often too early on calling tops and bottoms, however, their overall thesis for a deflationary credit collapse is spot on and playing out entirely as expected.  
In addition,  EWI has been correct at anticipating the big picture stock market movements i.e. the "a" wave, the ensuing "b" wave rally and now the "c" wave decline, so far...  Moreover, not withstanding the past year's rally, at this juncture, safe, low-yielding money market funds are still outperforming the stock market on a 12 year basis (back to 1998).  By the time "c" wave bottoms out, short-term funds will have outperformed on a multi-decade basis.  

According to EWI, we are seeing an "All the Same Market" phenomenon similar to 2008 in which ALL risk assets (stocks, Corporate bonds, Municipal bonds, commodities, emerging markets) are becoming highly correlated to the downside, leaving few if any alternatives to U.S. Treasuries.