Of course, China fixes the value of the yuan against the dollar at the moment. This is a big bone of contention between American and Chinese officialdom. The charge is that China is holding the value of its currency down to make its exports cheaper.

Whatever the outcome of that spat, it seems as if some currency appreciation is inevitable over time. The market anticipates a 3% increase this year. And in the past, China has let its currency appreciate gradually. For example, the value of the yuan rose 21% from July 2005 to 2008, before China stopped it. (What happened to commodities during this stretch is also worth knowing, and we’ll get to that below, too…)

So how cheap is China’s currency now? It is hard to say. Murray Stahl, the savvy investor who runs Horizon Asset Management, thinks it might be as much as 50% undervalued.

One way to look at this, though this hardly ends the debate, is through the famed Big Mac Index. It simply shows you how much it costs to get a Big Mac in different parts of the world. Based on this, one of the cheapest places to get a burger is China.

Put another way, China’s renminbi is 49% undervalued versus the dollar. I don’t know if the yuan is that cheap, but it seems it is cheap to some meaningful degree. If it is that cheap, then U.S. dollar-based investors stand to make a huge windfall. As Stahl writes, “If [the renminbi] were allowed to float, one might expect returns of up to 100% from the currency exposure alone. For a U.S. investor holding Chinese securities, a rise in the value of the renminbi would provide positive returns, even if the local share price were to remain unchanged.”

That’s how you make 100% without the shares going anywhere. Regardless of what the exact percentages wind up being, playing for a rise in the yuan seems the way to bet.

The dollar has lost ground against a bunch of other Asian currencies already this year. It lost nearly 7% again the Malaysian ringgit, for instance. Singapore, which also pegs its currency to the dollar, recently said it would allow gradual appreciation. China, I think, will be no different.

For this reason, getting a yuan revenue stream is a good idea if you are U.S. dollar-based investor. One way to do that is to buy shares in a Chinese company that does business mostly in China and hence makes sales in yuan. (You don’t want an exporter.)

My sense of it is that the Chinese will allow a gradual appreciation of their currency, perhaps 4–5% a year. For investors in China, this is a meaningful tail wind. I don’t think it will have much of an effect on Chinese exports. China’s advantages are deeper than that. In 2005–08, when China’s yuan rose 21%, its trade surplus actually tripled. A stronger yuan will also make the oil and iron ore and other commodities China needs cheaper for Chinese buyers.

This brings us round to the question of what else might happen if the yuan gets stronger. In 2005, when China allowed its currency to appreciate, oil jumped 15% the month after the news. Commodities in general rose. As The Wall Street Journal explains, “With a stronger yuan, imported raw materials already in high demand in China — such as crude oil and copper — would become cheaper there.” Hence, demand rises! In particular, those commodities of which China is short — oil, potash, soybeans, iron ore — could all receive a jolt if the yuan gets stronger against the dollar.

There is another reason to own Chinese shares beyond just the currency. China is underrepresented in the world’s stock indexes. This is important because it helps give you some sense of where the big money — the institutional money — will flow in the future.

As Stahl points out, the Morgan Stanley Capital International EAFE Index is the most widely used global benchmark for investment managers. (EAFE stands for Europe, Australasia and the Far East.) That means the global index funds, ETFs and other funds all look to ape this index or beat it. Think of it as the global S&P 500.

Well, this index has zero allocation to China. Zero. China is the world’s second largest economy, and it has no weighting in this popular index. “In principle, this is rather unusual,” Stahl writes, “since the object of the index is to replicate world financial performance outside of the U.S. It is difficult to imagine how this is to be accomplished if China, given the size of its economy, is excluded.”

Where it is included, it is often a ridiculously small portion of the index. State Street Global Advisors has the MSCI All Country World Index. China is 3.3% of this index, the ninth largest weighting. Japan, by contrast, has a 15.5% weighting. Investors thinking they are getting something representative of the world in the World Index are quite clearly getting a skewed view of that world. If China got its proper weight, it would be 17% of the index.

The reason for the neglect is because there are not enough China securities to fill out these indexes yet. The tradable volume of China’s market is still small relative to the size of China’s economy. As the market grows over time and as more securities come to the market, this issue will likely solve itself. This, though, is your opportunity as a smaller investor. You can buy now before the buffaloes come thundering in.

As Stahl puts it, “We believe it is only a matter of time [before] China will ultimately be included in indexes at the appropriate weights. If this were to occur, one could imagine the impact on the Chinese securities prices, irrespective of the underlying economic backdrop.”

The impact would be large and to the upside. The key is you want to be invested in these companies before that happens.

The market, like Mother Nature, seldom hands out freebies, however. Investing in China is likely to test the linings of your stomach, if history is any guide. Over the past 30 years, the Hang Seng Index — a benchmark of China securities — has fallen by an average of 56% in six episodes lasting anywhere from two months to three years. Yet to the strongest stomach go the greatest rewards. The annualized rate of return on the Hang Seng Index was 11.5% in the 30 years ending December 2009, compared with the S&P 500’s return of 8.1%.”

Today, Chinese stocks have a couple of tail winds that will keep that streak alive, as I’ve discussed above. Besides, many of the U.S.-listed Chinese stocks seem cheap on the face of it, with single-digit price-earnings ratios, good balance sheets and 20%-plus growth rates — such as one of the stocks in the Capital & Crisis portfolio. Those low price-to-earnings ratios could stay low and investors would still earn 20%-plus a year just from earnings growth. If the market should up the multiple, you’d do even better. Add in potential currency effects and you could do better still.

Regards,
Chris Mayer
Whiskey & Gunpowder

June 2, 2010

Two Reasons to Buy China-Based Stocks was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Doug: Sure. First of all, it’s because gold is actually money. It’s an unfortunate historical anomaly that people think about the paper in their wallets as money. The dollar is, technically, a currency. A currency is a government substitute for money. Gold is money.

Now, why do I say that?

Historically, many things have been used as money. Cattle have been used as money in many societies, including Roman society. That’s where we get the word “pecuniary” from: the Latin word for a single head of cattle is pecus. Salt has been used as money, also including in ancient Rome, and that’s where the word “salary” comes from; the Latin for salt was sal (or salis). The North American Indians used seashells. Cigarettes were used during WWII. So, money is simply a medium of exchange and a store of value.

By that definition, almost anything could be used as money, but obviously, some things work better than others; it’s hard to exchange things people don’t want, and some things don’t store value well. Over thousands of years, the precious metals have emerged as the best form of money. Gold and silver both, though primarily gold.

There are very good reasons for this, and they are not new reasons. Aristotle defined five reasons why gold is money in the fourth century BC (which may only have been the first time it was put down on paper). Those five reasons are as valid today as they were then. A good form of money must be: durable, divisible, consistent, convenient, and have value in and of itself.

L: Can you elaborate on that?

Doug: Yes, and from them, we can draw inferences that will help us anticipate the fate of the dollar.

First, let’s take durable. That’s pretty obvious – you can’t have your money disintegrating in your pockets or bank vaults. That’s why we don’t use wheat for money; it can rot, be eaten by insects, and so on. It doesn’t last.

Divisible. Again, obvious. It’s why we don’t use diamonds for money, nor artwork. You can’t split them into pieces without destroying the value of the whole.

L: If I paid for a new Ford GT with the Mona Lisa, what would be my change – a small canvas by Picasso?

Doug: [Laughing.] That’s right. Maybe you’d get millions of those paintings of Elvis or Jesus on velvet.
Consistent. The lack of consistency is why we don’t use real estate as money. One piece is always different from another piece.

Convenient. That’s why we don’t use, for instance, other metals like lead, or even copper. The coins would have to be too huge to handle easily to be of sufficient value.

Value of itself. The lack here is why you shouldn’t use paper as money.

Actually, there’s a sixth reason Aristotle should have mentioned, but it wasn’t relevant in his age, because nobody would have thought of it…

L: It can’t be created out of thin air.

Doug: Right. Not even the kings and emperors who clipped and diluted coins would have dared imagine that they could get away with trying to use something essentially worthless as money.

L: I think we can forgive Aristotle for the oversight.

Doug: I think so. At any rate, these are the reasons why gold is the best money. It’s not a gold bug religion, nor a barbaric superstition. It’s simply common sense. Gold is particularly good for use as money, just as aluminum is particularly good for making aircraft, steel is good for the structures of buildings, uranium is good for fueling nuclear power plants, and paper is good for making books. Not money. If you try to make airplanes out of lead, or money out of paper, you’re in for a crash.

That gold is money is simply the result of the market process, seeking optimum means of storing value and making exchanges.

But it’s not something that suits governments, because paper money is an excellent means for governments to tax people indirectly, surreptitiously, through inflation. That’s one reason central bankers love paper money, but also, phony economic theories, like those of John Maynard Keynes, hold that the government not only can but should meddle with the economy, and the ability to print paper money gives them a means to do that.

In today’s world, not only do people around the world take it for granted that paper is money, but that it should be so.
But it’s all nonsense. It’s one reason for taking a gloomy view of humanity – people will believe almost any kind of claptrap, if the story is retailed by those in authority.

After the current system collapses, as every paper money system in the past has collapsed, some form of money will have to replace it, and it’s almost certainly going to be gold.

L: There are already experiments with digital gold currencies. E-gold got taken out behind the woodshed by the feds, but GoldMoney.com seems to be doing well. Do you believe those could see widespread adoption, as paper currencies lose their credibility?

Doug: Sure. You know, in the 19th century, the “paper money” you carried in your wallet was called bank notes. Why? Because they actually were notes from your bank representing a specified amount of real money on deposit. People carried these things because they were much more convenient for large amounts of money than chests of gold. Dollars today say “Federal Reserve Note,” not “XYZ Bank Note” on the back, because they aren’t redeemable for anything besides more Federal Reserve notes. That’s why today’s paper money substitutes are called fiat currencies; they have zero intrinsic value and are not redeemable for anything, but are accepted because the government will put you in jail if you don’t. It’s a fiat accomplished by force, not real value recognized by those who accept the notes.

Things like GoldMoney.com are simply modernized, updated versions of bank notes. They are basically transferrable warehouse receipts that represent amounts of gold you have on deposit someplace. I do recommend GoldMoney.com, incidentally, because it allows you to hold your gold in digital form, outside the U.S. And to my understanding, these accounts are not reportable under current U.S. rules. It’s an excellent alternative to storing large amounts of gold in a safe deposit box.

L: But will people believe in them? Will the public accept them so they can be used in everyday transactions, as paper money is used now? Hundreds of years ago, people accepted bank notes because they knew the reputations of the banks issuing them (when you traveled, you went to a reputable local bank, which knew the reputation of the bank that issued your notes, and the local bank could issue you new notes in local currency, etc.). There was no central authority to certify these notes. But today, people don’t think that way. They think it takes a government to assure the value of money.

Doug: You’re quite correct on that – a sea change in thinking will have to take place. Of course, anyone in Zimbabwe can tell you a government’s guarantee is not necessarily worth anything. A collapse of the dollar – the worlds’ de facto reserve currency – could spark such a change in that way of thinking. With GoldMoney.com or the Perth Mint – another worthy alternative – it’s a question of predicting the solvency of an actual company, and we have tools for that. I believe this is exactly what is going to happen in the future. As far as I’m concerned, either of these outfits is more reliable than, say, Citibank. And gold is far more desirable than the dollar. So I’d rather have a thousand ounces of gold stored with GoldMoney.com than a million dollars deposited at Citibank.

The dollar will be phased out of the world economy, because everyone can see that it’s a hot potato. This Chinese have two trillion of them. They want to get rid of them because they aren’t stupid, and they can see what the ultimate fate of the dollar is. This is true of every country around the world at this point; their central banks know they are sitting on hot potatoes, and they are going to want to unload them.

What’s going to happen is that one or more countries are going to institute a sound, stable, gold-backed currency. Ten years ago, Mahathir Mohamad of Malaysia tried to get Islamic countries to return to hard money, adopting the gold dinar and the silver dirham, which are defined in the Koran as specific weights of gold and silver. It didn’t work because of mistrust between the players; the governments of Muslim countries are, as a group, almost universally corrupt. But I think it’s entirely possible, nonetheless, that something like that might arise in the Islamic world. After all, they believe that the Koran is the actual word of Allah, and there is a resurgence of Islamic fundamentalism everywhere.

According to press reports, the Chinese government is actually encouraging Chinese people to accumulate gold at this point. They might go for a gold-backed yuan – it would put them on the map as an international monetary leader. The press also reports that the Russian government has been consistently buying large amounts of gold. We might even end up with a gold-backed ruble.

Meanwhile, the U.S. government is creating trillions more dollars per year. This could result in the entire world monetary system being overturned. But there’s no reason for anyone to trust any of these other governments more than they trust the U.S. government. And rightly so; they shouldn’t trust any currency that doesn’t come with a guarantee of redemption for something specific. And as Aristotle and history have shown us, gold is the best choice.

L: So the question now boils down to, what is gold really worth in terms of today’s dollar? How do we compute that?

Doug: Well, aside from a few Spanish galleons at the bottom of the sea and dentures returned to the earth after a lifetime of use, pretty much all of the gold ever mined and refined is still sitting on the surface of the earth somewhere. Nobody really knows how much that is, but the most reasonable estimates I’ve seen are something like six to eight billion ounces. That happens to work out to about one ounce of gold for every human being on the planet at this time.

Out of this, the U.S. government reports that it has 265 million ounces of gold in its treasury. If we divide the money supply by the number of ounces the U.S. could back its paper with – and here we’d have to decide what measure of money supply we want to use. Nobody, including the Federal Reserve, actually knows how much money they have floating around out there. It would seem that there are about six trillion dollars outside the U.S. alone. Let’s estimate that M0 in the U.S., the narrowest measure of money supply that consists of just notes and coins, amounts to one trillion. So, 265 million into seven trillion gives you about $26,420 dollars per ounce of gold.

Now, if we add in the total obligations of the U.S. government, which it will either need to print more money to meet, or it will have to default on – that’s about 100 trillion. If those dollars are printed, that would give us $377,430 per ounce. The same ratio for M1 would give you about $6,226 per ounce and M2 would give you $31,320 per ounce.

All of these numbers are far, far above the current level of roughly $1,000 per ounce. And that’s the answer to the question you started this interview with. Why gold? Because it’s got only one way to go: up. It seems to me that everyone should have a very significant portion of their wealth in gold.

That’s not just for safety, security, and prudence, though those are reasons enough, but because gold is cash in its most basic form. Better yet, even though it’s quadrupled since its bottom in 2001, it’s also still an excellent speculation. I can see somewhere between three and ten times your investment in current capital. And there’s no limit to the upside in dollars, depending on how rapidly the government destroys the currency.

To my view, that offers an exceptional combined opportunity; by buying gold, you protect your wealth but also have enormous speculative upside.

L: Plus, as you like to say, gold is the only asset class that is not also simultaneously someone else’s liability.

Doug: Absolutely right. And in a world as financially unstable as today’s, you just don’t want to hold on to someone else’s liabilities any more than you have to. Especially if that’s a liability of an entity like the U.S. government.

L: Got it. You should own gold because it’s money, because of its security, and because it’s an excellent speculation. In our publications, we’ve been telling readers that they should have as much as 1/3 of their portfolio in gold, 1/3 in cash, and 1/3 in investments that could do well in times of crisis, including gold stocks, commodities, certain kinds of real estate, etc. Do you think those are still the right proportions? That worked out very well for our readers last year. Those who actually followed our advice would have had 1/3 in gold and 1/3 in cash, so even if they lost 50% of their remaining third, they would still have only been down 16.67% by the end of the year. But that was then, and there were signs of short-term price deflation, and now things are different. How should we be deployed today?

Doug: That’s still a good balance, but if you start really thinking of gold as cash, and the dollar as a merely temporarily fashionable means of exchange, you’ll find yourself loading your portfolio with much more gold and gold proxies. That will protect you against the very rapid loss of value the dollar faces in years to come. Inflation is going to truly get out of control.

The only reason to hold any dollars at all right now, other than what you need for a few months’ living expenses if you live in the U.S., is that there is still a possibility of a very short-lived but catastrophic deflation. That could make the silly things worth more in the short term and give you liquid capital to deploy quickly into other asset classes. But certainly within one year, I would start moving more money out of dollars and into gold and other investments, possibly including well-positioned real estate and stocks that could benefit from the destruction of the dollar.

And once again, I want to emphasize, especially for Americans, that it’s not just a question of what you have and what you’re doing in the market, but where you’re keeping these things. Everyone, not just Americans, should try to have half of their gold, cash, and investments outside of their countries of citizenship and/or residence. You don’t want all of your assets within easy reach of whatever government considers you its milk cow.

L: Good reminder. Well, we’ve talked a long time again, but briefly, what are the best ways to own gold?

Doug: I prefer gold coins to bars. They are more recognizable and convenient. You can walk into a coin shop in many places around the world, and they will recognize your Gold Eagles, Krugerrands, Philharmonics, etc. Dealers, or the public, may not recognize the hallmark of some bars.

For larger amounts, I like GoldMoney.com, as I mentioned above, and I believe Kitco offers secure and convenient accounts accessible online. I also think highly of the Perth Mint Certificate program, especially for those who feel more secure with some sort of government backing (though government involvement is a reason to run in the opposite direction, in most cases). And, of course, there are various banks that will store gold for you in vaults in London or Zurich, that sort of thing. We cover these sorts of things in Casey’s Gold and Resource Report.

L: Okay, then, one last question: how about the gold stocks – where do they fit into this picture?

Doug: That’s a whole new conversation. For now, I’ll sum it up with three words: leverage to gold.

L: Very well then – I look forward to our next conversation. Thank you for your time.

Doug: A pleasure, as always.

December 29, 2009

Why Gold Really Is Money was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Some bubbles have a significant amount of yield to them, depending upon how fully they were inflated and how sharp the object poking them is.

Some bubbles have thick, yielding coverings and are never inflated to rigidity beyond the point at which little kids sit on them and bounce along happily.

No bubbles can be reinflated after bursting, not even the ones which are blown through a little straw from smelly goo and harden almost instantly, a favorite toy of my youth.  Those wonderful bubbles could be pinched close to survive quite a while after the first rent appeared, and stuck to each other in the most delightful fashion.

Some bubbles can be reblown almost instantly and infinitely, particularly from gum formulated for that purpose.

You now know all there is to know about bubbles except what the title of this article means.

Bill Bonner made another excellent point recently:  why hasn’t the bond bubble burst messily all over the scenery?  I’ll play Cindy Lou Who:  is it because, Mr. Bonner, the wind blowing out of Washington gives the appearance of increasing activity and many people haven’t caught on that the wind is circular (as are those in hurricanes and tornadoes) blowing the money around and around through the Fed and the Treasury and the Banks?  Sound and fury, signifying nothing?  Far more apt than the Bard, the sound and fury which some of us have seen rising for many moons indicate that when this whale finally blows there’s going to be a spout to end all spouts and Moby Dick (if we even have a Moby Dick in this scenario; it sure isn’t Ben Bernanke.)  is going to go back to port and sit in the local sailors’ bar telling sea stories.

Our own beloved Gary Gibson pointed out recently that sometimes we’re a little off in our timing, but that it is better (and far more comfortable in the long run) to see problems and react early.   Y’all know my inner Cassandra:  sometimes she’s early in her warnings but sooner or later she is almost always right, and it is a whole let better to begin our preparations as soon as we can rather than to wait for further cracks to appear in the walls.  Sometimes, true, our fears are OBE, “overtaken by events.”  My detractors (who are blessedly few that I know about) point out gleefully that I was wrong about the Democratic National Convention slightly over a year ago.  I reply sweetly that Hillary Rodham Clinton may not have stolen the Convention from Barrack Hussein Obama–I’m still astounded that she didn’t–but that if she had done so there would have been riots in the streets.  It cost none of us anything to keep our heads down quietly in the country that week just in case.  Slight ridicule is a very small price to pay for having taken out an insurance policy that lapsed unused.  Most insurance never pays off, but when sixty years’ growth crashes across the roof (as happened to us two weeks ago) in the course of a storm that didn’t last five minutes paying the premiums makes excellent sense.

The Bond Market is going to go “Kablooie!” with ricocheting remnants that will have us whimpering for the good old days of upside down mortgages.  Which won’t have gone away either.  Which will probably have been augmented by the commercial real estate bubble which is covered by an integument stretched so thin that we can see through the shiny spots.  Go drive by any strip mall at random. Look at the Big Front stores.  They have “for lease” signs in the windows.

How could this not be so?  The bonds are of even less value than the currency which, by definition, is worth less every time a new cargo ship full of fiat money blows out the doors of the Treasury.  “Safety” is locking your current value into government paper at an interest rate that is lower than anything since the day before someone thought the concept up?!  Said value to be replaced at a later time in valuta that cannot fail to be worth less at a time when inflation has risen steeply?!  Anyone who thinks so should just go blow the money now in Vegas.

Which takes us over to “Why is there no inflation?”  At present in selected areas there is deflation, which in this case means you can buy a horse and buggy for a quarter of what they cost three years ago because almost no one has money to put in horses and buggies and even fewer see any need for them.  The carriage trade is still a small elite, as it has always been, as it will always be.

Inflation is defined casually as “more dollars chasing fewer goods.”  There are still plenty of goods, another situation that must, of necessity, by definition, change in the foreseeable future.  The more dollars aren’t chasing them because those who have more dollars are at government levels or in unions or in Hollywood, but they aren’t down here at the grocery store level.  They aren’t walking into car dealerships, where one out of four Cash for Clunkers suckers is feeling buyer’s remorse.  The dealers haven’t been repaid the $4500/car they fronted for the government and every car that goes back to the bank or dealer has lost the 20% or whatever it is now that it lost the moment it was driven off the dealer’s lot.  That’s one reason we passed a dealership yesterday offering to finance a major car brand for nothing for five years.

We have several situations which are going to collapse or explode and the only questions are “When?” and “Which comes first, the ARM mess or the Bond debacle or the Commercial Real Estate plummet or the next round of the Dow dive-bombing or devaluation of the currency either through butterflies being loosed in the Far East or deliberate governmental action?”  I don’t know.  It doen’t matter.  What matters is to be sure you don’t have funds tied up in any of those but have stored all of your value elsewhere.

I’m watching silver nervously.  Watching.  As ancient wisdom and Gary noted Friday, if you don’t know who the mug in the game is, you’ve already been tagged to be “It.”  Those of us with low, cunning, suspicious minds remain convinced that there are mice in the clockwork and those account for the strange things the clock has been doing.  We don’t perk right up, preen ourselves, and carol, “SEE!  We told you so!  We told you to buy silver.”  At least I am hunkered down in our little Whiskey Bunker. I don’t jump on invisible magic carpets because a genie invites me for a ride.  I don’t pounce on unseen coattails that may be whisked away before I have even located them, leaving me to fall on my face.  If some fellow tries to pick me up in a drugstore I don’t suppose I’m Lana Turner, an example so old it may be meaningless to anyone under seventy.

Yeah, long term silver is going up, and up, and up because it is real “money.”  Between now and at least the end of the year silver is almost certainly someone else’s game and he/she/it isn’t telling me the rules.  I understand Quidditch perfectly.  I can tell Offsides from Encroachment.  (No, gentlemen, the little lady isn’t trying to show off and revealing her ignorance.  She’s telling you that she has been in the game long enough to know that Offsides is Offsides no matter what you call it.)  I don’t know who or what is pulling the strings in metal but I’m content with the cheese I stole off the trap for now.  When–if, admittedly–silver gets below $13 again I’ll start buying again.  In the meantime, I’m going to store value in Galvalume.  Snap-ring barrels.  Whatever I see that is a traditional trade good, item that is always useful, or luxury at a great price.

I just bought two septic tanks!  Wow, is that a sexy investment, or what?  Well…if you want to circle the “guest quarters” (aka motor homes and travel trailers), and it will cost $20,000 plus tax to “have the man come do it,” and your gravedigger’s back hoe will dig out holes to bury the concrete vaults in a couple of hours…so far as I’m concerned we just turned eight hundred dollars into a twenty-five-fold profit AND the septic tanks will not be subject to costly annual inspections by the government.  And that’s without figuring the 8.25% tax in my head while typing although it should be obvious that it will be on the close order of another two-point-five increase.  If this is not intuitively obvious you’re probably buying into a PE of 130.  And you don’t read W&G.  Or you weren’t taught arithmetic in the Forties.

I got a diffident note from an old friend who sent me–pleased chuckle!–today’s Daily Reckoning.  Said friend doesn’t know investments from vestments from verticulitus.  This may well be the modern version of the urge to stuff gold coins into the straw, when people who have never had any interest at all are trying to find out what is going on.  And where better than right here?!

I’ve run out of space to tackle the unemployment and the jobless, venture capital-less, expansionless, profitless in most sectors, meaningless “recovery,” so I’ll close with where I intended to start which is saying that the giant sucking sound isn’t jobs going to Mexico, it is the millions who are living on the bubble.  That doesn’t mean those who profited from the real estate market collapsing or playing ring-around-the-banks.

I’ll put this first in the form of an old joke:  if you and I are walking through the woods and a bear rears up out of the berries and starts chasing us, I don’t have to run faster than the bear, I only have to run faster than you do.  Or climb a tree before you think of it.  Whisk myself to safety, and the Bear take the hindmost.

“Living on the bubble” is a racing term.  Let us suppose that 40 people will qualify to enter the Indianapolis 500 or whatever.  There are still trials going on, and you’re in 40th place.  Never mind the 39 ahead of you; you had your chance and you didn’t best them.  What you must worry about are the ten left who could still knock you out of competition.

That’s living on the bubble.  That is what almost all of us who don’t own thousands of hectares in Argentina are facing.

Don’t look forward other than to avoid snares, pitfalls, swamps, and alligators.  Keep your eye on the bears and those thundering up on your six.

Regards,
Linda Brady Traynham

September 10, 2009

Living on the Bubble was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

These three banks were following Wall Street like a shadow, and lending money to buy stocks and real estate.  While the US stock market was doubling, the Icelandic stock market went up 900%.  By 2006, Reykjavik real estate prices doubled, and the average Icelandic family was three times as wealthy as it was in 2003.  All this supposed ‘wealth’ was tied to the investment banking industry.  Sound familiar?  Naturally, the whole thing collapsed with a huge thud, when the three investment banks went bust last October.

Fishermen quit fishing, and the craze was to buy and sell stocks and real estate.  For the past few years, many Icelanders engaged themselves in speculation, and seeming to be successful, they did what Americans and the rest of the world did.  They bought things they couldn’t afford…on time.  Since interest on their krona was 15.5%, why not buy euros or yen at a 3% interest rate and clean up?  So they made huge loans of euros and yen.  Then their krona collapsed, and they still owe for the euros and yen they bought.  They now own $500,000 houses on which they owe $1.5 million, and $35,000 Range Rovers, on which they owe $100,000.    There have been lots of fires in Iceland recently, to pay the bills of course.  Lucky insurance companies.  It will happen here, and already has to a small degree.

Iceland has lots of wonderful glass and steel office towers and apartment buildings, which are unfinished and empty, with gobs of money owed on them.  Sort of like the rest of the world, I suspect, but it happened in Iceland far quicker.  The bomb went off in Iceland quickly, because it is so small, and its speculation went to such extreme heights.  Walking around Manhattan, the empty stores, streets, and taxis are quite evident I hear, and the same thing is obvious in big cities and small towns everywhere.  The bomb will explode later in these places outside of Iceland, but beware:  Iceland might be the prototype.

Icelanders discovered that trading bits of paper isn’t a productive enterprise.  A handful of guys, who fancied themselves as financial experts, were taking out tens of billions of dollars in short term loans from abroad.  They were then re-lending this money to themselves and their friends to buy assets, such as soccer teams, cars, homes, etc.  Since the entire world’s assets were rising; thanks to people of like mentality paying crazy prices for everything, the Icelanders appeared to be making money.  One non-Icelandic fund manager said that its like, “You have a dog and I have a cat. We agree that they are each worth a billion dollars.  You sell me the dog for a billion, and I sell you the cat for a billion.  Now, we are no longer pet owners, but Icelandic banks with a billion dollars in new assets.  They created fake capital by trading assets amongst themselves at inflated values.”  DOESN’T THAT SOUND LIKE THE REST OF THE WORLD’S FINANCIAL GENIUSES?

Iceland was and is, simply the extreme of what’s going on in the rest of the world, and it came home to roost in Iceland first.  When traders got a whiff of what was going to happen in Iceland, guess what they did?  They went short and made a lot of money.  Do we think that insiders at AIG, Citibank, and the rest of the bankruptcies, knew in advance of what troubles loomed ahead?  Of course they did!  Can we possibly imagine that they shorted their own companies in advance of the collapses and made tons of money?  And that such bonanzas are carefully guarded in the sacrosanct walnut-paneled boardrooms of these holies of holies?  I think there’s no doubt about it.

Iceland looked so good to the rest of the world…for a time anyway…just like Madoff. That they “invested” heavily in Iceland, with its 15.5% interest.  Germans banks put $21 billion into Iceland banks.  The Netherlands gave them $305 million. Sweden kicked in $400 million.  U.K. investors forked over $300 billion from various pension funds, hospitals, universities, and other public institutions.  Oxford University lost $30 million.  It’s all so sad that 99% of the world believes things to be true, which couldn’t possibly be true.  That “experts” can do no wrong, and are to be trusted with wealth and surplus assets.  A few years ago, and not in the current time frame at all, a local retired electrical contractor and his wife, who had bought gold eagles from me @ $301, and silver eagles @ $7.50, were lured by a fast talking Madoff type into “investing” $100,000 in his scheme with the promise of a ten percent annual return.  They tried to get me involved and even introduced him to me.  I said NO, and tried to tell them that it would cost them their $100,000.  It did.

See, gold and silver don’t require “trust” and expertise to own.  No degrees or licenses from experts are required to decide to buy gold and silver, which after all, are historic money throughout the ages.  They’re simply a way of protecting assets from the criminal inflating of the world’s currencies.  The dollar is not alone.  Don’t be fooled by the “strength” of the dollar.  It is strong only in comparison to other pieces of paper, which are all being printed with merry abandon by the world’s governments.  People who brag about their CD making 4% rather than 2% are essentially bragging that their boat has a smaller leak in it than their neighbor’s, and is sinking more slowly.

Hope you went to a Tea Party!  I went to two, and it was a blast.  We sang the National Anthem, God Bless America, America the Beautiful, My Country Tis of Thee, saluted the flag, and had a grand time. In this town of 17,000 we had over 400 at one of them.  People were driving by honking their horns and waving.  It made tears run down my face.  Sorry, I am a hopeless romantic, and I love America.  It’s the current government I hate, and both parties.  If the Republicans would listen to our music and pay attention, they could take both houses at the next election, but it’s doubtful they’ll wise up and think straight.  How sad!

Regards,
Don Stott
Colorado Gold

April 17, 2009

Iceland: Harbinger of Worldwide Collapse was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

First, let’s consider a bit of history. Money was originally just coinage rather than currency, as the root of the word (and of the word mint) is Moneta, from the name of a temple that was used as a mint in ancient Rome. Coins throughout history have mostly been made of silver and gold. These have natural qualities that are appropriate for money, being durable, divisible, universally recognizable, of high rarity and of high intrinsic value due to their attractiveness for artifacts. It was only later when rulers got strapped for cash, they started producing ‘money’ that was not made from silver or gold – pretend money if you like. The paper versions were, in effect, credit notes for proper money, or currency. This word comes from the Latin currere, meaning to run or flow. And how it does run and flow nowadays – off the printing presses and down the fibre-optic cables! Of course it may simply refer to the way currency facilitates the flow of trade. Paper currencies are described as fiat, deriving from ‘an official sanction or decree’, from the Latin ‘let it be done’. Meaning that it’s worth something because the Government or ruler says it is. Its inherent worth is negligible, and so its value is entirely dependent on confidence and acceptance by the populace. In fact it is mostly dependent on the confidence of a few currency traders, and how they react to unfolding events. Fiat currencies are always over-printed, so they are not a very sound basis for an economy in a mature civilization. So what are the options after the dollar is worth only pulp and scrap value?

The obvious option is partial backing of one currency with gold, as with the dollar before 1971, when 25% of the money supply was allegedly backed. The new reserve currency would not necessarily be the dollar, because after a dollar crash people probably wouldn’t want anything to do with them, and America would not be seen as economically reliable. The Euro, Renminbi, or perhaps a new currency issued by the IMF are possibilities. Whichever currency it was, a problem with partial backing is that it allows room for sliding – why not 20%, or 15%, ‘just to get us through these hard times’? And without policing, we could not be sure that too much money was being printed compared to the gold reserves. Backing of only one currency perhaps gives the relevant country too much power and influence, as we have seen with the dollar, which even with its unbacked reserve status has allowed America to rack up huge debts at the expense of other countries. Having only one currency backed by gold, or indeed other precious metals, is that the other currencies are still at risk of having to be revalued and of being over-printed. Partial backing also allows uncertainty in the event of a collapse in confidence, as not all holders of the currency could redeem their money for precious metals.

100% backing would get round these problems, rather like the ‘Liberty Dollar’ currently in use in America, which is 100% backed by silver. This system does not allow the kind of over-lending and inflation problems that we have seen in recent years. Hardly anyone, except in times of economic crisis, would in reality bother redeeming their currency for metals, apart from those needing them for some practical use – the important thing is that the metals are there to back the currency. Having all currencies fully or even partially backed would bring more global stability, but this would need policing, and it would be difficult for countries starting off with small reserves of metals. This system would also tie up most of the world’s precious metals in bank vaults, creating shortages for their many real-world uses.

If all currencies were 100% backed by precious metals, you’d have to wonder why you were bothering, and why you didn’t cut out the middleman and just use the precious metals directly. This is the most honest and trustworthy system, and no doubt would be welcomed by many people whose wealth during a future meltdown had been destroyed by inflation. However, using precious metals directly is not without its drawbacks.

There is the age-old problem of forgery. In this day and age it would be no doubt be possible to produce highly convincing coin forgeries to pass off in everyday use. However, coin weighing machines are already widely in use, and it should not be too difficult to make these a little more sophisticated so that they can measure density and determine whether or not coins are genuine, and for every outlet to use one for all transactions. Measuring of electrical conductivity to a high degree of accuracy might also be informative. And in any case, it’s not as if paper notes can’t be forged is it?

There is also the problem of fluctuation in the value of the metals, which in the past has led to coins going out of the country, but this is a problem only if other countries are not using precious metals as currency and buy up your good coins with their rubbish. In any case the exchange rate should reflect the value of the metals. A more difficult problem is if the relative values of silver and gold move substantially, then people start hoarding the more valuable coins, or selling them for scrap. This can be got round by just using one precious metal directly – obviously silver – or effectively having separate currencies in the different metals. This would mean that you would not have a fixed relationship between different metals as in the past, such as 1 gold unit equaling 30 silver units equaling 3000 copper units. The relative values would change with the markets, so prices of goods would be in a combination of metals such as 5 silver 650 copper. If you required change the retailer would have to check the latest relative market prices of metals before knowing how much to give you, and this could be automated on tills of course. Actually, for practical purposes you would probably need to use an alloy rather than pure gold in coins, to make them more hard-wearing – as is current practice. This would complicate any valuations, but again it could be automated.

Another problem, or rather inconvenience, is the weight and bulk of coins as opposed to notes – but  a benefit is that this also makes money more difficult to steal. And you would still have cheques, bankers’ drafts, credit and debit cards and electronic transfers for convenience. You could even have a hybrid system of large-denomination notes, fully backed by reserves of metals of course. The trend is in any case for most transactions to be done by card – it would just mean the banks would periodically have to physically send bullion to each other to settle up.

Notwithstanding the above, the big problem with any system involving precious metals is that in the 38 years of free-for-all since the gold standard was abandoned, the money supply has grown astronomically. Replacing fiat notes and electronically-recorded currency would show up how little these are worth in terms of the precious metals reserves of the issuing country, and would require extremely small gold or silver coins for buying everyday items. Let’s take the dollar as an example. In 2006 the figure for the M3 dollar supply was $10.3 trillion, but since then the Fed has stopped publishing figures on this to try and hide how much money it is printing. However, others have been keeping tabs on it, and reckon it is now about $15 trillion. America probably had a sneaking suspicion that it would eventually have to go back to a gold standard, as it has hung onto reserves of 8,133.5 tonnes (261.5 million Troy oz). This is much more than any other country, but doubts have been expressed as to the veracity of the figure. Anyway, this is worth only about $250 billion at today’s prices (gold is at $950 as I write). For the national gold reserves to be worth the current M3 figure, gold would have to be worth about $1844 per gram or $57,361 per ounce! Put another way, each dollar is backed by just 542 millionths of a gram (micrograms, or µg) of gold. A few grains of gold dust. You could even argue that US Dollar Bonds, Treasury Bills and Notes all represent real dollars, so should be counted. These would take the ‘money’ supply many trillions higher, and push the gold price into the stratosphere.

Ignoring this, even with the M3 figure, the dollar would have to be drastically devalued in order for gold or silver coins to be usable for everyday items. The smallest usable silver coin would weigh about 2g and be about ? of an inch across, and at current prices ($13) it would be worth about 84 cents. However, if the price of silver were to rise in line with gold as above, i.e. sixty-fold, a 2g coin would be worth about $50 in today’s money. The modern dollar coin weighs 8.1g (0.26 Troy oz), and to have a silver version at the same weight at the increased value it would be worth about $204. A Silver Eagle, (which has a face value of a dollar, so is probably what we should be aiming for!) weighs 31.1g (1 Troy oz), and would be worth about $780 in today’s money. A sixty-fold devaluation of the dollar against precious metals is an indication of how false its current value is, but far worse things have happened in pre-war Germany and in modern Zimbabwe. And this is conservative, because silver could be expected to rise faster than gold as it would be the more affordable investment, probably eventually reflecting its 15:1 ratio of rarity to gold in the Earth’s crust. As for gold coins, gold is currently about 70 times the price of silver. It is about 80% denser than silver so the smallest coin would have to be about 3.5g with a value of about a hundred re-valued dollars. Base-metal coins would make up denominations of less than a dollar of course.

If we were looking at just backing the M3 with the gold reserves rather than directly using the gold as coins, the basic unit of money would have to be as low as a milligram of gold. As all of the world’s economies and currencies would be devastated by a dollar meltdown, a fresh start might be needed, and the Gold Milligram could potentially become the standard world currency. It would currently be worth $1.84 on the basis of it being fully backed by the stated US gold reserves. As a milligram of gold is impractical to handle there would presumably have to be a minimum value of currency, say a gram, that could be redeemed for gold!

Of course, if one or more Governments sought to back their currencies with gold, they would seek to increase their gold holdings dramatically so that they could maximize the value of each unit of currency. The price would rocket, and we would see the widespread melting-down of less important artifacts, and no doubt the passing of laws, ‘in the national interest’, like Roosevelt’s 1933 Gold Confiscation Order banning the private holding of gold for investment purposes. Gold mines would be nationalized. Prices would be so astronomical that the other precious metals – silver, and possibly platinum and palladium – would be dragged along too, and might also come into use as standards. Even copper’s status and price could be elevated. However, the rise in precious metal prices could mean no more catalytic converters, gold fillings and wedding rings. The cost of electronics would rocket due to all the silver electrical contacts that they need. These are good reasons for having just one strong currency backed just by gold, with the other currencies pegged to it. However, this would still leave leeway for the other countries to grow their money supplies and cheat people. Ultimately it’s difficult to shake off the attractiveness of money just being simple and incorruptible gold, silver and copper coins everywhere in the world. Indeed, after a dollar crash it might be a long time before people trust paper money again.

However, it’s also difficult to see Governments giving away ‘their’ hoarded gold to people they see as peasants in exchange for their worthless fiat notes, so my money is on a cosy agreement between Governments for the IMF to create a new fiat currency that everybody has to use. How they would allocate it is another matter.

Sincerely,
David McCabe

April 7, 2009

After the Dollar was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

The noodle company got itself into some trouble. To simplify the story greatly, it basically lost a lot of money using derivatives to bet on dollar-rupiah movements. The loss suffered was, in fact, more than the capital of the company itself. At one point, Das writes: “What this had to do with producing noodles was a mystery.”

Exactly!

Unfortunately, this kind of story riddles the markets today like worms in an otherwise worthy cut of swordfish. There are so many of these incidences and they are ruining companies and investors across the world. It takes a nasty crisis like the one we are in to expose all these things. And the rot is extensive.

I want to share with you three little-reported events and one historical example that all show how pervasive this mindless risk-taking became during the last few years. They would be almost comical if they weren’t true.

First, consider the sad example of several Mexican and South American companies that made, large, company-jeopardizing currency bets. For example, Mexico’s third largest retailer, Controladora Commercial Mexicana (COMERCIUBC: MXK), recently filed for bankruptcy after losing so much money speculating in the forex markets. What does currency speculating have to do with selling tortillas, milk and eggs? Nothing. That’s the point.

Similarly, Sadia (SDA: NYSE), a poultry producer; Cemex (CEMEXCPO: MXK), a cement outfit; and Gruma in tortillas – all lost huge amounts of money on currency bets. Aracruz Cellulose (ARA: NYSE), the much admired pulp giant of Brazil, owes more than $2 billion to its banks for making bets on currencies that went sour. What was once a great franchise has been brought to its knees. It will take years to pay that back and debt payments now make up 40% of its pre-tax earnings.

The second example of mindless risk-taking is the story of so-called “portable alpha.” Apparently, the brain trusts that run pension funds thought this strategy sounded like a good idea. What is it? I still don’t understand it fully. But it basically amounts to a leveraged bet on the stock market. If you lose, you lose big as many pension funds are finding out. So now the Pennsylvania state employees’ pension fund, for instance, will have to take a multi-billion bath on this exotic investment strategy.

As the Wall Street Journal reports: “The stock-market downturn could force the Pennsylvania state employees’ pension fund to make cash payments of $2.5 billion or more to trading partners on Wall Street.” The fund has only $27 billion in total. At least, it had $27 billion.

Several other funds have reported billion dollar losses on portable alpha strategies. I can only imagine how many more institutional investors are in the same boat. The people running these things and advising these people should all find other work.

The third example is so-called “accumulators,” which is another kind of tactic for placing highly leveraged bet on stocks, currencies or commodities. I don’t want to get into the details. It’s so complicated; it would take me a page to explain it. Just know that, like “portable alpha” if you are wrong, you lose big.

And yet all kinds of wealthy individuals and businesses have gotten wrapped up in these things. Accumulator losses are showing up in some unlikely places. For instance, VeraSun Energy Corp. (VSUNQ: OTC), which makes ethanol, filed for bankruptcy in part because of big losses on accumulators tied to the price of corn. Citi Pacific (CIY: ASX), a Chinese conglomerate, lost $2 billion on accumulator contracts linked to currencies.

Billions and billions of dollars lost on nonsense. There was no reason for anybody to buy these things – especially when they clearly did not understand the risks involved. The losses are so bad in Hong Kong that Any Xie, an independent economist, said recently that “Accumulators are ruining Hong Kong.”

I’ll offer one other example of this kind of recklessness that is both a historical and contemporary study: Goldman Sachs.

I just recently finished perusing Charles Ellis’ new history The Partnership: The Making of Goldman Sachs. I was particularly interested in the early history of Goldman Sachs. I thought I would come away thinking how Goldman Sachs used to be a simpler business. I thought Goldman’s history would show how it took prudent risks with adequate equity backing those risks. My conclusion would then be that the current crop of leaders at Goldman were just reckless and ruined a franchise that had been around since the 1880s.

In fact, that’s not what I learned at all. From Goldman’s earliest days as a commercial paper specialist it operated with minimal capital. All through its history, it has been a business that took big risks and often took huge losses. That Goldman even exists at all today is something of a financial miracle.

In reading this history, I was struck by how the company found itself in the soup again and again and again. In the 1920s, one of the biggest speculative busts was in investment trusts in which a small amount of capital supported a spider’s web of investments in other companies. Guess who had the biggest blow-up of them all?

Goldman was big in this through a subsidiary called Goldman Sachs Trading Corporation, which basically lost everything for its investors. Ellis writes:

“While all the investment trusts suffered, Goldman Sachs Trading Corporation – because it was so large and so highly leveraged…became one of the largest, swiftest, and most complete investment disasters of the twentieth century.”

The loss to Goldman Sachs itself was enormous. It basically wiped out thirty years of profits and eliminated the “fruits of all the labors of a generation.”

Fast forward to 1970 and the biggest bankruptcy in the country at that time. You find Goldman was waist-deep in it. Penn Central at the time of its bankruptcy in 1970 was the eighth largest corporation in the country. Again, Ellis writes: “the loss it [Penn Central] threatened to impose on Goldman Sachs was not only larger than any prior loss, it was larger than Goldman Sachs.”

And so it is today, that the company once again finds itself in the middle of yet another big crisis that threatens its very existence. I don’t know about you, but I have to wonder about all the brains at Goldman Sachs and all the people who say what a great firm it is. Seems to me, for such a bunch of supposed geniuses, they routinely shoot themselves in the foot, time and time again. You don’t find Berkshire Hathaway fighting for its life every decade.

All of these anecdotes scream at me to avoid the complex and the leveraged, which often means a potential for a mega-loss if you’re wrong. The problem is these kinds of bets infect many companies, as I’ve shown, even when they have nothing to do with the core business. Even otherwise seemingly simple enterprises, like making tortillas or producing chicken, have been hurt.

The advice I have is not novel, but bears repeating since so many seem to forget it. Stay away from anything you don’t understand. (All those folks who lost money with Madoff in his $50 billion Ponzi scheme would’ve saved themselves a lot of money just with this single insight.) And avoid excessive leverage. It’s one thing to lose money. It’s another thing to lose it taking on stupid and pointless risks.

Regards,
Chris Mayer

January 8, 2009

Mindless Risk Taking was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

It’s a story as old as human civilization. The humble village and modest republic eventually grows into a bumbling empire; death and taxes come along for the ride. We believe in the sovereignty of the individual over the state not because of slavish devotion to an ideal, but because it works best. We’re not ones to keep defending ideas that look good on paper, but ignore frivolous things like history, biology and reality.

Our job here is pretty straightforward; knowing that things tend to move away from their sustainable starts, we take stake in the opposite position when we see things heading toward extremes. A slight simplification of history would be to call it a series of stories in which over time otherwise rational individuals become dangerous mobs willing to plunder their neighbors, both foreign and domestic. We fully expect our society to follow suit and degenerate under the influence of growing government, growing debt, unbacked currency, interventionism, redistributive taxation and war. Does any of this sound familiar?

Our currency’s fiat status is old news; it’s been completely unfettered from the discipline of the gold standard for nearly forty years. A gold standard is one of the things that keep governments in check. Without it, governments tend to do really evil and stupid things…like setting up a central bank that creates “money” at will, simultaneously destroying the savings of the citizenry and subsidizing unproductive businesses, practices and people. OK, now this really is starting to sound familiar.

The bad news: Our currency is probably going to collapse completely and we are probably seeing the very first days of a very long, very severe economic depression. These things happen. They happen because people think that there is something magical about voting, that it can repeal the laws of physics and that despite the old adage, one really can get something for nothing. Or at least one can simply vote what’s in a neighbor’s pocket into one’s own. It’s like magic.

Before you know it, every humble republic gives way to a society of freeloaders, nannies, connivers and bums. One set of folks makes lifelong careers out of telling independent adults what to do with the fruits of their labor. And each person in the populace expects to get at least a few things at the expense of some other portion of the populace: Housing, healthcare, food… And they don’t stop at trying to pick each other’s pockets either. At fairly regular intervals a nation will cast a covetous eye abroad at another nation’s bounty.

It’s entirely natural for people to want more than they currently have…but actually believing one can have as much as one wants is a fantasy for children…actually trying to take as much as one wants is the province of criminals. Governments by their nature result from and promote this sort of infantile banditry.

That’s why we love gold so much…and why we hate taxes. Gold enforces a rigorous standard. Gold keeps governments from quietly stealing from individuals through inflation…and what they can’t steal they can’t use to finance invasions and land grabs. And what they don’t tax they can’t idiotically redistribute.

This country’s founders got it as right as any human beings ever could and the Constitution they produced indeed resulted in the most perfect union. We wish that document hadn’t been continually ignored almost immediately thereafter.

Just a few years after the founding of the Republic, the new federal government assumed the states’ debt from the Revolutionary War. Taxes were needed to pay this debt. Alexander Hamilton convinced Congress to approve a tax on whiskey, which had become the de facto currency for western settlers. These settlers were perennially short on cash, but long on grain that was very difficult to get to faraway markets over very poor roads. Fermenting and distilling the excess grain into portable spirits just made sense. These spirits became a medium of exchange along the frontier, in effect commodity money.

The whiskey tax led to protest and revolt. General Washington himself led the federal forces to Pittsburgh to suppress the rebellion. This was the very first time under the new United States Constitution that the federal government used military force to impose its will over U.S. citizens. You can see why we take inspiration from the rebellion’s name.

We’re not really counting on a taxpayer revolt this time around — as nice as that would be — and frankly we don’t expect things to work properly for very long even after they are set right. That’s just how it is. Nothing stays in whack. A nation, like the individual bipedal organisms that comprise it, moves from birth to a peak of vigor to frailty and senescence. Then it dies. Then something else comes along and goes through the steps again.

Just because the world gleefully marches into Hell on a regular basis doesn’t mean one should lose one’s bearings. In fact it’s vital for at least a few of us to be ready to put things back together after the mobs rip everything apart.

Whiskey & Gunpowder will merrily continue to explore the intersection of personal liberty, government, sound currency, commodities and encroaching commodity scarcity.  We hope you continue to join us as we wish for something better but plan for the worst.

Regards,
Gary Gibson
Managing Editor, Whiskey & Gunpowder
November 21, 2008

History Rhyming: Gold, Government and Taxes was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

This analysis covers five factors:

1. Technical analysis
2. Politics
3. Commitment of traders (speculation vs. hedging) of currency futures
4. The carry trade
5. Fundamentals

Let’s kick off with the technicals.

Forex traders will note that charts marked with an asterisk are inverse of normal trading pairs. This was done to put all the currency pairs in the same frame of reference (e.g., a weakening chart on a currency pair is bullish for the U.S. dollar and U.S. dollar index).

Yen/U.S. Dollar (Monthly)*

Euro/U.S. Dollar (Weekly)

Canadian Dollar/U.S. Dollar (Monthly)*

U.S. Dollar Index (Weekly)

U.S. Dollar Index (Monthly)

The charts show that we are at a significant inflection point on the U.S. dollar index, the yen, and the euro. Let’s look at additional factors to see if we can gather insights as to which way the charts may break. Following is the political perspective.

Congress Takes Aim Over Yen

The Financial Times is reporting, “U.S. Congress Takes Aim at Tokyo Over Yen”:

“Powerful House Democrats are pressing the Bush administration to persuade Tokyo to strengthen the yen, claiming the currency’s weakness is bolstering Japanese imports at the expense of U.S. manufacturers.

“In a letter to Hank Paulson, U.S. Treasury secretary, the House members alleged that Tokyo was pursuing a cheap currency to subsidize exporters and urged Mr. Paulson ‘to press the Japanese government to reverse their weak yen policy.’

“The pressure from Democrats sets up a confrontation with the U.S. Treasury secretary, who argues the yen’s weakness reflects Japan’s economic fundamentals, rather than a deliberate policy of manipulation…

“Michigan Rep. Sander Levin, chairman of the House Trade Subcommittee, told the Financial Times: ‘Japan is clearly following policies to maintain a weak yen.’

“The yen’s fall continued on Thursday, down 0.4%, to Y121.20 against the dollar, and 0.6%, to Y157.90 against the euro.

“Japanese exports as a percentage of gross domestic product have — at 16% — surpassed the levels of 1985, when Japan was forced to revalue under pressure from the U.S.

“Takatoshi Ito, a member of the Japanese cabinet’s council on fiscal and economic policy, said: ‘Japan has not intervened since March 2004 — not even oral intervention — so the ministry of finance is clean as market fundamentals push the yen weaker.’

“Tensions over the yen are set to be reflected in legislation drafted in the Senate on currency manipulation, analysts said.

“Rep. Barney Frank, chairman of the House Financial Services Committee, said: ‘This is directly tied to the administration’s efforts to get trade promotion authority renewed. It cannot be the case that we will let the status quo go on.’”

Comments on Taking Aim

• The Democrats in Congress believe that higher prices on goods from Asia (nearly everything but food, energy, planes, and weapons) will be a good thing. It won’t
• The Democrats also must think that higher prices on goods will bring back manufacturing jobs to the U.S. They won’t
• Michigan Rep. Sander Levin, chairman of the House Trade Subcommittee, says, “Japan is clearly following policies to maintain a weak yen.” Hmmm. Like we are not doing everything in our power to maintain a weak dollar? Does any country want a strong currency? The answer to that question should be obvious: Competitive currency debasement is everywhere you look
• Takatoshi Ito, a member of the Japanese cabinet’s council on fiscal and economic policy, said: “Japan has not intervened since March 2004.” That is the fact. And oddly enough, the yen did not plunge until Japan stopped intervening. That goes to show you two things: 1) A primary trend in currencies or anything else cannot be defeated by manipulation, which is something gold bugs need to remember when screaming about these conspiracy theories purported by the Gold Anti-Trust Action Committee, and 2) sentiment was so universally bearish on the U.S. dollar by the spring of 2005 with numerous magazine covers and the shoeshine boy telling everyone that Gates and Buffett were short the dollar; that the dollar was bound to rally
• If Congress takes action against either China or Japan as currency manipulators, I fully expect a severe market reaction, and that reaction will generally not be welcome anywhere
• While cautioning against underestimating the shortsightedness of legislative bodies in general, this jawboning is more than likely nothing more than frustration by Congress and this administration that we can no longer bully the world markets into doing what we think is in our best interest (and on that, we are not even right). After all, who wants higher prices across the board on all kinds of goods and services when it will not bring a single job back to the U.S.? That is essentially what Congress is begging for.

Paulson Sides With Japan

Bloomberg is reporting, “Paulson, in Congress, Sides With Japan on Yen”:

“Henry Paulson’s defense of Japan’s currency policies over the last week is forcing traders to pay more attention to a U.S. Treasury secretary than they have in years.

“Paulson caused fluctuations in the yen at least three times in the past week by responding to questions about whether it is undervalued, as alleged by some Democrats and European finance ministers. He sparked an hour-long slide yesterday when he told the House Ways and Means Committee that the currency is set in an open market and that Japan is still struggling with deflation…

“Paulson first discussed the yen’s slide against the dollar on Jan. 31. Answering a question during testimony at the Senate Banking Committee in Washington, Paulson said he’s watching the yen ‘very, very carefully’…

“The testimony was only Paulson’s second since Bush nominated the 60-year-old for the Treasury post in May. It took Paulson three months to even mention the dollar. When he did, he said he favors a ‘strong dollar,’ a script developed by fellow Goldman alumnus Robert Rubin, who was Treasury secretary from 1995-1999.

“‘He has a very hands-off approach to markets and doesn’t seem to want to comment very much,’ said Sophia Drossos, a currency strategist at Morgan Stanley in New York. ‘He brings a high level of financial savvy. He is viewed as the Republicans’ answer to Robert Rubin’…

“Paulson’s remarks may also have had an impact because investors are growing wary about the magnitude of the yen’s decline. The currency is near a 20-year low on a trade-weighted basis, and Commodity Futures Trading Commission figures on Feb. 2 showed a record 173,005 positions betting on a weaker yen…

“‘As soon as he mentioned that he was watching it very closely, that gave traders something to run with,’ said David Gilmore, a partner at Foreign Exchange Analytics in Essex, Conn. ‘It took literally a couple of days for the market to fully understand,’ he said.

“Paulson ‘did an admirable job’ in cogently laying out his view, Gilmore added. ‘The interesting thing is that he was so prepared to speak on the yen.’”

Comments on Paulson

• Supposedly, Paulson is watching things “very, very carefully.” So what? Is the U.S. going to sell dollars and buy yen? Wouldn’t that be fun? (Especially if Japan reacted as it did before, by selling yen to buy dollars)
• Sophia Drossos, a currency strategist at Morgan Stanley, said: “He has a very hands-off approach to markets and doesn’t seem to want to comment very much,” and “He brings a high level of financial savvy. He is viewed as the Republicans’ answer to Robert Rubin” OK, Sophia, if his approach is hands-off, exactly why should anyone care what he is watching, or, for that matter, saying? Why does that make him “savvy”? Is he really Robert Rubin?
• David Gilmore, a partner at Foreign Exchange Analytics, had to say: 1) “As soon as he mentioned that he was watching it very closely, that gave traders something to run with” and 2) The market ran with it even though “It took literally a couple of days for the market to fully understand” and 3) Paulson “did an admirable job” in cogently laying out his view. Sheesh. I will leave this to the reader to sort out the various contradictions in those statements.

Let’s now turn our focus on speculation as defined by the Commitments of Traders reports (COTs).

Commitments of Traders

For those unfamiliar with this frame of reference, commercial traders and noncommercial traders have to report their open interest in futures (in this case, currency futures) once a week. Those results are summarized in COT reports. A quick glance at any of the following charts will show noncommercial, commercial, and nonreportable positions.

Think of commercial traders as either producers or hedgers. In the case of something like gold or corn, the commercials will be the miners or the farmers. But they could also be jewelry makers or cereal makers like Kellogg’s. In short, the commercials represent someone wanting to hedge future costs from rising or producers wanting to lock in prices at which they can profitably produce. In the case of currencies, the commercials might be importers or exporters not wanting to take on currency risk. The commercials might also be big trading houses wanting to hedge exposure to various markets for one reason or another. Commercials are thus hedgers.

Think of the noncommercials as the big hedge funds speculating one way or another (long or short) in a commodity or currency. The nonreportable positions would be a small trader speculating one way or another on currencies or commodities. Trading size determines reportability.

Using the COT Report

Investopedia offers advice on using the COT report:

“In using the COT report, commercial positioning is less relevant than noncommercial positioning because the majority of commercial currency trading is done in the spot currency market, so any commercial futures positions are highly unlikely to give an accurate representation of real market positioning. Noncommercial data, on the other hand, are more reliable, as they capture traders’ positions in a specific market.

“There are three primary premises on which to base trading with the COT data:

The COT reports come out on Friday as of the previous Tuesday. (This delay is nonsense in the current electronic age, but it is what it is.)

If you are still with me, following are a few snapshots from the most recent currency COT reports:

Yen

The above chart shows that the noncommercials (big speculators) are short 128,526 contracts in the yen (betting it will fall lower, or that if it rises, they can make more elsewhere). This is part (but likely only a small part) of the infamous carry trade (shorting the yen and investing elsewhere, typically U.S. Treasuries). Each contract represents 12,500,000 yen (as of this writing, $102,804 per contract). The total amount bet on interest rate differentials between the yen and the U.S. dollar as of the report date is $13,212,986,904.

The article on Paulson above made this statement: “The currency is near a 20-year low on a trade-weighted basis, and Commodity Futures Trading Commission figures on Feb. 2 showed a record 173,005 positions betting on a weaker yen.”

The COT charts in this blog were reported on Friday, Feb. 9, so we can see some unwinding of positions since then. Or can we? Notice I said reported on Feb. 9. They reflect positions as of Tuesday, Feb. 6. Just as with stock market short interest (reported only once a month), potentially useful information is kept from the small traders while others potentially know. This is not as bad as short interest in stocks, but there is no real excuse for it. We do not know the current position of the COTs.

At any rate, the carry trade in the yen will unwind at some point. It will not be to the benefit of the U.S. dollar when it happens. For more thoughts on this idea, please refer to “Mr. Practical on the Yen, Carry Trade, and Credit Expansion.”

One more point: An unwinding of the yen position will be yen supportive and dollar negative. That increases (but certainly does not negate) the likelihood that the trendline break in the yen as shown on the first chart is a fake one:

British Pound

A quick look at what the noncommercials are doing shows a chart that is about as lopsided as it gets. There seems to be mammoth one-sided speculation on the British pound versus the U.S. dollar.

62,500 pounds is currently $121,950, and the big specs are long 92,728 contracts, thus there is $11,308,179,600 bet on U.S. dollar versus British pound currency differentials. This will get unwound at some point, and in contrast to the yen, an unwinding of these contracts should be U.S. dollar supportive when it happens. Timing the reversal is, of course, the issue.

Canadian Dollar

For whatever reason, hedge funds are short 80,646 contracts on the Canadian dollar.

The unwinding of this trade would be supportive of the Canadian dollar and that similarity to the yen suggests a possibility that this is a potentially false breakdown.

Euro

Speculation on the euro is not as massive, nor is it as one-sided, as some of the others. However, small speculators (nonreportable positions) are substantially long (relative to small spec positions), with commercials net short 65,632 contracts and the big speculators long 45,330 contracts. The unwinding of those contracts would likely be supportive of the U.S. dollar. Each contract represents 125,000 euros (as of this writing, $162,562 per contract, or $7,368,935,460 total on 45,330 contracts). On the surface, this might not seem like such a big deal (at least as compared with the yen). But one must also look at the relative weighting of currencies within the U.S. dollar index, and that is where the rubber meets the road.

Relative Weightings

What is the U.S. dollar index?

• A widely recognized benchmark that reflects the value of the U.S. dollar on global markets
• A geometric average that tracks the value of the U.S. dollar against a basket of 6 currencies
• The USDX is based upon the original U.S. dollar index calculated by the Federal Reserve Bank, base year of 1973.

The following pie chart tells the story:

Weightings

What the Swedish krona is doing in the index, I haven’t a clue. But the key issue is that those expecting a huge rebound in the yen to sink the U.S. dollar index are likely barking up the wrong tree (at least from the standpoint of an unwinding of futures contracts). The yen is only 13.6% of the index, while Europe (the euro and pound) comprise 69.5% of the weighting, with the euro a whopping 57.6%.

This concludes Part I of Focus on Currencies. This is NOT a complete view. The carry trade in the currency markets (as opposed to the futures market) dwarfs the significance of the COT data according to some well respected economists. The message here is that it is easy (too easy) to focus on one or two aspects of a trade while missing the big picture. Tomorrow, I will attempt to fill in some of the rest of the picture with a focus on the carry trade, as well as a brief discussion on the fundamental factors that drive the relative valuations of currencies.

Regards,
Mike Shedlock ~ “Mish”

February 12, 2007

Focus on Currencies, Part I was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.