History Lesson from Niall Ferguson

A couple of months ago, Niall Ferguson was asked to speak at the Ninth Annual Niarchos Lecture. Niall Ferguson is a famous historian from Harvard. He has written many books like the following: The Cash Nexus, War of the World, and The Ascent of Money: A Financial History of the World. When he speaks people listen; here are some of the points of interest from his speech (most bullet points taken directly word-for-word from Niall himself):

• There is a suddenness to things when they go wrong in finance
• Canada is one country that is NOT involved with the extraordinary debt increase that most of the rest of the world is experiencing
• Crises of either war or internal politics (sometimes both), drove investors to sell bonds and therefore to drive up the yields on the bonds
• Exploding deficits to pay for the war and surging public debts caused an increase in risk in the eyes of investors
• It is striking the way in which very suddenly confidence can be lost in a country
• Ken Rogoff made the point that 90% debt-to-GDP is the threshold after which public debt tends to be associated with problems of low growth or high inflation, usually both (currently we are at 89% debt-to-GDP)
  
• Italy is much less vulnerable than Greece in the respect that most Italian debt, like most Japanese debt, is held by natives; it's not actually held by foreigners
• In the months ahead, look for debt default synonyms like repudiation, standstill, moratorium, restructuring, rescheduling, etc...Don't be fooled by the language, it still equates to debt default
  
• US treasuries are a safe haven the way Pearl Harbor was a safe haven in 1941; safe but not for much longer
• Favorite cartoon: Chinese sub threatens the US Navy. The Chinese submarine captain is says, "Turn around or we sell all our T-bills!"
• When you're spending more on your debt than on your army or your navy, it's all over as a great power
• It's not a thousand years that separates imperial zenith from imperial oblivion. It's really a very, very short ride from the top to the bottom
  

Economic Indicators

Let's review some important economic indicators, think about some questions, and draw some conclusions. Starting with Real GDP:

Number 1:

Real GDP = C + I + G + (Ex - Im) (Inflation adjusted)
where C = consumer spending - Think consumers are spending?
I = private investment - Think money is being pumped into businesses?
G = government spending - Think the government has blown all the money yet?
Ex = exports - Think we produce much in this country anymore?
Im = imports - Think we buy more US made than Chinese made products?

1st quarter of 2010 Real GDP: 2.7%
4th quarter of 2009 Real GDP: 5.6%
(source: bea.gov)

The Real GDP shows the effects of government stimulus running out. The last time we saw a nearly 3% drop in Real GDP was from the 3rd to 4th quarter of 2008.

Number 2:

M2 - aggregate of money supply in circulation.

June 2010 M2: 8,611 (in billions)
(source: federalreserve.org)

Fed Reserve uses this to determine whether to raise or lower interest rates thereby contracting or expanding the money supply. The more you have of something the less it is worth. A good analogy for those sports card collectors out there is when you open a pack of baseball cards the cards that are most abundant are worth the least (a.k.a. the commons). This is the highest M2 has been in two years, which means that higher interest rates could be coming soon.

Number 3:

Consumer confidence survey - economic sentiment of 5,000 random people
Consumer confidence index - based upon the numbers from the survey

June 2010 Consumer Confidence Index: 52.9
May 2010 Consumer Confidence Index: 62.7
(source: conference-board.org)

The consumer confidence index is used loosely to determine what consumers think of the economy. A higher number means consumers are optimistic, and that they tend to spend more.

Number 4:

Housing starts - indicates housing construction activity on building new homes/buildings, and modifying existing homes/buildings

May 2010 Housing Starts: -10%
April 2010 Housing Starts: 3.9%
(source: census.gov)

Housing starts are a large part of our GDP (about 5%). This indicator is historically volatile, but over the course of six months solid trends can be formed.

Number 5:

S&P 500 index - 500 stocks from a broad selection of industries that gives us a good indication of our economy's overall health

July 16, 2010 S&P 500 Index - 1065 points (downtrend forming)
Mar 6, 2009 S&P 500 Index - 683 points
(source: finance.google.com)

One of the best indicators of the overall economy's current health. The index is off 200 points in about 3 months. All the news about the economy's performance in all sectors and industries is factored into the price.

What are Your Conclusions?:

• What do you make of these indicators?
  
• Where do you see the economy going in the second half of 2010, if there is government stimulus, and if there is not government stimulus? (Two very different outcomes!)
• How can be bring the manufacturing base back to this country?

Union Bailouts?

President Obama is asking for $50 billion dollars worth of emergency aid for the State and local governments. For more info on this act of desperation, click the link Obama Pleads for $50 billion. According to President Obama, "the money would avoid massive layoffs of teachers, police, and firefighters". It does NOT fix anything, but rather kicks the can down the road for the next politician to deal with.

This bailout is clearly for unions, as they are not willing to accept concessions. There was a rally of Union employees recently where their chant was "raise our taxes". Here is a link to the video: Union Employees' Want Higher Taxes. You have to read the top comments associated with the video...

We cannot bailout the unions because that will NOT solve the underlying issues. The issues are as follows: union pay (far above private companies), union benefits, and of course pensions. The process will be difficult, but the sooner we fix the underlying issues the sooner we can be on the road to recovery. Regardless what the mainstream media tells you, we are clearly not in "recovery" just take a look at the foreclosure numbers (among many other economic metrics).

Preserve Your Wealth

Cash won't be King; buy and hold real assets like commodities, real estate, raw land, etc... In the near future (three years maybe sooner), you will be much more worried about preserving your wealth than making a huge profit. Here are some reasons why I think this way:

1. U.S. government expanded money supply from 500 billion in late 1990s to over 2 trillion in 2010
   
2. Warren Buffett stated “Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value.”
3. $45,000 today has the same purchasing power of $5,000 in 1950
4. $5,000 held from 1913 is worth about 5 cents today
5. US debt hits a record of 13 trillion
   

US Treasury Market Looking Shaky

Take a look at the numbers below of a fairly recent 30 year US government bond auction, things are not looking good.

(Source: SeekingAlpha.com)

Out of the highlighted numbers two of them are particularly horrible; the Bid to Cover and Indirect. The bid to cover is calculated by taking the number of bids received divided by the number of bids accepted. Essentially the higher the bid to cover the higher the demand. In the bond auction community, a bid to cover of 2.0 or less is considered an auction failure, and we came very close to that.

Soft demand in a low bid to cover ratio is verified, as foreign demand for treasuries is falling. China recently sold about $35 billion worth of their treasuries, and Japan sold about $10 billion worth of their treasuries. Also, Dec 2009 was the worst sell off on record. Interest rates could be increasing in the near future at the worst possible time for the US because of the sheer amount of debt to be auctioned in the near term future.

Then the indirect number is high. An indirect bid is a bond bid that does not go through a dealer, and this is generally viewed as quantitative easing because there is no transparency in who is bidding. Nearly 30% of the winning bids came from indirect bidders. In the bond market community this is seen as the US govt purchasing more of their own debt with the intention of selling at a later time when demand is stronger.

Bond market is currently leaning more towards inflation instead of deflation. This could be largely because of the long term weakness in the US dollar. A good indication of confidence in the US dollar is shown in the price of the treasuries. If the chart was extrapolated five years in the past we would see that the current price level is what the price was in 2002.
(Source: Google Finance TLT quote)

Conclusions:
1. This decade we should see some serious inflation
2. Interest rates must rise to entice foreign buyers to take on the risk
3. This decade is going to be a horrible one for the US dollar's purchasing power; hyperinflation is probable
4. Quantitative easing will not slow down, but rather accelerate as demand lessens over time

Casino Bet With Odds In Your Favor

The money making trade (in the short term 3 - 6 months) with the odds in your favor is shorting the stock market, and profiting from the decline that could be heading our way at the end of this year and into 2010.

Why would this be a good trade? Below are my top 3 reasons.

Reason #1:

Based on the last ten years, the "January Effect" has led to stock declines nine out of the last ten years. Much selling occurs in the final week of December and into the month of January. All this selling, causes stock prices to pull back a bit. Below is a chart to illustrate the January Effect over the past decade.


Reason #2:

As of late there has been a strong inverse correlation between the dollar and the stock market. If the dollar increases in value the stock market decreases and vice-versa. As such, the dollar has been losing much value as of late, and a short term dollar rally might be in the cards.


Reason #3:

The appetite for risk is going to lessen because of what is happening around the world. There is Dubai defaulting on their debt, which is not too significant if it was an isolated event that did not affect other parts of the world. Greece just recently received a debt downgrade from Moody's, and the Baltic area in general is experiencing many economic and social issues because of the huge deficits they have. Also, Spain just received a debt downgrade from Moody's. These occurrences are not isolated to the countries with which they happen, there will be worldwide effects from these issues with debt whether it is big or small.

US States' Budget Deficits

It is an endless cycle until we see a "real" recovery. Unemployment continues to rise, salaries and hourly rates of those who still have a job are seeing their incomes drop, and States are continuing to spend more money then they receive. More and more Americans are on food stamps, yet bankers continue to receive billions in bonuses for a job well done. States are going to have to make a choice (they might select multiple options). They will either use inflation (debasing the currency) to pay back the debt in cheaper dollars, significantly raise taxes, or default on the debt. Debasing the currency seems to be a popular trend right now for the US; I think throughout 2010 we will start to see higher taxes along with it. I would think defaulting on the debt is the last thing a State wants to do, but we could see some of this over the next few years in high risk States like California, and New York. Below are a few related articles for your viewing...

http://manyeyes.alphaworks.ibm.com/manyeyes/visualizations/state-budget-deficit-map-2010-estima

http://www.saratogian.com/articles/2009/11/21/news/doc4b0768cb81be1584614972.txt

http://www.sdnn.com/sandiego/2009-11-19/politics-city-county-government/california-budget-politics-city-county-government/california-budget-crisis-diaries-new-guess-for-state-deficit-tops-20-billion/comment-page-1