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The household balance sheet remains the primary concern with regards to the economic recovery. The latest data from the Federal Reserve on consumer credit showed the first expansion in credit in 12 months. While many view this as a positive I remain skeptical of the sustainability of the recovery. Total consumer credit expanded to $2.46T in January. Unfortunately, this is exactly what the consumer shouldn’t be doing right now and substantially increases the risk of a stimulus withdrawal resulting in a double dip in 2011 or 2012. At the same time we are beginning to see signs of life in consumer sales – another potentially negative omen for the wobbly recovery. While all of this might appear to be a positive at first glance it substantially increases the risk of a double dip. Allow me to elaborate.
Fitch recently reported that the charge-off rate for prime credit cards remains at its highs:
Fitch Ratings-New York-03 March 2010: U.S. credit card charge-offs surged to near record levels set last fall, according to the latest Credit Card Index results from Fitch Ratings.
Fitch’s prime credit card charge-off index jumped 112 basis points (11%) to 11.37%. The results, which cover the January collection period, pushed the index to its highest level since September 2009’s record 11.52% and 54% above year earlier levels. The increase was largely driven by a payment holiday for Chase credit cardholders, which pushed more charge-offs into the current period .
This highlights the continuing debt woes in the private sector (specifically consumers). As we’ve long maintained, it is this perpetual expansion in consumer debt which not only caused the credit crisis, but could ultimately result in its nasty revival. As Fitch notes, these trends are likely to continue barring some miracle return in jobs growth:
“Late-stage delinquencies are still trending in the 4% range industrywide, which is keeping chargeoff levels in the double-digits,’ said Managing Director Michael Dean. ‘Until we see some meaningful improvement for employment numbers, consumer delinquencies and defaults will remain elevated at or near these levels.”
Remember, we’ve lost over 7 million jobs during this recession. If the jobs recovery were similar to the 2003 employment recovery it would take until 2016 to get back to the pre-credit crisis employment levels.
What’s so interesting in all of this is the potential for a consumer led double dip in 2011 or 2012 if the government steps aside and the stimulus programs end. As the following chart shows, you can easily see that American households have simply spent more than they earn over the last 6 years. Ignore every single one of those parabolic (fear mongering) debt charts you have seen all over the internet and in research reports that attempt to show how scary the U.S. government’s mounting debt woes are (remember, as the sovereign issuer of the currency, THE UNITED STATES CANNOT DEFAULT ON ITS OBLIGATIONS! – see here & an explanation of the continuing deflation threat here). But households certainly can default and do so every day.
What’s crystal clear over the preceding 12 months is that the government stimulus has attributed for the majority of the economic rebound. The hope, of course, is that the public sector will soon hand over the baton to the private sector. I fear that is not a transition that can occur just yet. According to my calculations the $1.4T gap between what households earn and household liabilities will continue to be a strain on households for approximately TWO more years. This assumes no major structural changes in the economy or the housing market (which I actually expect to further weaken barring even more stimulus). Households need to continue de-leveraging in order to repair their balance sheet back to a time when their incomes are in-line with what they spend.
Of course, a continuing culprit in all of this is the banks. This industry which takes much and produces little, continues to hurt the potential economic recovery with their debt based revenue model. This is not to imply that the U.S. consumer played no role in taking out more debt than they should have, but the lack of regulation in the banking industry substantially contributed to the gross amount of debt that consumers (and banks) have been allowed to take on (no doc, no down loans come to mind here). The United States government absolutely must pass harsh regulation on these banks and prohibit them from ever being able to fool the consumer into taking on so much debt (or leveraging up their own balance sheets with reckless products). At the same time, U.S. consumers must wise up, continue to fix their balance sheets and make prudent and educated financial decisions.
The latest data from the Fed on consumer credit shows that the days of saving and financial prudence may have been short-lived. If the consumer continues to take on more debt than their income we will continue to see a very weak economic recovery. And if the government attempts to pass on the baton by falsely assuming that the consumer can run with it, then we are at very serious risk of a double dip in 2011 or 2012.
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Gold is hotter than ever. You can’t turn on the TV these days without seeing a gold commercial. Several well known hedge fund managers have leveraged up positions in gold while John Paulson even went so far as to start his own gold hedge fund. As an asset class gold has outperformed just about everything over the last 10 year period. It’s been an impressive run. But is it all justified? Bear with me for a bit while I take a long-term macro look at gold as an asset class….
After having experienced deflation through much of 2008 and the beginning of 2009 the economy began to reflate as the Fed’s printing press (or button pressing if you prefer) went to work. Asset prices began to stabilize and bank balance sheets were suddenly flush with cash as the Fed provided liquidity like it was going out of style. The inflationistas immediately began crying wolf. All of this extra cash was certain to cause inflation. And that meant one thing: buy gold and short dollars. Right?
All was not what it seemed, however. Underneath the surface, there was no real reflation – only continuing signs of deflation or at best, very benign inflation. Asset prices surged as money flowed out of low risk assets (for which investors were no longer rewarded) and into high risk assets. This herding of the Federal Reserve has given many the impression that the economy is “recovering”. But underneath the surface lies the continuing problem of double D’s (and not the good kind) – debt and de-leveraging. While asset prices have improved the liability side of the ledger remains in tatters in the U.S. economy and around the world. De-leveraging continues and demand for more credit remains subdued. Yet, the price of gold rallied. I believe a large portion of the move is based on the misconception of gold as an asset class.
When analyzing the price of gold it’s important to understand that gold prices do not move like most other commodities. It has certain built-in unquantifiable characteristics that drive price. The price of gold is actually a function of four things: 1) its replacement potential for the U.S. dollar; 2) the future rate of inflation, 3) Sentiment – generally fear based and 4) true supply and demand. Let’s take a look at each.
Nouriel Roubini recently quoted Keynes in describing gold as a “barbarous relic”. While I can’t entirely agree with that opinion I think there is a certain level of truth there. Let me elaborate. There is a certain premium built into the price of gold because it is viewed as a currency – currently an alternative to the dollar. It has served as a reliable currency for thousands of years and continues to be seen as an alternative to fiat currencies. Going forward, I think this is a dying belief which has led to considerable confusion in the current economic environment.
The fact of the matter is, the fiat currency system is here to stay (or at least some form of it). The odds of reverting back to a purely gold based system is next to zero in my opinion. The truth is, the gold standard as a currency system is a barbarous relic. It is a currency system that worked well in the old world economy, but simply does not have the flexibility to meet the demands of the growing global economy. The global economy has become too complex and too intertwined to be constrained by the gold standard. The fiat currency system is a product of economic evolution and the growing demands and strains of international trade. Famous examples of the break-down of the gold standard and its inflexibility to meet trade demands include the UK in 1931 and the U.S. government’s destruction of the gold linked currency system under the Bretton Woods agreement.
Gold investors generally make the false argument that the gold standard somehow stabilizes prices (as if the price of gold is stable) or will restrain governments from excess spending, but the truth is, under sound stewardship, the fiat currency system provides all the benefits of the gold standard and all the flexibility that the gold standard didn’t contribute. In addition, the gold standard had a tendency to cause severe strains on countries due to trade imbalances and the inability to provide flexibility to countries with trade deficits. The argument that inflation, instability, corruption and mal-investment cannot occur under the gold standard is historically false.
If we were to alter our currency system it is most likely that we would move to a currency basket of some form, a global currency or move to a commodity basket – of which gold would likely be a component. Realistically, however, the odds of moving back to the gold standard (or even a commodity basket) are next to nothing. Nonetheless, gold investors remain hopeful of a currency collapse and a rewinding of our economic evolution. Don’t count on it. The current monetary system provides sovereign issuers of currency with a powerful monopoly over their currency and they are unlikely to relinquish this power into the hands of gold producers or an international currency (or bank) any time soon.
The popular idea of hyperinflation is one of the primary arguments in favor of gold. Of course, as we’ve already discussed, this is inherently flawed because the likelihood of reverting back to a gold based monetary system is virtually nil so anyone hiding gold bars under their bed is unlikely to find themselves trading them back and forth at the local Wal-Mart any time soon. Regardless, speculation, corruption and mal-investment will occur in any currency system that allows such things to persist. If these inefficiencies are allowed to persist they can lead to inflation and economic ruin. The favorite arguments used by inflationistas are the Weimar Republic and Zimbabwe, however, any true historian understands that the United States is not even remotely comparable to these corrupt and inefficient economies. The comparisons are completely and entirely debunked by Bill Mitchell at Billy Blog. This is not to imply that inflation cannot occur in the modern currency system, but under sound stewardship the fiat currency system is no more potentially destructive than a gold standard (where sound stewardship remains a necessity).
Of course, there is nothing in a gold standard that keeps a country from becoming a poor steward of the currency. In fact, the restrictions of the gold standard have resulted in more government defaults than any flexible exchange rate fiat currency. The argument that 99% of all fiat currencies have failed is simply an outright falsehood. Fiat currencies restricted by the gold standard or pegged to another currency have failed repeatedly. That is not the system in which we reside today. It’s important to understand that the currency system in which we reside is vastly different from the pre-Nixon Shock currency system in which currencies did not freely float and currencies were convertible. As I described last week, a sovereign issuer of currency with no foreign denominated debt cannot go bankrupt in a floating exchange rate system unless it effectively decides to. Inflation is another story altogether, but we’ll touch on this further.
Most of the hyperinflationists or gold investors I know are worried that the Fed’s printing press (or button pressing if you will) will ultimately result in inflation. This is not entirely correct. As I have previously explained, when you pour an iced tea packet into a pitcher of water you don’t automatically get iced tea. You have to stir it in. Our banking system is much the same. There is no demand for credit as of now and therefore there is no expansion in the amount of actual money in the system. Because the private sector is busy repairing their balance sheets aggregate demand remains historically low. Therefore, the hyperinflation argument remains bunk. The latest readings on wage inflation, demand for credit, etc all point to continued de-leveraging and low demand for credit, and in our banking system that means inflation is not yet a concern. For all his faults, even Bernanke would not be ignorant enough to leave rates at 0% when there are signs of inflation. Mr. Bernanke is actually acting as a relatively good steward of the currency now (we’ll see how long that lasts – I am not banking on it).* For a more detailed explanation of the deflationary risks please see here.
In terms of sentiment there is an inherent premium built into gold because it is viewed as a safehaven currency. This opinion is generally sold to the public by investors who genuinely believe the world is going to end or that the modern economic system will ultimately fail as the dollar crumbles. These people genuinely believe that the entire global economy will collapse one day and we will all be sitting around trading our gold bars back and forth. This is pure and simple fear mongering. This is not to imply that the U.S. dollar can’t fail or that the fiat currency system will always exist in its current form, but the idea of reverting back to a time when we carry gold in our pockets in order to purchase goods is simply ludicrous. “Barbarous” as some might call it. The truth of the matter is that the fiat currency system is simply an evolutionary step in our economic progress. Those who latch onto the days of the gold standard simply don’t understand how fiat currency works in the current floating exchange rate system. If you want to believe the global economy will one day collapse that is just fine, but should that scenario actually pan out the last of your concerns will be which local market is accepting gold in exchange for food. The man with the most lead will be the man with the most food in that scenario.
Where gold does contain real value is as an actual commodity. I don’t believe that gold has no intrinsic value as many gold haters believe. I believe it has intrinsic value in the same way that diamonds have intrinsic value. I just don’t believe gold should have any intrinsic value as a currency. None. From a purely supply and demand perspective the gold market actually looks fairly constructive. Nouriel Roubini pointed to several reasons why gold is not necessarily a bad investment:
“the global supply of gold—both existing and newly produced—is limited, and demand is rising faster than supply over the medium term. The recovery of the global economy has started a revival of retail gold demand especially in India. Central banks looking to diversify their portfolios account for further demand—see for instance, the recent increase in gold holdings by emerging market central banks. Most of the increase in demand comes from private investors using gold as a hedge against low probability tail risks of high inflation and another near depression caused by a double dip recession. Inflation risk and the risk of a double-dip are both low, suggesting lower gold prices, but increasingly investors want to hedge against such risks early on. And given the inelastic supply of gold, it only takes a small shift in the portfolios of central banks and private investors to boost increase the price of gold significantly.”
Passport Capital recently laid out the bull case as well:
- Demand in India and China is surging and demographic and wealth trends should bolster prices.
- Demand from central banks has undergone an important shift in recent years in response to the credit crisis.
- Mined supply peaked in 2001.
- The ability of above-ground gold stocks to satisfy demand is undergoing structural change, and markets may be overestimating their ability to satisfy an increase in demand at current prices.
One might conclude that I think gold is a terrible investment after reading this. That couldn’t be farther from the truth. I simply believe gold is a misunderstood asset (particularly as an alternative to the dollar). I know that the overwhelming majority of investors see value in gold and therefore it is ignorant to ignore its potential as an asset. The modern fiat currency system is still largely misunderstood and very young. It will take time for investors to learn to trust it and fully understand its benefits.
Of course, these misconceptions are likely to persist for years if not decades and ignoring the beliefs of a huge amount of the investment world is no different than the fundamental analyst who ignores the millions of chartists in the world. The belief is there therefore the price action is there. I believe there are good reasons to hold gold in ones portfolio, but those reasons should be purely based on the underlying laws of supply and demand at work as they pertain to gold’s value as a commodity. The idea that we will one day revert back to the gold standard is simply not pragmatic in my opinion. If I were a betting man (and I am) and if I had to bet my lead on it I would bet that the idea of gold as a currency will be almost entirely extinct in 500 years. But that doesn’t necessarily mean the price of gold won’t be much much higher.
In conclusion, I continue to fail to grasp the rationale for gold as a safehaven in this environment. As we learned in 2008 the true safehaven in the modern floating exchange rate fiat currency world is actually the reserve currency. With little to no inflation the inflation hedge argument remains bunk. As for sentiment and the collapse of the modern economy, well, I don’t think gold will be the thing you really want to own in that world. It is not gold we will all be clamoring for, but lead and God save you if you don’t have something to load that lead into because those gold bricks are mighty hard to throw at someone….
*It’s important that I enter one caveat here. As regular readers know, I believe the current print and spend policy will do little to fix the long-term structural problems in the real economy. The real problem in the U.S. economy is that we remain in a stranglehold by a banking sector that is too large, too powerful, unproductive and poorly allocates capital. The problem with Bernanke & Cos. plan is not that they are necessarily being poor stewards of the currency, but rather that they continue to allow bankers to allocate capital in an entirely unregulated manner. This should not be fixed via currency restructuring or even austerity necessarily, but through harsh regulation and permanent downsizing of the banks. But MUCH more on this in a later article….
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We’ve compiled many of the very best outlooks from various analysts, gurus, hedge funds and investors. We hope you find the list helpful in mapping your successful 2010:
Wall Street Banks
Hedge Funds & Investment Gurus
Actionable Ideas, Alternative Assets & Potential Potholes
The Outlook Abroad
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The full report is attached below. For more outlooks please see our 2010 investment guide.
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Eric Sprott of Sprott Asset management has been very vocal about his disbelief of the 2009 rally in equities. He believes the U.S. economic recovery is simply a continuation of the ponzi debt based scheme the U.S. has been running for years. He’d be easier to shrug off had he not predicted the current crisis and navigated his firm through it with extraordinary success. Sprott’s fund has returned almost 500% during a period where the S&P was sliced by a third. In a recent Bloomberg interview he said:
“We’re in a bear market that will last 15 or 20 years, and we’ve had nine of them. We don’t have employment gains. We have less of a decline. That’s a sign of weakness. The data is weak.”
Sprott thinks the U.S. debt based/printing recovery has the potential to cause further gains in gold as investors lose faith in the U.S. dollar and shy away from fiat currencies:
“If you get into this thing where you’ve got to keep printing more and more and more, who knows about the price of gold? It will be the new currency in due course.”
You can read his full thoughts on the Ponzi economy below:
Source: Sprott, Bloomberg
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The only way to become a great investor is to have a strong strategy, a good plan and superb execution. But like any business or profession, things don’t always go as planned. Mistakes occur and the unforeseen impacts life in curious ways. The greats in industry study their mistakes and learn from them. Ali didn’t become the greatest until he lost, learned from his losses and then used these lessons to succeed. The investment business is no different. You’re going to make mistakes. Own them and learn from them. (For more on this please see our 9 rules of trading and why you likely trade like a loser).
With that said, I’d like to take a few moments to do what few investment professionals take the time to do – hold our feet to the fire. A year ago we made 10 investment predictions (you can see our 2008 predictions here as well). Some were good, some were bad, but all can be learned from. Let’s take a look:
1. The U.S. economy remains in very poor condition throughout the first half of 2009. Stock market volatility remains high and the market remains in a trading range between the 7,500 November low and the 9,500 October 31st high throughout the first two quarters of the year. Ultimately, signs of recovery appear evident by the 4th quarter of 2009 and the market ends the year near Dow 10,000 for a total return of 18%.
Besides a brief dip below 7,500 in late February and early March the market remained in its volatile range of 7,500 and 9,500 for the first half of the year. At the beginning of 2009 we were quite bullish about the second half of 2009 based on the severely depressed expectations. At turn of the year investors were very complacent and we remained cautious in the near-term. As markets deteriorated rapidly we were forced to evolve with it. The potential for drastic government intervention became clear to us in early March and we were incredibly lucky in timing our first bullish positions in 2009. Ultimately, we sold into the rally far too early and never fully trusted the rally throughout the year as the fundamentals never caught up with the liquidity driven rally. Aside from our very timely earnings buy calls (prior to each of the last three earnings seasons) we remained overly cautious (though we maintained a “no shorts” position throughout the move higher) and never fully trusted the true bullishness that was on full display in our expectation ratio (which turned bearish in mid 2007 and bullish in January of 2009). As the risks appeared elevated throughout the year we remained diligent in our goal of managing those risks. Nonetheless, our overall predictions regarding the equity markets were solid (though our execution could have been more aggressive). With the Dow up 18.7% as of today our 18% prediction is closer than I could have ever imagined.
2. The jobs picture remains very weak throughout all of 2009. The unemployment rate reaches 10% by the end of the year.
The unemployment rate is at 10% as of the end of November and the jobs picture remains the one missing piece of the recovery puzzle.
3. Housing remains in a steep decline, though the rate of decline slows substantially by the middle of 2009. The market does not rebound, but false hope of a sharp turnaround appears possible by the end of 2009.
Housing prices continued to fall in 2009, but the recovery calls are becoming routine. False hope of a sharp turnaround certainly appears to be on the table. After all, even Bob Toll is looking for “a serious good time”.
4. The Euro weakens throughout 2009 as the Eurozone economy remains in a deep recession. The dollar makes a surprise rally in 2009 as the U.S. becomes a safe haven currency because the U.S. appears to be crawling out of recession sooner than other nations.
This was just flat out wrong. We theorized that inflation would make a greater appearance in 2009 and that rates would likely rise. We thought this would boost the dollar and the Euro would sell-off as Europe lagged other markets. We were just plain wrong. Curiously, the reflation trade proved enormously successful despite few signs of inflation.
5. Commodity prices stabilize in 2009, but no huge rallies occur as we saw in oil last year. Oil maintains an average price of $50.
Oil rallied 60%+ on the year and averaged $60 for the year, far exceeding our expectations. Like stocks, we got the direction correct, but the strength of the move wrong.
6. Foreign stocks are mixed. Europe underperforms the U.S. as its recession deepens, while Asian stocks rally for 20%+ gains in 2009.
Once again, the idea was dead right as Europe underperformed the U.S. and the U.S. underperformed Asia. The move, however, was far more powerful than we assumed.
7. The Fed is forced to raise interest rates by the end of 2009 as inflation appears to be gaining some traction and the threat of deflation appears to be overblown.
This was the missing piece of our investment outlook. We severely underestimated how far the government would go to save the economy. The amount of money that has been thrown at these problems is truly staggering. The recklessness of government spending and the Fed’s bubble policy is beyond our wildest expectations.
8. Treasuries underperform TIPS (treasury inflation protected securities), as inflation fears cause a sell-off in bonds and a rush into TIPS.
Anyone running fixed income portfolios with this low risk trade on at the year’s beginning was on the beach by June 30th. This was a home-run trade all year long as TIPS rallied over 6% and Treasuries tanked 20%.
9. The big 3 bailout turns out to be a black hole bailout. The billions in bailout money do little to revive the companies and they are forced to consider massive restructurings before getting the hundreds of billions the Obama administration is bound to fork over.
With Chrysler and GM coming out of bankruptcies and an estimated $30B in taxpayer losses I think it’s safe to say this was pretty spot-on.
10. Russia experiences a massive fiscal crisis as the value of the ruble tumbles, oil prices remain under $70 and corruption takes its toll on the country.
This couldn’t have been more wrong. The Russian stock market doubled on the year and oil is likely to finish the year above $70. With Russia’s high beta correlation to EM’s we should have known better than to predict a decoupling from the rest of the emerging markets.
Stay tuned in the coming weeks for our 2010 outlook and predictions.
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If you missed Keen’s speech on the credit crisis it is an absolute must see. His predictions for 2010 follow. They are equally good:
* Special thanks to Credit Trader for bringing this to our attention
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It kind of feels like the credit crisis is behind us, right? Spreads have normalized, markets have rebounded a large portion of their losses, etc. But don’t be fooled. These problems will plague the U.S. economy for years to come. As the top comment on YouTube says – “This should be required viewing for everyone in Congress”.
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Central Banks are re-inflating bubbles all over the world. This is a must read piece of research by David Rosenberg. There no doubt that we are in the throes of a central bank induced re-inflating of global bubbles:
