Wednesday, October 22, 2008


When the real estate recession began to bite in 1989, international stocks began to suffer in relative terms. 1989 was a good year for investments with the average investment up 18.24%, but the average REIT was up only 8.6% and the average international stock was up 10.5%. The next three years, international stocks were at the bottom of the list of performers. In 1990 the average investment was down 4.8% while the average international stock was down 23.4%. From 1989 through 1997, international stocks were the worst or second worst performers 7 out of 9 years. The 1990's were great years to be an investor, an American investor. A similar story can be told about the years following the 1973-74 real estate recession. US stocks do very well in the years that follow real estate recessions.

This morning the EU has fallen relative to both the US Dollar and the Japanese Yen, again. The big turn is still happening. The price of a barrel of oil is trading below $70, the China market is down again, the 10-year treasury bond rate is down, the wholesale price of gasoline is down to $1.63 (implies the retail price will soon fall to $2.23), gold is down another $11and the list continues. Silver, platinum, Korean stocks, Thai stocks, European stocks, Hong Kong stocks are all trading down. Over the next 12 months, assuming energy prices stay at current levels, the average household will save $4,800 on energy costs. The savings in other areas are more difficult to determine but they will be even greater. With the price of copper, steel, zinc, palladium, down 50% or more, the price of your next new car will be considerably lower than it would have been. Loan rates will soon be at lows not seen in 70 years.

This morning, the big movers, in England, are once again basic materials, capital goods and energy. Commodities of all stripes have gone from tight supply to excess supply. In the mean time, Paulson has asked banks to apply for bail out money by November 14. Paulson's push to get congress to act was once like a man whose house was on fire. After he got control, the government bail out is moving as fast as molasses. At the same time, the FOMC is supplying all sorts of funds to the banking system. Bankers are being given plenty of liquidity with which to remain in business while they wait to find out their fate. Will they be forced to sell shares to the government or not? Many banks will be forced to merge with others. Those who do not need the government money are making plans to buy banks that do not "qualify". The treasury department has been given extraordinary power to pick winners and losers. It is clear that the Bush administration cared more about making big money for the super fat fat cats than about winning republican votes. The action of throwing McCain and the rest of republicans under the bus, has caused billions if not trillions of dollars to run from the market just when money should be running to the market. The super fat cats have purchased billions of shares, including shares from former fat cats. A number of billionaires who were not close buddies of the super cats are now millionaires.

Yesterday, a sophisticated reader, one who is in the investment business, worried that the huge amounts of money being printed by the FOMC are going to cause hyper inflation. I reminded this fellow of the fact that private banks actually control the printing of money. Yes, the FOMC has injected high powered reserves but the money pipeline flows through the banks. The FOMC cannot fill the swimming pool as fast as the banks can collectively drain it. To put it another way, the job of the FOMC is to lean against the banks. The FOMC did not do its job a few years ago when the banks were "printing tonnes of money", but it is currently trying to fill the pool that is being drained rapidly by banks. The monetary base has recently grown by more than 15%! The FOMC is supplying money; stocks and money growth trade together; the new supply of money is increasing the demand for stocks.

Banks print money by loose lending. There are always willing borrowers. The way congress set up the mortgage rules, banks were being paid fees to lend money and there was no end to the lines at the door. The banks that sold the loans seemed to have avoided all risks; most got burnt by buying the AAA rated securities packaged by investment bankers such as Paulson. The current situation is that many banks are on the hook for bad loans made in the past. The average bank has raised the qualifications for getting loans. The FOMC is printing money but banks are soaking up old loans.

To put the above in mathematical terms M*V = P*Q = GNP. The FOMC is printing money but the velocity of money has fallen dramatically and thus the product of P*Q probably fell from second quarter levels. In the energy, basic materials and capital goods areas, we know that it is P that is falling rapidly. Quantity sold in a some areas has been falling but there is a see-saw effect going on. The further the declines in P, the greater the Q that will be sold. In the past quarter, GNP was probably lower than the previous quarter but the quantity sold is going to soar over the next couple of quarters.

The other thing to remember is that money is nothing but another commodity; the rapid fall in the price of commodities, including the falling price of money, is anti inflationary. Copper went up from 50 cents to $4.25 while the retail price of gasoline went from $1.25 to $4.11. The price of copper is now close to $2 and, based on the wholesale price that is working its way to market, the retail price of gasoline is down to $2.23. The price of copper went up 850% while the price of gasoline went up 320%. Gasoline gets noticed, with big signs posted on every corner, while the price of copper is hidden in the price of other goods. The price the FOMC charges for money has fallen from 5.25% last year to 1.5% this year. The decline in the price of money has been bigger than the decline in the price of copper which was bigger than the decline in the price of gasoline. The average fellow spends far more on money and other commodities than he does on gasoline.

One of the ways to play the current situation is to own commodity short funds. For example, there is a double short gold fund and a double short oil fund. These funds have been soaring for the past few months. If the price of gold and oil continue to go down, these funds will continue to do well. I am most confident about the continued decline in the price of gold. The current price includes a "flight to quality" premium. People have purchased gold because they believe the wheels are coming off the economic wagon.

One fundamental reason to buy gold is to protect against negative real interest rates (inflation). The thing is that declining commodity prices are going to raise real interest rates. As soon as the economy starts to move, the FOMC is going to reduce the stimulus of new money, short rates will rise and gold will face high real rates. The past several years were remarkable in that inflation remained relatively tame even as the price of corn, copper and oil exploded. China gets all the blame for the high price of corn, copper and oil, but it also should get the credit for supplying labor at cheap rates. The average American has been blessed by the lower cost of goods and by the creation of high paying jobs in America, jobs that in one way or another are connected to the strong economic growth in China.

In regard to the international situation, Iran's economy is being crushed by the decline in oil prices. The risk of war with Iran keeps going down. Iran is now talking to western nations about nuclear power plants. Russia is about to finish Iran's first nuclear power plant. Volume refiners can supply Iran with nuclear fuel for these plants at a small fraction of Iran's cost of refined ore. The Israelis now believe it will take 5 more years for Iran to make a nuclear bomb. It is in Iran's best interest to sue for peace, especially if they do not have the expertise to build a bomb. The country is hurting and Amadenijhad is at risk of losing power next June. The point for investors is that gold is partly over priced due to exaggerated fears of war. Said another way, it is the price of industrial metals that pull the price of gold up or down; deflation in industrial metals means the rational for holding gold has been reduced.

THE BAD NEWS -- the world wide slow down in economic growth combined with increases in production of commodities over the past 7 years has resulted in a steady decline in the price of goods -- THE GOOD NEWS

Add the savings from oil, corn, copper, money and all other commodities and the average house hold will save $12,000 to $15,000 per year for the next many years. Can you see why companies such as Best Buy will sell a lot of goods over the next several years? Can you see why auto sales are finally going to turn up? Can you see why mortgages are going to get paid?

A sophisticated friend, one who makes his living in the investment arena, made a great point yesterday when he noted that he knows of no one who has lost their job as a result of the current economic recession. One can argue that lay offs are coming and that there are people out of work and there are people hurting, but, the other side of the coin is that the cure is already on the way. Last night, I paid $2.87 for gasoline. The highest I paid this summer was $4.11. Within two months, I expect to pay less than $2.11. On the way up, the extra $2 per gallon hurt, but it will help on the way down. My tank is a 22+ gallon tank. I normally buy about 21 gallons. $42 savings per fill-up will be welcomed relief. Two to five years from now, there will be much talk about just how low prices will go. With anti oil democrats about to take control of government, the US will spend too much money subsidizing wind mills and solar panels. Taxpayers will foot the bill for extra energy supplied. This will mean lower fuel prices and it will mean that we continue to buy a lot of foreign oil. We will pay a lower price by the time the fields in Cuba and Brazil are fully developed.

Buying at a low price from foreign suppliers is not a bad thing. We get fair value for our money when we trade. I frequently buy Washington state apples and grapes from Chili. Still, we should allow drilling while reducing subsidies. We can bring the price of gasoline down to $1 per gallon. Yes, we should convert our tax system from an income tax to a consumption tax, we should be taxing the use of energy rather than subsidizing the production of it, but that is another story. For now, investors should deal with the good news. Make enough money in stocks over the next several years and the relative importance of the price of gasoline will collapse.