Econ Base's  Instablog

I listened to this clip on CNBC on August 7th: http://www.cnbc.com/id/15840232?video=1208650738&play=1. Former President Clinton's Labor secretary Robert Reich, now an Economics Professor at UC Berkley seems to be making a point to anybody who listens that we are in a very ugly recession. The turnaround is no where in sight. His point is that businesses have laid off workers and without job growth no economic turnaround is possible: Consumers are in a savings mood and are not spending and businesses cannot make more products unless there are consumers, and so on. He has a point.


Let's crunch some numbers. The unemployment rate is running around 10% nationally, with a total of approximately 15 million unemployed. Since this recession started sometime in 2008, 7 million jobs have been lost. According to the recent Sep. 5th report by chief economist of US Chamber of commerce, there are about about 1 million net new entrants in the job market every year. Therefore 11 million new jobs are needed by 2012, just to keep unemployment rate even at the 2008 level. What kind of shovel ready projects are going to create such jobs? What kind of innovations or break throughs are in the pipeline that are being counted upon for a V shaped or U shaped recovery? If we are counting upon emerging markets to create the US or global recovery, that will not happen either, because all these economies rely on the US consumer for exports to a very large extent. Therefore, from a fundamental economic standpoint a quick recovery and back to boom times is far fetched and wishful thinking really


Now let's compare the only point in mordern US history that comes close to the financial times we are in, namely the 1930 depression period.






































The top chart is a 5 year chart of the Dow Jones Industrial averages (DJI) during the depression era, and below that is a DJI chart from Septemper 2007 till September 2009. The shapes look eerily similar! Perhaps it took only 2 years for this chart formation this time instead of 5, due to rapid globalization, quicker information and money flows due to technologies such as internet, computers and cell phones, etc. I am sure just like I discovered, the "experts" too have been looking at this chart comparison. The experts have however have concluded that the DJI has seen its low point and the worst is over.


Sadly this may not be the case. After the 1930's depression era, going into WWII, the US was leading the world in innovation. They created some of the amazing technologies and the high paying jobs: Cars, planes, telephone, radio, television, main frame computers, weapons, etc. Ofcourse there were shovel ready projects also such as new highways and bridges. So the experts will be correct in their assumption that the worse is over and the DJI will never see the March 2009 lows in the mid 6000's, but ONLY if the innovation and job growth that followed the depression era continues.


While Information Technology (computers, internet and software) and cell phones are examples of new technology in the recent past, the biggest reason for GDP growth was spending by the US consumer (based on borrowing) and not just by job growth (by new technologies such as IT). If the expectation of recovery is based on more borrowing and more spending by the US consumer, that is an unsustainable expectation. The reason is that the interest payment on the high level of debt by US consumers and government will crowd out any investment in new technologies. And we therefore come to a full circle: Unless the 11 million new jobs by 2012 are innovation and technology related, productivity enhancement jobs, the recovery is not going to be long lasting.

Robert Reich is absolutely correct, the economy needs a structural change, an X shaped recovery. The shovel ready projects are not going to cut it. By the way what is the report card on the administration's shovel ready projects?

An unemployment report this week was perceived to be bad. Fear rose in the markets all of a sudden. The bulls who rang the markets up with the green shoots theory were perhaps hiding this week. I still do not understand why the markets rose from March until recently. If you have been reading the news, the economic recovery is always 6 months to a year away. Maybe the bulls are getting some sense knocked into them and the DJIA closed down this week at ~8280, S&P500 at ~896. Dollar closed strong against most major currencies enabling the 30yr. bond to also close strong, with the yield down to 4.32%. As the dollar strengthened gold/platinum weakened somewhat at ~932/1191 per oz. respectively.

It would be best to stay on the sidelines without making any major moves. Cash is king for now. The emerging market stock indices of China/India stay strong, but remains to be seen for how long. The lesson learned from the 2008 "Total Liquidation" was that the emerging markets were not as independent from the US as once thought. As US markets fell, so did the other markets. Nothing has fundamentally changed since then. So if the earning season dissapoints the bulls further and US markets go down further, China/India/Brazil etc. will also follow down as fear takes over. Good luck.

Recap of Upturn: Let us compare the price of Treasury Inflated protected securities (TIP), Gold (GLD), Gold Index (^GOX), Dow Jones Industrial Average (^DJI) and the 30yr. Bond (^TYX) from the week of Nov. 22nd through today. Irrational optimism caused DJI to peak just above 14000 in Oct. 2007. Gold followed the rising DJI, convinced it is infationary, peaked near $1000 per oz in March 2008. TIP also peaked at about $111 in the same period as Gold peaked. Meantime the 30yr. bond yield peaked at 5.3 around July 2007.

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Let us first do a quick 2 week high level recap. Gold closed today approximately at $934, silver $14.23 and platinum $1215 per oz. Compared to the values on June 6th, the precious metals weakened. Dollar demand must have therefore strengthened. The long bond closed today at 4.52%, at a lower yield than June 6th, confirming dollar's strength. So far so good, the data makes sense! But this is just a 2 week end to end data point. In between there was a whole bunch of news. A tug of war went on, where the market could not make up its mind: Is the economy on the mend (inflationary)? or is recovery still quite a ways away (deflationary)? The bond prices and precious metals therefore see-sawed a little bit.

So where to put new money? Precious metals or CD's

If there is new money to invest, where to put it? If building a Portfolio for life, like the one I described in my June 13, 2009 post, you are likely a conservative investor and an infrequent trader. While precious metals may keep weakening, this may be a point to dollar cost average depending upon our specific situation in assett allocation, based on the formula described earlier.

However, if the portfolio was heavy by way of precious metals, investing in FDIC insured CD's was the other alternative. The best reward seems to be for 1 year timeframe (about 2.5%) to 2year time frame (about 2.9%). The yield is not much higher for longer duration CD's with the 5 yr. being 3.55%. Different areas in the country perhaps have different rates.

How about Corporate bonds?

For those with a slightly higher risk appetite, a very small portion of the cash portfolio could be invested in corporate bonds. A good one is the 7 year Goldman Sach's bond. They recently sold this new issue yielding 6%. Given that Goldman Sach's returned all the TARP money, and more importantly knowing their connection to the white house, this bond should not go bust in the next 7 years! Let's not forget that Clinton tapped Robert Rubin as his treasury chief, Bush selected Henry Paulson and now Obama has chosen Tim Geithner, all with links to Goldman Sach's. But again, debacles happen, so a very small portion should be put in corporate bonds. The main objective to juice up the portfolio yield a little but, which is not possible by only FDIC insured CD's.

Stocks?

The US recovery is still far away, as I discussed in my earlier post. Nothing has really changed since then. Meantime, the whole world is convinced that emerging markets will lead us out of this economic mess. The BSE (India) closed today at 14,521, nearly double from a 52 wk low of 7697. Similarly China's Shanghai composite is at about 2880 up from the 1706 lows. There is a big risk that the US won't be buying as much Indian software or Chinese toys. The US has been the primary consumer in the past. Those betting the emerging market recovery based on their own local growth may be sorely dissapointed. China's 2008 Olympics are over, and where will they want to put their money in this climate? They are already over built by way of Walmart factories. India needs to grow in infrastructure, but that is an old story and missing from that story is that no body yet knows how to make money if they invest in the infrastructure projects (too much red tape and corruption). So the emerging markets are a big bet indeed. May not be a bad idea to stay away from these overheated markets for the time being. Not worth the risk.

Disclosure: I own CD's, corporate bond and precious metals described in this posting

A traditional rule of thumb, for a conservative investor, advised by money managers is to put an percent equal to your age in bonds and 100 minus your age in stocks. Some can put more in bonds or less, depending upon their risk appetite to stocks. To keep things simple, lets assume for the moment, that bonds are in the same broad category as CD's or cash, dollar or foreign currencies.

If substantial assets are tied in cash (i.e. dollar bonds), it becomes extremely important to understand the relationship of dollar vs precious metals such as gold or platinum. This is the most important relationship to grasp. Not Oil vs. Gold, not Oil or gold vs. stocks such as dow jones average. Also not important is Gold vs. Foreign currencies such as Australian Dollar, Euro or Canadian dollar. Reason is that Gold is priced in dollars, and the relationship is largely inverse: i.e. Gold rises in price as dollar weakens and vice versa. Prior to the 1971, dollar and all currencies were backed by Gold reserves. That was abandoned, and central bankers ever since have run amock. So dollar is backed by really nothing other than the full faith of the US govt. That is also ok, as long as the govt. does not default, nor they print excess dollars. Default is not yet a risk because the Democrats will likely raise taxes even in this climate. Example is what Oregon did yesterday: raised income tax from 9% to 11%. But the bigger worry is that the printing presses are on. The Fed has been using its left hand to buy the treasury bonds with its right hand. Hasn't $300B been committed for this purpose? If this amount is correct, this is effectively "printing" $300B more dollars. So if the central bankers are not honest, backing up the bond (or cash) portfolio with precious metals becomes a necessity. Essentially that is what they used to do pre 1971. If they are not doing it, we need to do it ourselves!

Due to very good marketing by mutual funds, lack of alternative investment categories in 401k accounts and easy access to wall street by discount brokerages, stock market investing became very popular since the 80's. But there were stock market downturns due to 1) internet bust of 2000, 2) 9/11/2001 and 3) Bank crises of 2008. There will be more busts, how frequently, no body knows. If the time horizon is 20 to 25 years, carefully picked stocks belong in the "Portfolio for Life".

So the Portfolio pie needs to be sliced such that a little bit of stocks and bonds make room for precious metals. For the conservative investor, perhaps following would work: % equal to age in (CD's or bonds), % equal to 25% of current age in precious metals. Remaining in stocks (and/or other risky investments). Examples: For a 40year old: 40% in CD's, 10% in precious metals or precious metal equivalents (such as GLD or GDX) and 50% in stocks/real estate etc.

With this background, lets go back and analyze the dollar and assess a short term trend where Gold is headed:
1) Bond market. The 10 yr. treasuries had trouble selling earlier this week, and the 10yr. interest rates went up, (stoking inflation fears) but then the next day or so the 30yr. bond sold well, there was no shortage of buyers, and the 30yr. treasuries rallied with interest rates going down to 4.63%. The dollar strenghtened as a result and gold went down to $939, Platinum to $1260 and silver to $14.87. This trend should continue in the short term.

2) The hard currency Central banks around the world have been dropping interest rates drastically to stimulate their economies. The Australian $ rate is highest at 3% NZ$ is at 2.5%. US $ rate is 0.25% and lowest is the Japenese Yen at 0.10%. The Aus$ is strong from the commodity boom created by Chinese buying (Australia exports commodities such as copper, precious metals, wheat, wool, etc.), but that should slow down eventually. Chinese are on a global hunt for commodities since they are diversifying away from the US dollar. But that should abate as the economies world wide keep cooling down. I am not convinced the economy will expand later this year as the governments would like you to believe. So as this "news" of a postponed recovery into 2010 becomes mainstream, Chinese commodity buying slows down, as interest rates stay low for longer than what the market has factored in, or in case of Aus$, their central bank cuts interest rates, all this may keep dollar strong in the short term, i.e. gold, pltinum and silver prices may drift lower. These would be dollar cost averaging buying opportunities into precious metals.
Disclosure: Long precious metals