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Joseph Stuber
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Joseph has been an analyst, investor, and student of economic theory; money and banking; and statistical methods for evaluating and implementing risk/reward trading algorithms since 1972. Joseph is also an occasional contributor to financial publications and his essays are frequently cited by... More
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  • A Look At Corporate Earnings Growth, Liquidity Traps And The Law Of Diminishing Returns

    Stocks have moved dramatically higher off the 2009 lows based in part on the belief in the Fed's QE policy and in part based on very solid earnings growth. However, the Law of Diminishing Returns is readily apparent as it relates to QE. We just aren't seeing much impact on the two benchmark metrics the Fed asserts as the ones that must show improvement in order to begin the process of unwinding their balance sheet. Those two metrics are inflation and unemployment.

    Here is the chart of CPI:

    (click to enlarge)

    What we see is that QE 1 had a significant impact on inflation but each successive attempt to spur inflation and push it up to the desired 2% level has failed. The most recent data point on the chart shows that we are technically in deflation territory at this point as the rate is below the 0% line. In fact we've struggled to stay in positive territory through 2012 and 2013 as we have dipped below the 0% line 4 times.

    Keynes explained the concept of a "liquidity trap" as a condition where policy efforts to expand money supply and in so doing to stimulate growth were effectively stymied by the propensity of individuals and businesses to hoard cash. In other words if monetary or fiscal policy measures attempt to flood the system with liquidity and that excess money is spent to buy good and services we grow the economy.

    On the other hand if we don't spend that money we are in a "liquidity trap" and that produces a deflationary effect as the chart above indicates we are seeing today. The problem isn't the Fed's lack of effort - rather the problem is the underlying fear that we haven't really solved our problems and that fear means cash is hoarded.

    Perhaps the most stunning chart one can look at today is the following chart of checkable deposits held by corporations:

    (click to enlarge)

    I have often thought the most astonishing chart one could look at was the massive increase in the level of excess reserves held by banks and we will look at that in a minute but the chart above speaks volumes about where we are today and what the prospects are for moving into a period of significant economic growth. The chart above is even more dramatic and significant in its implications and shows that corporate America has been the single beneficiary of monetary and fiscal policy and they are offering nothing in return as they are simply sitting on the massive transfer of wealth created by these policies.

    When you see a chart that looks like the one above you must admit that history is useless in terms of predicting the future. The truth is we have never seen what we are seeing today. Does this chart suggest to you that corporate America is confident of the future or scared to death and hoarding cash to brace against what is to come?

    Let's take a look at the most recent chart on excess bank reserves:

    (click to enlarge)

    The chart above shows that banks are in the same camp as corporations with no propensity to make bank loans. It can't be argued that the Fed hasn't done their part to feed the system with excess liquidity. We've never seen a surge in excess reserves like we've seen since the end of the Great Recession. The banks just aren't lending and there is a reason - no faith in the efforts of the government to stimulate the economy with fiscal and monetary policy. The banks remain fearful and therefore they are not making loans - loans we need to see in order to expand M2 and in so doing produce the inflation rate the Fed so desperately wants and needs.

    The Fed insists that QE will continue - at least in some form - until we reach their targets on inflation and unemployment levels. We've already seen that QE is simply ineffective as far as inflation is concerned - in particular if banks won't lend and corporations won't spend. The chart below is the headline unemployment rate and the U6 unemployment rate:

    (click to enlarge)

    Granted we have seen some progress in this area but we are still substantially higher today than we were pre-recession. Perhaps the issue with unemployment is more structural than anyone wants to admit. In other words productivity advancements have been so dramatic that we simply don't need as many workers. After all a machine can paint a car better, faster and cheaper than a person and one clerk who can use an Excel spreadsheet with proficiency can crunch more numbers than dozens of clerks before the invention of electronic spreadsheets.

    A look at the chart below demonstrates that corporate America has been the beneficiary of productivity advancements:

    (click to enlarge)

    The redline shows capacity utilization and the green line shows corporate profits using 2007 as a base year. Looking at this chart it is hard to argue the fact that corporate America hasn't taken full advantage of technological advancements since the end of the Great Recession. The problem is we are killing the goose that lays the golden eggs - the goose in this case being the middle class worker. In other words productivity advancements can result in short term profits but at some point the demand destruction created by eliminating workers means that no further gains are possible and in fact profits must necessarily fall.

    The following chart simply reinforces the point that we are in a liquidity trap:

    (click to enlarge)

    Total M2 expansion that has occurred substantially through the impacts of QE has been significantly outpaced by that portion of M2 that is held in savings and money saved is not money spent and does little to boost GDP growth or corporate sales. More troubling though is what the following chart demonstrates:

    (click to enlarge)

    The chart above shows that at the onset of the Great Recession personal savings spiked higher. It was a fear induced move that resulted in less spending and more saving. It seems logical to infer from the chart that as unemployment surged higher the total dollar amount of savings and the amount of savings as a percent of disposable income began to fall and the reason wasn't the result of a resumption of spending at a rate that existed prior to the recession but more the result of consumers needing to tap savings or reduce savings to meet basic living needs.

    How QE has created a divergence between stocks and the economy

    The argument that stocks can go higher is a 2 part argument. Part 1 has to do with QE and Part 2 has to do with corporate profits. We've dealt with Part 1 and the only conclusion we can reach based on an objective review of the efficacy of QE is that it has created an environment that has pushed investors into a high risk, yield chasing frame of mind. It cannot be said that the Fed has been effective at reaching their inflation and unemployment targets as they clearly have not and in fact there is a valid argument for why QE is actually counterproductive at this point. We need to discuss QE a little further in order to establish what the Fed has done to push stocks to all time highs but first let's take a look at Part 2 - corporate profits.

    Lance Roberts does an excellent job of putting things in context with his article - Analyzing Earnings As Of Q3 2013.

    Here is what Lance has to say on the matter:

    In order for profitability to surge, despite rather weak revenue growth, corporations have resorted to four primary weapons: wage reduction, productivity increases, labor suppression and stock buybacks. The problem is that each of these tools create a mirage of corporate profitability which masks the real underlying weakness of the overall economic environment. The problem, however, is that each of the tools used to boost EPS suffer from diminishing rates of return over time.

    The following chart is useful as a way of demonstrating the validity of the argument Lance makes:

    (click to enlarge)

    The chart above dates back to the 2009 lows and validates the claim that earnings have grown without a commensurate rate of growth in top line sales. Stocks during this period have appreciated by roughly 170% but the point is that in order to achieve such spectacular earnings growth without a commensurate growth in sales it is necessary to reduce costs and in so doing increase margins. All the data we have looked at in the first part of this article suggests that is exactly what corporations have done and of course that brings us back to the issue of diminishing returns going forward.

    Can we continue to grow profits without growing sales as the prospects for growing sales don't look very promising? And is there any way we can grow sales if we continue to cut labor costs to expand profit margins? In other words we are back to the goose and the egg. If we kill the goose - American workers - then how do we expect those same workers to fuel sales growth?

    From the Fed's perspective the only way to impact GDP growth resulting from their ill conceived "wealth effect" policy is for investors who have created new wealth from their ownership of stocks to convert those profits into cash and spend it. In other words if investors sold $850 billion in stocks and took the proceeds and spent 100% of that for goods and services we would see a 5% jump in GDP assuming a status quo in all other metrics. That of course translates to a modest jump in the top line sales of publicly traded companies.

    The sad truth is that QE is just not growing the economy but it is clearly pushing stock price multiples higher and higher. In other words the Fed is creating inflation but only in risk assets. We will look at the transmission mechanism that is in play and pushing money into stocks through QE in a minute but first let's look at another of the charts Lance uses to demonstrate the smoke and mirrors efforts corporations are making to squeeze a little more out of per share earnings:

    (click to enlarge)

    The extremes corporations will go to in order to create the illusion of organic growth is unprecedented. What the above chart shows is that corporations see no other use for their balance sheet cash and are therefore willing to make a balance sheet move to expand earnings per share. Mind you this move doesn't increase corporate earnings and has nothing to do with the income statement at all. They are simply debiting the outstanding shares line item on the equity portion of the balance sheet and crediting the cash line on the asset portion of the balance sheet and in so doing they magically get a spike in earnings per share.

    What seems most illogical in this strategy is the extremely short term nature of the move. Clearly these companies are buying their stock back today at all time highs at a time when - based on their cash hoarding tendency and forward guidance - they see prospects for the future as weak. Does this make sense?

    To fully appreciate the smoke and mirrors being used to push stock prices ever higher with a reckless abandon consider the following chart - again from Lance Roberts:

    (click to enlarge)

    Here is what Lance had to say about forward estimates:

    The use of forward, operating estimates, is only beneficial to Wall Street analysts who need to create a "valuation" story when none really exists. Overly optimistic assumptions about the future spurs faulty analysis in the present as sliding earnings leads to sharp valuation increases.

    The Fed seems determined to create an asset bubble in stocks

    The real question is not whether the Fed will or won't create a bubble in stocks or even if we are currently in a bubble. The real question is how far the Fed will go with this insanity. And related to that question is this one - do they really have any choice at all but to continue with QE at this point?

    The answer to the second question is yes they do have a choice but if they stop QE at this point stocks will fall dramatically and it can be reasoned that the economy will also be impacted negatively. On the other hand to continue to inflate stocks without the benefit of real organic growth is a very dangerous policy indeed.

    Here is the problem and a problem that is different from times past. Earnings growth has been based almost entirely on cost cutting strategies and not real economic growth based on high employment, GDP growth, modest inflation and top line sales growth.

    What is problematic is that the increase in the value of stocks has actually been based more on earnings growth at this point than multiple expansions but the growth rate is falling and has been for a while now meaning that the only way we've been able to push stocks higher in 2013 has been through multiple expansion. Even more important is the fact that the earnings growth realized by cost cutting appears to be fully exhausted in terms of further gains going forward.

    That said the Fed's QE transmission mechanism could continue to drive stocks higher by adding more and more QE cash that is being re-employed by investing in stocks. For those who don't understand the transmission mechanism that drives money into stocks through the monthly purchase of bonds and mortgage backed securities let me explain.

    Here is how it works - the Fed buys an asset from a primary dealer bank or in the alternative from a non-bank investor. If the purchase is from a primary dealer bank it increases the banks cash balance in the form of expanding excess reserves held by the Fed. In this instance the cash doesn't expand M2 - it is just an asset exchange.

    However, if the bank then uses the cash to buy a security from a non-bank investor that expands bank deposits and therefore M2. The non-bank investor will then use those cash deposits to buy another security - either stocks or bonds. In that fashion the Fed's transmission mechanism is driving money into stocks each time they buy a security and that pushes stocks higher.

    The second possibility is that the Fed goes directly to a non-bank holder of the security they wish to purchase. The effect is the same but more direct. The Fed uses newly created money to buy the security and when that happens the seller has a new deposit that goes into the bank increasing M2. The problem is that the seller of the security will not end up spending that newly created money in the economy but use the money to buy another risk asset - in other words stocks.

    The point is none of the Fed's money is moving into the economy as it would if a bank were to make a loan to a business or a consumer. In that instance the borrower would use the loan proceeds to expand GDP but what the Fed is doing instead is creating a situation where the system is being flooded with new dollars and almost none of those dollars are going into the economy - rather they are going into stocks and pushing stocks ever higher.

    There is almost no benefit at all to the broad economy as a result of QE. The transmission mechanism works like this - the Fed buys a security with newly created money and the seller of that security buys a new security with that new money. Next month repeat process and push stocks a little higher. The month after that repeat process and push stocks a little higher. And the next month the same and the month after the same - apparently with no end in sight.

    QE is doing nothing at all for the real economy and therefore almost no impact to GDP, inflation, corporate sales, employment levels or any other metric we use to measure real economic growth. No metric we look at is responding to QE except stocks. What that leaves us is a situation where top lines sales actually begin to fall and corporate profits begin to fall as stocks continue to rise.

    What really bothers me

    There are a number of things that really bother me about the current state of affairs and it has absolutely nothing to do with missing out on the rally as so many in the bull camp suggest. The truth is I was a little early in turning bearish stocks in 2007 and also a little early in turning bullish the market. I got bullish stocks around 900 in late 2008 when the Fed first embarked on QE so I missed the bottom a little but did ride the bull wave until September of 2012 when the Fed moved to QE3 at roughly 1475.

    And those who suggest I am talking my position don't know my position. I have been bearish since September of 2012 and based on the fact that QE is not working and that the economy didn't respond to policy stimulus this time unlike times past. To me that is prudent as I think capital preservation trumps short term opportunity loss.

    My strategy has been to employ a very small amount of money in percentage terms in out of the money put options in selected stocks and VIX ETF's. My losses playing the short side in this manner are highly leveraged and involve very small amounts of cash in relative terms and I will continue to follow this strategy. It is a strategy that produces a series of small losses and at some point one really big gain.

    So I am not an angry bear. What bothers me though is that the Fed is persisting with a policy that is clearly not working and in so doing pushing investors into very high risk trades. This can't end well as we have no support under this market other than the Fed and once the Fed does make the decision to stop manipulating stock prices the sell off will be significant and rapid. More important - what policy moves - either fiscal or monetary are left if we do go back into recession?

    What we have today is nothing more than a corner on the market and anyone who attempts this in the private sector is in violation of the law. According to Sec. 9 of the Securities Exchange Act of 1934 manipulation is addressed as follows:

    Prohibition Against Manipulation Of Security Prices

    Sec. 9. (a) It shall be unlawful for any person, directly or indirectly, by the use of the mails or any means or instrumentality of interstate commerce, or of any facility of any national securities exchange, or any member of a national securities exchange -

    (2) To effect, alone or with one or more other persons, a series of transactions in any security other than a government security, any security not so registered, or in connection with any security based swap or security based sway agreement with respect to such security creating actual or apparent active trading is such security, or raising or depressing the price of such security, for the purpose of inducing the purchase or sale of such security by others.

    Few doubt the Fed's direct attempt to manipulate stocks by driving investors out of fixed income and into equities. The Fed has acknowledged as much in numerous statements - both written and verbal. It is worth noting that the Act distinguishes between "a government security" and other securities and for good reason as one of the Fed's mandates is to control interest rates to effect price stability and the Fed - through the FOMC - has always manipulated bond prices to achieve the desired end as it relates to interest rates.

    What the Fed has never done before is initiate a policy designed to manipulate stock prices and in fact it can be argued that the Fed's current policy - at least if it were being carried out by a private actor - would be in direct violation of the Act. Even though the Act makes no exclusion for the Fed in the language as it relates to manipulation one can rest assured the courts would figure out a way to absolve the Fed were a charge ever made against them.

    Final thoughts

    We all have to play it as we see it and there will be those reading my comments that will disagree with my views. Some will assert that I have been wrong for the entire year and that paying attention to my views has cost them. No defense to that claim as I have failed to call a top but then my guess is that few - if any - bulls called for a high in the S&P of 1800 for the year 12 months ago or even 6 months ago.

    We are now up 34% off the November 2012 lows. As of November 1, 2012 the Cyclically Adjusted PE ratio was 20.89. Today it is 25.41. Looking at the more traditional trailing twelve month as reported PE ratio we have moved from 16.12 to 19.84. It is hard to say that the rally in stocks over the last 12 months has anything at all to do with earnings or economic growth and everything to do with an irrational, Fed induced blow off top.

    I readily admit I don't know how much further we have to go on the upside at this point. I really believed common sense would take hold long before now so I will defer to the bulls who constantly criticize me for presenting data that supports the idea that stocks should sell off and ask them to offer up some evidence in support of higher prices and preferably something other than the idea that the Fed will continue to blow the bubble larger and larger or that stocks can go higher simply because we are still a little below the most extreme PE highs.

    Disclosure: I am long UVXY.

    Nov 24 8:26 AM | Link | 9 Comments
  • What Is Obama Doing, Why Is He Doing It And How Might It Impact Gold?

    As the battle between Obama and Boehner rages on over the matter of the CR and the debt ceiling almost everyone sees this as a very extreme version of business as usual. This is not business as usual and as we move from one Act to the next Act in this saga it is becoming more clear to me that Obama may have - and I emphasize may have - an agenda that almost no one sees.

    What is that agenda - dealing a final blow to the US dollar as the world's reserve currency. I readily admit I may be wrong on this thesis and only offer it as an alternative to the mainstream view of what is going on. If I can't explain something in a way that makes sense to me I continue to search out explanations that do make sense. I think perhaps there is a reason Obama is doing what he is for reasons that seem wholly improbable to most and I will get into that in a moment but first I want to talk about gold.

    I have been asked time and again why gold fell so sharply right after Obama met with the CEO's of the big banks back in April. To me there is no doubt at all that those CEO's sold a massive amount of gold futures immediately after that meeting with Obama back in April. The question - why did they do that?

    The answer may lie in the dark recesses of the shadow bank risk-on system that allows these banks to use the assets of others for speculative bets to the benefit of the bank. So how does that relate to the sharp sell-off in gold? Well maybe President Obama told the bank's CEO's that they could expect sovereigns to make a demand for the return of their gold holdings stored by JP Morgan. In other words sovereigns across the globe would be repatriating their gold.

    Taking this a step further what happens if JP Morgan at some point decided to sell the gold held in trust for others and use the proceeds for speculative bets for their own account in other assets such as stocks or bonds. Would this be legal? I am not really sure but it would be typical of what has taken place in the shadow banking system. Consider that JP Morgan could see the storage agreement as an obligation of the bank to deliver X ounces of gold on demand. They could actually sell the gold and receive the cash from that sale and still meet their obligation's to deliver the gold on demand if they were able to buy the gold on the open market when a sovereign made demand on them.

    Let's assume they did in fact sell the gold and invest the proceeds in stocks or bonds. They would then be earning profits based on the assets of others and that would be a pretty sweet deal and in particular if they were receiving a very modest storage fee for storing the gold that they really weren't storing. And they would rightly reason that at any point in time when a sovereign would make demand on them they could simply sell the asset they bought from the sale proceeds and go into the physical market and buy a quantity of gold sufficient to meet their obligations.

    So how does that fit in with the crash in gold of over $200 in two days immediately after the bank CEO's met with Obama? Well, if the thesis I set forth above is accurate then when the bank did sell the physical gold they would need to cover the risk of price moving higher. In other words if they sold gold for $800 and at some future date a demand was made for the physical gold and the price was at that time $1400 the bank would have a big problem - a $600 per ounce deficiency meaning they wouldn't have the cash needed to buy the physical.

    How would they protect against such risk? By implementing a hedge in gold futures. At the time they sold the physical gold they would buy an equal quantity of gold futures. In that sense if gold went from $800 to $1400 they would make a $600 profit on the futures contract and they would also have received $800 from the original sale and the sum of the two would be $1400 - enough cash to go into the physical market and buy enough physical gold to meet their obligations under the terms of the storage agreement.

    Back to April of 2013 - if Obama told them to get ready as a demand for the physical was going to be made on them they would need to immediately acquire enough physical gold to meet those demands. What would that involve? They would need to cash out of the futures contracts and use the cash profits from those contracts to buy the physical. What else would they need to do? Well, let's say they invested the proceeds form the original sale of the gold in US Treasuries. The rest of the money they would need to raise the needed cash to buy the physical gold would have to come from the sale of their US Treasury holdings.

    Consider that shortly after the meeting in early April gold has been in free fall and starting on May 1 Treasuries began their free fall. Also consider that at the time Treasuries started their descent the Fed hadn't yet started to hint at tapering. That began later on in the month of May after Treasuries had fallen by roughly 5%.

    That is the most plausible reason I can come up with for why both gold and Treasuries fell so dramatically from about April 10 to May 22 when the Fed began to talk of taper. Movements after the Fed started the taper talk are based on different market dynamics but from the date of the Obama/banker meeting until the Fed began taper talk the market movements could be based substantially on the asset sale of the big banks and in particular JP Morgan to raise the cash to replace the physical gold needed to honor their obligations to those demanding the physical gold.

    What happens next and what is the impact to gold?

    So what is Obama doing here? The fact is that President Obama is in position to usher in a New World Order single-handedly. It can be argued that the President is in a position to do more damage - or benefit based on how you see it - in the short term than any President since Harry Truman.

    What do I mean by a New World Order? What I mean is a New Bretton Woods system of global trade that ends up replacing the US dollar with the IMF's SDR as the world's reserve currency.

    I have argued that Obama is in favor of such an arrangement and I think he is. What does a New Bretton Wood's system mean. It means the US dollar is no longer the world's reserve currency. Is that a good thing for the US? In the short term it could be argued that it is a bad thing as the US loses it's "exborbitant privilege" that allows the US to borrow and spend at will and without consequence - at least as it relates to the cost of borrowing. In the long term it could be the only real answer to the problems we face today.

    How would such an arrangement be configured. Well, much like Keynes originally envisioned - that is a hard fix on all sovereign currencies relative to the reserve currency - not a floating structure as we now have. When the original Bretton Wood's adjourned what we had was an arrangement where currencies were fixed to the dollar and convertible to gold at the rate of $35 an ounce. Keynes pointed out that the dollar/gold fix wouldn't be a sustainable arrangement in that as M2 expanded as it would the numbers of dollars in circulation would end up meaning that the gold reserves held by the US would be insufficient and redemption of US dollars into gold wouldn't be possible.

    Keynes was right of course and we went off the gold fix arrangement in the 70's under President Nixon. Our system today is one where the US dollar remains the reserve currency by default and all currencies are allowed to float against one another but the majority of international trade is conducted in US dollars. That means that each sovereign who is a net exporter receives dollars and ends up with a surplus of US dollars and each country that is a net importer ends up with a shortage of US dollars.

    That in itself has the potential to disrupt global trade as liquidity shortages of the reserve asset inhibit global GDP and wreak havoc on net import countries. And those countries with a surplus of the reserve asset must do something with those dollars. What the exporting countries do is exchange the US dollars received by companies that are domiciled in the exporting country with the sovereign currency of that nation leaving the nations central bank with an excess of the reserve asset. What the exporting countries like China and Japan do with those reserves for the most part is to buy US Treasuries - thus the "exorbitant privilege" that is bestowed upon the US.

    The result of this dynamic is that global economies are placed in peril when the US makes a misstep that produces volatile shifts in the US dollar and interest rates on US Treasuries. A fear induced credit freeze can have severe liquidity problems as it relates to reserve currencies and countries - to the extent they are able - must hold excess dollars or Treasuries as insurance against a freeze up in the credit markets and a liquidity crisis.

    A solution to this problem is to abandon the US dollar as a reserve currency and move to a non-sovereign reserve asset such as the IMF's SDR. In such an arrangement each sovereign would be allocated SDR's that would be used to settle international trade obligations. The ideal situation would be to assign SDR's based in part on a formula that related to the sovereigns gold holdings. In other words the SDR would have a formulaic gold backing.

    Perhaps more important to the arrangement is that the IMF would act as a sort of central bank to all central banks in that they would drain reserves from those holding an excess and inject reserves into the systems of those in need of reserves much like the Fed's system accommodates liquidity amongst member banks by facilitating the overnight lending of reserves to member banks whose reserves fall below the mandated threshold and in extreme situations acting as the lender of last resort for banks who are short of liquidity.

    Back in 2009 Jose Ocampo, former United Nations Under-Secretary-General for Economic and Social Affairs explained the flaws in the existing system as follows:

    Both China and the United Nations Commission on Reforms of the International Monetary and Financial System have called for a new global reserve system. That issue should be at the top of the agenda when the IMF's International Monetary and Financial Committee next meet.

    The essential idea is quite simple: in the long run, an international monetary system cannot be built on a national currency - a point made a half-century ago by the Belgian-American economist Robert Triffin. Recognition of this fundamental problem was the reason why the IMF's Special Drawing Rights (SDRs) were created in the 1960's.

    The dollar standard with which the world has lived since the early 1970's has three fundamental flaws. First, as with all systems that preceded it, it puts the burden of adjustment on deficit countries, not on surplus countries. The main exception is the United States, which, thanks to its reserve currency status, has so far been able to finance its deficit by issuing dollar liabilities that are held by the rest of the world.

    Second, the system is unstable, because it makes the major reserve currency's value dependent on US macroeconomic policy and the vagaries of the US balance of payments and associated domestic deficits. Since the abandonment of gold-dollar parity in 1971, the world has experienced increasingly intense cycles in the value of the dollar and the US current account. The dollar has lost what any reserve asset should have: a stable value. The governor of China's central bank recently emphasized this basic point.

    Third, the current system is inequitable, because it forces a transfer of resources from developing countries to the industrial nations that provide reserve currencies. This transfer has dramatically increased over the past two decades. Developing countries' main defense against world financial instability has been to accumulate international reserves.

    The issue is not a matter of whether or not a New Bretton Wood's system that uses the SDR would be an improved system - the issue is one of getting the United States to buy into such a system and abandon its "exorbitant privilege" status. Perhaps more relevant to the matter is whether it even matters at this point what the political class in Washington thinks as it appears they won't be able to stop it anyway. We know that since the beginning of the year the playing field has changed dramatically and led by China with bi-lateral trade agreements popping up all over the place - trade agreements that literally by-pass the US dollar.

    The most recent being the ECB/PBOC currency swap deal that effectively by-passes the US dollar explained here:

    China and the European Central Bank have signed a currency swap agreement worth 350bn yuan ($57bn; £36bn), state-owned Xinhua news agency has said.

    Such agreements mean the central banks can exchange currencies and firms can settle trade in local currencies rather than in US dollars.

    It is stunning to me that the main stream media fails to link the current standoff in Washington to the rapidly changing dynamic of these bi-lateral trade agreements preferring to portray the whole matter as utter and complete dysfunction on the part of Congress. I would suggest that to ignore this matter is to ignore one of the most relevant issues facing global economies in the coming weeks and months.

    But back to the question set forth in the sub-heading above - what happens to gold if the US dollar is suddenly dethroned as the world's reserve currency? Well, if the SDR does emerge as the new reserve asset and if it does have some type of formulaic gold backing then the gold held by sovereigns effectively reduces the amount of gold in circulation as each sovereigns gold holdings will become static.

    Additionally the value of the US dollar will fall dramatically as will US Treasuries in the short term as they will no longer be needed as reserve asset liquidity insurance. That means we could see a very rapid explosion in the price of gold.

    The standoff - political dysfunction or planned dollar destruction?

    Consider that the Republican controlled House of Representatives has made a number of gestures designed to retain their bargaining chips while offering to alleviate the now imminent threat of US default. A short term offer to increase the debt ceiling for 6 weeks that would allow the US to avoid debt obligation default was summarily rejected by President Obama on the pretext that it was short term.

    One wonders if Obama isn't OK with a default which seems a very real possibility at this point as we are only a matter of days away from that occurring. Whether Obama is so confident of his position that he is certain Speaker Boehner will agree to "unconditional surrender" or whether there could be another agenda here is not so clear to me. Obama seems to be confident that his all in bet won't be called by Boehner but I think Obama actually knows that Boehner will call the bet. How Obama and Jack Lew respond to this on Thursday is another matter.

    They could prioritize payments and in so doing pay the debt obligations of the US that are coming due in the short term if they choose to do so. However, as Jack Lew pointed out last week that isn't really so easy to do and is simply not an option. Actually it is an option so that too tends to suggest the President will allow a default - at least in the short run.

    Consider this statement from a Reuters article - World top bankers warn of dire consequences if U.S. defaults:

    Jain, JPMorgan Chase chief executive Jamie Dimon and Baudouin Prot, chairman of BNP Paribas, said a default would have dramatic consequences on the value of U.S. debt and the dollar, and likely would plunge the world into another recession.

    It appears to me there is more to the stand-off between the House Republicans and President Obama than meets the eye - at least from the President's perspective. Whether that is true or not is yet to be seen but if we do move past D-day on this matter it is safe to say that the dollar's status as the world's reserve currency will come to an end.

    Furthermore, it won't be a matter of the decision being based on gaining the political class support for such an arrangement - it will be the de facto outcome of a decision that ultimately must fall on the President himself.

    Obama - hero or villain?

    What comes to mind is the idea of "short term pain for long term gain." If we do actually default the short term consequence will be stunning in it's impact on markets across the globe and the impact will be decidedly negative. It can be argued though that in the aftermath of the crisis/crash scenario that political leaders across the globe will come together in rapid fashion and implement the new currency regime based on the SDR.

    Consider this won't take long at all as the system is already substantially in place and the magnitude of the work that has been done on this in the aftermath of the Great Recession means that a New Bretton Wood's System could be put in place by convening world leaders and hammering out the necessary agreements over a single weekend. Odds are the agreements are already in place in draft form.

    In the aftermath of this would be a brief period of deleveraging that will be decidedly painful for many who are overleveraged. A process of real price discovery will ensue and the consequence of a widespread true price discovery will pull the curtain back and force a "mark to market" on assets that have been propped up by artificial means since the end of the Great Recession.

    My guess is that it won't be the kind of systemic risk type crisis we saw in 2008. Just looking at the massive levels of excess reserves in the bank system would suggest that any "run on the bank" will end in short order as there can be no question the banking system as a whole is highly liquid - perhaps more so than at anytime in history. Consider that a combination of required and excess reserves means that the banking system in the aggregate is holding cash equal to almost 30% of M2. If you want your money you will be able to get it.

    Bank capital issues may be a real concern though as loan loss reserves may not be sufficient but that too seems to be a situation of isolated instances and not a systemic crisis. After all there has been a significant effort to build bank capital in the aftermath of the Great Recession and the major banks have all passed the stress tests that deal with a crisis event. In fact the crisis event that they were asked to consider involved a stock market crash of 50% and again they all met the criteria for withstanding such an event.

    Once the cleansing process is complete one can argue that the private sector banks will be in position to rapidly reflate through fractional bank lending. Based on current reserve levels the banks could literally expand M2 three fold and M2 velocity - it can be argued - would revert to normal levels.

    From my perspective we could be on our way to real growth fueled by private sector expansion as opposed to the current state of affairs that is wholly dependent on ever increasing fiscal stimulus provided by an ever increasing level of public debt that is financed through deficit spending - a situation that all know is not sustainable in the long term.

    I didn't vote for President Obama but I am not one of those who falls hard on one side or the other on the matter of Republican/Democrat or fiscal conservative/fiscal liberal. The reason - I think they are all wrong. That said if Obama's agenda is the one set forth in my thesis then I readily admit his current stance is both bold and courageous.

    More importantly I think it is probably the only longer term solution to our current dilemma. The cleansing process will be painful - perhaps more painful than many can fathom but the aftermath of the process could set us once again on a path to real growth and on a global scale. The truth is our systems are broken and neither the fiscal liberals or the fiscal conservatives offer a solution that works.

    Most - preferring to embrace the status quo - will reject my thesis but those who see it as a real possibility need to consider how this impacts investment assets. If I end up being right on this the best asset going forward will be gold (NYSEARCA:GLD) and other precious metals. Mind you I am not a gold bug. My calls on gold in the aftermath of the Great Recession have been both bullish and bearish based on reasons I have clearly articulated. Furthermore, my calls on gold have been much more accurate as to timing than my calls on stocks.

    Both stocks (NYSEARCA:SPY) and bonds (NYSEARCA:TLT) will be crushed in this scenario in the short term. Those who have a long term buy and hold strategy would be well advised to take protection with SPY puts or any of the many VIX ETF's such as (NYSEARCA:UVXY) and(NYSEARCA:VXX).

    Make no mistake on this - I don't see this as a doomsday forecast. To the contrary - I think we have one more leg down in a secular bear market that began at the turn of the century. The playing field has changed and changed in a dramatic way as all countries now claim a right to be involved and part of global prosperity. The emerging market economies are rightfully demanding a more stable playing field than the current system of global trade offers and it would appear they are going to force the issue and I would suggest they are proving they can do so with the numerous bi-lateral trade agreements that have been signed since the first of the year.

    In closing consider these excerpts from an article that appeared on this morning dealing with the "new world order"

    "As US politicians of both political parties (fail to find a) viable deal to bring normality to the body politic they brag about, it is perhaps a good time for the befuddled world to start considering building a de-Americanised world," the commentary on state news agency Xinhua said.

    "A new world order should be put in place, according to which all nations, big or small, poor or rich, can have their key interests respected and protected on an equal footing."

    Disclosure: I am long FAZ, UVXY, VXX.

    Additional disclosure: I am also long PCLN puts and SPY puts

    Oct 13 2:00 PM | Link | 11 Comments
  • House Republicans Risk Political Backlash

    John F. Kennedy's 1957 Pulitzer Prize winning book Profiles In Courage reflected on the courage of 8 US Senators who demonstrated a willingness to do the right thing as opposed to the politically expedient or popular thing. I wonder if Kennedy were writing the book today if he wouldn't want to at least consider including Ted Cruz in his short list of Senators who demonstrated courage and leadership by pushing back against the status quo.

    There are many who see Cruz as acting irresponsibly. I am not one of those people though and I do see Cruz as doing all he can to challenge the status quo and using all the tools at his disposal to do so - a demonstration of courage and leadership that is sorely lacking in Congress today.

    As I listen to the back and forth rhetoric on the consequence of attaching to the spending bill a provision to delay implementation or defund Obamacare all I hear is that the right approach to the matter is to first "not allow a government shutdown". My own view is that the House Republicans - apparently ignited by Cruz's leadership - are finally doing the right thing and that right thing has very little to do with a government shutdown or Obamacare.

    What they are doing is exercising their right as a part of a "checks and balances" system of government. That is not a bad thing. That is after all why we have both a House and a Senate and why we have two parties. The idea was that no one group would be allowed to implement an agenda unimpeded. The issue isn't whether the Democratic Senate or the Republican House is right or wrong on the matter as neither is right. The issue is whether the system of "checks and balances" should or should not be employed.

    The House Republicans are insistent on spending cuts. Are they wrong? I don't think so. The Senate Democrats are insistent on more fiscal stimulus to the economy based on ever increasing deficit spending. Are they wrong? Probably not - at least in the short term.

    The truth is that a continuation of deficit spending at the current rate is unsustainable. That is as close to a fact as we can get in matters economic as pointed out by the Congressional Budget Office. This is also as close to a fact as we can get - a withdrawing of fiscal stimulus will have very detrimental consequences to the economy. That is also pointed out by the Congressional Budget Office.

    The point is there is no right answer to this dilemma. I think the best analogy is to think of a person who is riddled with cancer. He has two choices. He can undergo a very uncomfortable treatment that may involve chemo and radiation or he can die. We are at a point with the economy where we have the same choice - we can undergo a very uncomfortable process of dealing with the problem which means we curb spending or we can continue with the status quo until we no longer can.

    Nobody has a good solution to this problem in the short term. We have added more to the national debt in the last 6 or 7 years than all prior administrations going back to the beginning of our republic. What have we gotten in exchange for this massive increase in debt? Not much in relative terms. If we didn't have a number of government financed safety nets in place today we would be just as bad off today as we were in the Great Depression.

    But that is not really the point. Our political leaders always tend to take the easy way out as there is a real desire to avoid economic catastrophes on their watch. Most of us know instinctively and intuitively that we can't continue to borrow and spend our way to economic health but most of us it seems would prefer that the status quo continue for as long as possible - just keep "kicking the can". The inconvenient truth is that the longer the cancer patient waits before accepting the discomfort that comes with the treatment the less chance he has of surviving.

    Here is the argument that one Democrat made on CNN a few minutes ago. She used the following analogy. If you spent a lot of money on a kitchen remodel and didn't like the outcome would you burn down the house or make some changes to the kitchen.

    Her point is that even if you don't like Obamacare you don't shut the whole government down to get your way. My own thinking goes like this - if you firmly believe that a continuation of the status quo regarding off the charts spending will end badly you use whatever tools you have at your disposal. Depending on your perspective and your understanding of the matter it could be the most responsible thing to do.

    Let us understand - the world doesn't end if we shut the government down. At some point one side or the other will blink or even better - both parties will choose to drop their partisan stance and actually engage one another in a positive way. That doesn't mean they come up with a solution that avoids pain as no such solution exists. What it does mean - at least I hope it does - is that both sides recognize that political expediency for their own self interests needs to take a back seat to the issue of survival.

    The problems by the way are not exclusive to government. The problem is one of basic human nature. We all tend to see things from our own self interest perspective which is usually short term in nature. Corporations will employee lobbyists to gain advantage even if they recognize intuitively that what is in their best interest on a personal level may not be in the best interest of the masses. Lobbyists for their part will do whatever they can to achieve the desired end of their employers - again as it serves their self interest. Congress for their part will do the same and succumb to the pressure of lobbyists for personal gain - either political or financial.

    The same applies to voters who will vote for those they see as promoting their own self interests. The same applies to governmental regulatory agencies that figure out ways to spend the full amount of their budget allocations and lobby for more next year even if it isn't needed to carry out their original mandate. It is the nature of man that we do these things. We all tend to promote our own self interests to the detriment of the greater good.

    I used a quote from John Dalberg Acton in a recent article that seems appropriate to the subject:

    The danger is not that a particular class is unfit to govern. Every class is unfit to govern. The law of liberty tends to abolish the reign of race over race, of faith over faith, of class over class.

    I followed that up with this statement:

    I am in no way suggesting we assemble a vigilante lynch mob and go after our political leaders. After all, in my opinion they have succumbed to the same power induced delusions that most of us would probably fall prey to were we in their position.

    I for one like what the Republican led House is doing and for reasons that have nothing to do with Obamacare. They are playing the hand they were dealt and they are using the only leverage they seem to have to shift the tide and redefine the playing field as it relates to deficit spending. In other words they - at least this time - seem to have the courage of their convictions and they are willing to accept the potential political fallout from their actions. This takes courage and is indeed a shift that we haven't seen for a long time.

    More importantly it forces legislators to seriously engage one another and work to legitimately deal with the issue and not just kick the can. That is a good thing. I will say that I also understand the President's stance as well as Harry Reid's stance on the matter. I am not critical of the President, Reid or the House Republicans on this matter. They are all pursuing a course they see as right. On the other hand I am pleased that the House is following through with their own agenda as that is what a system of "checks and balances" is all about.

    Are there solutions?

    The truth is we want black and white solutions to our problems but no such solution exists. The effect of an action can't be viewed in isolation. For example if we engage in fiscal stimulus we are creating both good and bad consequences. The good is the impact it has on GDP. The bad is the impact it has on the debt and deficit. There is a trade off and that is unavoidable.

    Fiscal stimulus can have an impact on jobs and not just in the US but on a global scale. Jobs mean paychecks and paychecks mean increased spending and increased spending means higher demand and higher demand means more jobs and so on. Since the US represents a huge part of the global economy a thriving US economy benefits other countries who export goods and services to the US.

    The downside occurs when the economy doesn't respond to fiscal stimulus. In other words if corporate America decides to work in their own short term self interest - as they have done since the onset of the Great Recession - and continue to shrink payrolls they shift the burden of economic growth back onto the government. The end game is that all are impacted negatively over time.

    The number of variables in the ultimate economic equation that delivers the desired answer are so numerous that we will never be able to get it right. That said, we should be able to get it less wrong and that should be our goal - at least in my opinion. And that won't happen unless our political and business leaders see the merit in thinking outside the box and taking on a longer term view.

    The inconvenient truth is that corporate profits are dependent on a large consumer pool and a large consumer pool is dependent on corporate America employing people they may not need to meet current demand or in the alternative for the government to provide fiscal stimulus to take up the slack. Should corporate America be encouraged to hire people they don't need? Or maybe a better question is can they be made to recognize that they will - in the long run - be better off in doing so as eroding and undermining the aggregate purchasing power of the consumer will result in their own ultimate demise?

    Perhaps what makes sense is a tax incentive to businesses that rewards them for taking on employees they may not need in the short term. I haven't done the math so I don't know how this all would work out but I suspect we could develop an equation that would work to incentivize corporate America to do more hiring. Perhaps it would be in the form of a progressive tax that punished those whose payroll costs were below a certain percentage of total sales and reward those whose payroll costs were at or above the defined threshold.

    Such an arrangement would need to be approached as a win/win for all and that includes corporations who would - in the aggregate - benefit from an increased level of employed people who would enter the consumer pool and produce increased corporate sales in the aggregate. The government would increase their tax base and therefore less fiscal stimulus and less debt would be needed and the American people would benefit through a higher standard of living in the aggregate.

    One could even envision a progressive tax on consumers tied to their level of consumption. The more they spent on goods and services up to a pre-determined threshold the lower their tax consequence. It would be a progressive tax in that those with low incomes would pay appreciably less tax than those with high incomes and those with high incomes would have the incentive to spend a higher percentage of their income and in so doing drive demand and therefore GDP. A kind of virtuous circle of spending that benefits all.

    A consumption tax credit would be the opposite of a consumption tax or national sales tax that has been proposed by some. A consumption tax would punish the low income as a much higher percentage of their gross income is needed to provide basic necessities. A much more logical approach would be to incentivize consumers and businesses alike to do those things needed to reinvigorate the economy and that means hire more and spend more.

    Again, I haven't done the math on these tax incentive ideas and therefore can't say with any degree of certainty that the numbers would actually work to generate a sufficient increase in the tax base and therefore a sufficient increase in tax revenues to offset the reduced tax rates. Maybe it wouldn't work but I suspect some arrangement that defined the objective and then offered sufficient incentive to tax payers could be formulated in a way that would work.

    The point though is that the status quo is clearly not working and it is only through out of the box creative thinking that a better solution will surface. As a Keynesian I have no problem with fiscal stimulus as a stop gap measure and certainly no problem with deficit spending. In fact as the world's reserve currency nation we are literally required to operate at a deficit for reasons way to complex to delve into in this article but I also recognize that a vibrant economy can't be built on the back of fiscal stimulus and that is what we have attempted to do for decades and the truth is we have reached a point where the "Law of diminishing returns" has reached its apex and the risk of continuing this policy going forward is that we are likely to experience negative returns - not just diminishing returns.

    At some point we must accept reality and reality in this case is simple - what we've been doing isn't working and it is time to accept that fact and change course. Anyone who clings to the idea that we are in a business as usual dynamic today is simply in denial.

    Reading between the lines

    As the theatrics continue it is easy enough to assume that the matter is purely political and that all concerned are being honest in the way they are communicating with the public. I never assume that to be the case. For instance I think there is ample empirical support for the fact that President Obama abandoned the Bernanke "wealth effect" strategy back in February when he met with Bernanke at the White House.

    Shortly after that meeting Bernanke announced that he would not attend the Jackson Hole Summitt. Then in April Vice-president Joe Biden gave a speech on the need for a New World Order. Was that Joe Biden just being Joe Biden or can we assume that President Obama sent his messenger out to float the idea to see what reaction it might receive?

    Then Obama met with the CEO's of the TBTF banks and gold dropped $200 in 2 trading sessions. It seems a bit naive to assume that the meeting with the CEO's didn't have something to do with that sell off. But if that isn't enough to convince you consider that the Justice Department has aggressively attacked JP Morgan with civil and criminal actions. JP Morgan has agreed to roughly $1 billion in fines for their role in the "London whale" fiasco and they are now negotiating with the Justice Department on what appears to be another $11 billion fine for their involvement in the mortgage credit fiasco.

    Criminal actions and fines of close to $12 billion are not in the category of token slaps on the wrist. More importantly though is my thesis that JP Morgan has been the equity arm of the Fed's Open Market activity. The Fed is allowed to buy bonds but not equities and it is my position that the Fed conspired with JP Morgan to back stop equities.

    That position of course is pure supposition but for those willing to look at the evidence it is hard to argue against the idea that someone - a really big player - has actively pushed against the natural tendency of the market to sell off in the face of negative data time and again. In late December of last year the Congress grappled with the "fiscal cliff" issue that dealt with tax hikes and spending cuts. Most believed the "fiscal cliff" would have a significant negative impact on the economy and they were right. But stocks took off like a rocket right in the face of the "fiscal cliff" - a counterintuitive move to say the least as we did go most of the way over the "fiscal cliff" with tax hikes and sequestration cuts.

    Are we to assume that market manipulation wasn't in play in this situation? You are free to view this as you choose but I will also point out that the "bad is good" market response doesn't appear to be in play in recent weeks. My thesis - JP Morgan is no longer actively back stopping the markets. The reason - they have been put on notice by Obama that the "Bernanke put" has expired.

    That brings me to the issue of the Fed Chairmanship. Most seem certain that the status quo as it relates to monetary policy will be in safe hands with Janet Yellen. But not so fast - Donald Kohn is the only candidate President Obama offered up for consideration. Larry Summers, Janet Yellin and Tim Geithner were in the running by assumption only and both Summers and Geithner withdrew leaving only Yellen and Kohn.

    We all know that Yellen is in the Bernanke camp as far as monetary policy is concerned and we know that Obama was very dismissive of Bernanke in an interview with Charlie Rose a few months back. We also know that Obama is pushing hard against JP Morgan and we know that Bernanke saw the bank as an ally in their "wealth effect" agenda.

    In an effort to connect the dots one should consider Donald Kohn's comments on macroprudential monetary policy. The best way to view macroprudential policy is to think of monetary policy in the context of the big picture. Kohn's remarks centered on the ideas floated by the IMF and the IMF's main thrust as it relates to monetary policy is the need for a non-sovereign reserve currency - apparently the IMF's own SDR. The subject is simply not understood by the media and certainly not discussed by the media.

    More relevant to the discussion though is that Kohn is clearly in the camp that sees macroprudential policy as desirable and that suggests he is on board with Joe Biden on the need for a New World Order - at least as far as it relates to monetary policy. That doesn't bode well for stock investors expecting the QE bull market to continue.

    What can we expect going forward?

    I am sure I will be disparaged by my perma-bull readers but I think the game is over. The truth is the economy does matter and the economy isn't responding to massive stimulus - both fiscal and monetary. More importantly it seems to me that Donald Kohn will be the next Fed Chairman - not Janet Yellen and that means the QE bull could be over. It does make sense after all as it certainly never produced the promised results as it relates to the economy.

    We are still in a secular bear market and we are at the top of the 13 year trading range with a lot of risk to the downside. In January I made a very bearish forecast suggesting we would re-visit the 2009 lows this year. At the time I never expected the Fed to push QE to the levels they did nor did I expect investors to be deceived by the impact of QE as it relates to its economic impacts.

    I did anticipate the possibility of the debt ceiling and deficit serving as a catalyst that would send stock prices lower but I expected that to occur back in the 1st quarter - not the 4th quarter. That said, it occurs to me that the catalyst that starts the markets lower may still be the debt levels and the matter of the deficit.

    At times I feel like the "boy who cried wolf" a few too many times but the truth is the wolf did eventually come.

    Disclosure: I am long FAZ, UVXY, VXX.

    Additional disclosure: I am also long SPY puts

    Sep 30 12:37 PM | Link | 4 Comments
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