Real Estate Mania Persists in the Face of Disconfirming Evidence

31 January 2008

I recall that in the spring of 2004, while Susan and I were travelling through Los Angeles, the bus stop benches were plastered with advertising for "get rich through real estate investing" conferences featuring Donald Trump, Robert Kiyosaki and Anthony Robbins.

I am shocked to learn that these conferences are still taking place, with the next one coming to Toronto on March 29-30, 2008. The usual suspects will be present - including the kingpins of the long-deflated real estate bubble and other new age icons - Donald Trump, Anthony Robbins, George Foreman, David Bach, the Teachers from "The Secret," and an additional "all-star line-up," including Jack Canfield, Alan Greenspan(!?!), and Magic Johnson.

What? This is still happening in 2008?

I must be out of touch, because I don't get it. (I'll grant you, Canada as a location still makes sense. While we lack the United States' spiralling international debt, our central bank governors persist in inflating the Canadian money supply at no less frenetic a pace than our mania-prone cousins to the south.)

Since 2004, real estate investors have been brutally slammed. And now these gurus are going to tell us... get this... what again??? How to make money in real estate in 2008???

I don't have much more to say on this forlorn subject, except that the bus stop bench advertising has now changed.

What is being advertised in 2008?

Foreclosure assistance.

Trump and Robbins may still be running real estate wealth conferences (Kiyosaki pulled out of that game in 2005), but the bus stop benches are now telling a different story.

I would caution against following the pied piper on this particular adventure.

Deconstructing the S&P/TSX Global Gold Index

27 January 2008

I have found a new way to look at the S&P/TSX Global Gold Index (which I shall refer to by its StockCharts symbol, SPTGD, for convenience).

The SPTGD index consists of 25 precious metal mining companies traded on the Toronto Stock Exchange (TSX). Those companies and their current share prices are listed here.

The rules for including a gold mining stock on the SPTGD index are as follows:

- Listed for at least 12 months on TSX, NYSE, NASDAQ
- Included under the Global Industry Classification System (GICs) Code 15104030 – Materials - Metals Mining – Gold
- Minimum float market cap of US$300 million based on three day VWAP
- Average daily dollar value traded of at least US$1 million for the two months preceding a security’s consideration as a candidate for inclusion
- Liquidity ratio (dollar value traded/average float market cap over past 12 months) of at least 0.30
- No more than 25 non-trading days over the past 12 months

The S&P/TSX Global Gold Index is calculated based on a modified market capitalization approach, as follows:

"On any given day, the index value is the quotient of the total float-adjusted market capitalization of the index’s constituents and its divisor. Continuity in index values is maintained by adjusting the divisor for all changes in the constituents’ share capital after the base date. This includes additions and deletions to the index, rights issues, share buyback and issuances, and spin-offs. The divisor’s time series is, in effect a chronological summary of all changes affecting the base capital of the index. The divisor is adjusted such that the index value at an instant just prior to a change in base capital equals the index value at an instant immediately following that change."

At face value, things look pretty good for the SPTGD index, as it is the best performing index of the current (albeit so far brief) millennium on the TSX exchange since 2001:


In fact, the TSX is the best global exchange for financing mining exploration and development, as the following chart reveals:


Here is the problem.

The ascending Canadian dollar and the vagaries of the mining business have caused the SPTGD index to underperform its rival, the AMEX Gold Bugs Index of unhedged gold mining companies (the “HUI”) by a dramatic margin. I have been writing about this problem for some time now.


This is all the more striking, as the HUI index for the most part consists of many of the same gold mining companies as are listed on the SPTGD index (link).

The differences are (1) the HUI index consists of a smaller number of capitalization weighted companies, and (2) the SPTGD index is priced in ascending Canadian dollars, while the HUI index is priced in collapsing US dollars.

The Canadian dollar has climbed almost exactly 60% against the US dollar, since reaching its early 2002 low of $0.6192 US.


But this is the shocker…. The SPTGD index declined 74% against the HUI index from its relative peak in late 2000 to its relative November 2007 low. By any measure, that is a dramatic collapse in relative value. That is, the multiplier required for the November 2007 low on the SPTGD index to recapture its (original high) December 2000 value is a factor of 3.8 – dwarfing the gains made by the Canadian dollar.

Here is the rub – US investors, holding weakened US dollars, who have invested in the HUI index since the last quarter of the year 2000 have done far, far better than Canadian investors who have held the SPTGD index in Canadian dollars over the same period.

To put it in the most dramatic terms possible, the HUI index, admittedly in weak US dollars, outperformed the SPTGD index by a factor of 425% for the period December 2000 through November 2007. This while the Canadian dollar gained only 60% during roughly the same period. In this chart, we are looking at the same phenomenon as before, just in reverse:


That is, the HUI gained a relative 425% for US investors while their currency fell only 38% against the Canadian dollar. Subtracting the 38% currency loss erodes the HUI gain by 162 percentage points, but leaves US HUI index investors still with an absolute gain of 263% against Canadian SPTGD index investors during more or less the first decade of the present millennium – this subtracting all influence of the ascending Canadian Loonie.

To sum it up, in Canada, with a soaring Canadian dollar and the world’s best climate for funding mining ventures, there has been no relative advantage of investing in the SPTGD index over the course of the present decade to date. Far better to be an American, holding a collapsing currency, but investing in the HUI index.

There is no other way to look at it.

Now that the Canadian dollar has reached parity, and probably topped out against the US dollar for some time to come (as the “carry trade” currencies, such as the Swiss Franc and the Japanese Yen now find favour in international currency markets against the backdrop of a looming global recession), will Canadian gold mining stocks find any greater traction compared to their American-listed counterparts than before?

My short answer is… “I'm not sure.”

The trend continues to favour the AMEX Gold Bugs Index (the HUI) against the S&P/TSX Global Gold Index (the SPTGD) until it doesn't.

Eavesdropping on the Gold Sceptics

22 January 2008

It is always interesting to learn how we are perceived by others. I have this opportunity at times provided by Sitemeter, which allows me to study how visitors travel to and from my site.

A very interesting series of visits occurred through a link to my site on the "AppleInsider" Forum. The topic of discussion follows below:

"What do you think is a good investment now?

---

"It looks to be kind of a dangerous time to invest - if you invest in the US what if the dollar keeps on dropping? If you invest overseas what if the dollar rebounds? What about recession, inflation, rising interest rates, bad loans and problems borrowing money as a result (even for good companies)?

"I am looking at commercial REITs - they seem low now, provide income, and have average returns greater than the stock market. The only stocks that look like good buys right now are Cisco and Starbucks.

"What are you investing in/thinking of investing in?"

---

One participant chose to cite my most-commonly-visited article on the $5000 inflation-adjusted long-term gold price target. Citing my article, the person commented as follows:

"Gold!

---

"http://gullarsahir.blogspot.com/2007/07/golds-1980-high-think-5000-per-ounce.html

"Quote:

'The implication of this recalculation is that by normal cyclical fluctuation alone, it is reasonable to expect the current gold bull market to top out somewhere higher than $5000 per ounce.'

"Now, there are a lot of reasons why this won't happen...

"One being that it starts becoming child's play to mine it our of the oceans once it gets above $1,200/ounce. Which was a similar problem back in the 80s which is why it never broke $900. Well, that and a few other issues."

---

As I am not a participant at this site, I was not able to reply directly, and believe me, there is much I could have said.

Fundamentally, however, the most pleasing aspect of reading over this discussion was the confirmation of broad scepticism pervading the investment community with respect to the wisdom of investing in gold (despite gold's being essentially the present decade's best-performing investment sector so far - apart perhaps from energy and several other of gold's cousins and extended family members).

Also of interest was the contributor's primary argument, that when gold becomes sufficiently valuable, much more will be produced, perhaps we'll even begin to filter it out of the oceans!

I cannot comment on ocean filtration recovery of gold. I am not an expert. It is a "for real" technology, as I discovered with the help of Google, which yielded the following link on Science Direct, a reputable professional scientific site.

New Scientist has considered the matter of gold in sea water, and cautions us that no one will grow wealthy by extracting one gram of gold per 100 million tons of sea water: "The presence of gold in sea water has been known since 1872 and has, since that time, motivated much hope of financial gain. But as analytical techniques have improved, the estimates of the amounts in the oceans have decreased dramatically. These most recent estimates are three orders of magnitude lower than those made before 1988. There may indeed be gold in the oceans, but not enough to make anyone rich."

However, one matter of which I am quite confident is that the folks at Barrick and Newmont have devoted some thought to how much gold can be recovered over the next several years, by what means, and at what prices.

The bottom line is that there is no system for producing gold, no how matter cost-effective, which does not involve extensive lead times, and only a very gradual increase in our total store of global gold supplies.

In short, all of the mined gold in the world - approximately 140,000 tons above ground (with an additional known or inferred 50,000 tons underground, half of which is in South Africa) - will soon fill an elongated cube or block the base of which is the size of a single tennis court. Gold mining adds about 2% per year to the total mined supply. It takes ten years and often much longer to commission and bring a new gold mine into operation (assuming the mine is not confiscated by greedy governments, etc.) At today's present production rate of less than 4,000 tons per year, we will still require 20 more years to complete our first-ever tennis-court-sized block of gold. Today's above-ground gold is presently valued at approximately $4 trillion US dollars, about double its value of only 4 years ago, and more than triple its value in 2001.

No matter what you do, you will not be able to increase the world's minuscule supply of gold by a very great amount. What you must reckon with, primarily, is the potential of increased demand for gold as the following asset classes decline in value: currencies, equities, bonds, real estate, manufacturing capacity and manufactured goods.

That is, the real issue potentially driving the value of gold is not the prospect of minimally or greatly increased supplies of gold, as the author at the AppleInsider Forum suggests, but of greatly increased demand for gold as alternative asset classes fail as viable investments.

We presently live in a world in which gold and precious metals taken as a whole represent far less than one percent of the value of all capital assets. For example, all of the gold stocks constituting the Amex Gold Bugs Index, at about $160 billion in market capitalization, represent approximately 0.3 to 0.4% of the market value of all the companies in the world, estimated by Wikipedia at about $51 trillion US dollars as of March 2007, and less than the market capitalization of Google ($182 billion today), even following one of the steepest slides in US stock valuations in many years.

So long as people are not buying gold because it might cheaply be separated from ocean water at some future point in time, one can rest assured that all of those who might one day desire to own gold are not presently contemplating doing so.

In short, every indicator I can see presages a gold price much higher than today's value.

$5000 gold is many years away, of this there can be no doubt. But $1000 gold does not appear to be a distant vision at all - particularly following the US Federal Reserve's most recent currency devaluation - attributable to today's dramatic 0.75% cut in its federal funds lending rate.

Continued rate cuts assure ongoing devaluation of all "paper" currencies, and sustained reinforcement of the market value of gold and of gold mining shares.

Take my advice. The prospect of scientists producing gold from seawater will not erode the value of your long-term investment in gold. Have much more fear of central bankers and government leaders continually undermining the value of your local currency - whatever it might happen to be!

Pre-Crash Talk and Behaviour?

18 January 2008 (updated 21 & 22 January 2008)

I feel nervous about how our political and financial leaders are presently talking about the economy.

After spending the US into its deepest deficit position in history, US President George Bush is now talking about scraping another $150 billion out of this deepening hole to prevent loss of confidence in the economy. (By the way, the latest downturn has already shaved $2.5 trillion off of the market capitalization of the stock market, so how much difference is $150 billion going to make in any case? Such old-fashioned maxims as "good money after bad" come to mind.)

Wait a minute - isn't it economic health that is supposed to sustain confidence in the economy - not remedial measures?

And how exactly does more deficit spending by the most indebted government in world history promote economic health?

Something doesn't add up here, and I think it is our politicians' logic!

Among other possibly relevant facts, did not the Dow Jones Industrial Average just set an all-time record high in October 2007 at 14198.10? And now, three months later, desperate measures are needed to keep the boat floating? That argument just doesn't hold water!

I'll grant you, the recent action in the Dow has been ugly, and by my reading of the technical indicators, the Dow can't get much lower than it closed on Friday without violating many multi-year technical uptrends, for example, in the RSI and PPO indicators, not to mention the absolute value of the Dow itself. Note too that multi-year MACD support has already broken down, in August 2007.

But what really concerns me is the way our politicians and financial leaders are talking and behaving. President Bush stated, "The economy needs a shot in the arm."

What? This is an economy that has had an injection of $5 trillion in liquidity through increased (doubled) money supply over the past decade. Chris Laird estimates that over the past two years alone, corporate buyouts, corporate stock buybacks, the Yen carry trade and mortgage derivatives markets have added perhaps another $5 trillion in liquidity to the economy. And the answer now is... more of the same? I don't think so.

The US economy has had enough shots in the arm to induce a coma, and to qualify it for admission to a rehab centre!

No, the current situation is not about the requirement for another shot in the arm for the US economy....

Rather, our current predicament is about coming to terms with economic reality. And economic reality is that saving and investment create economic health, not borrowing and spending. I think it is really that simple.

Tonight's coverage of the topic on CBC radio featured a succession of authority figures offering reassurance that the sell-off in the markets is overdone, and that investors are overlooking long-term value by selling at this point.

Nothing worries me more than talk of that kind in a historical context such as our own.

In fact, I beg to differ with the reassuring experts. By my estimation, the US economy is in its deepest trouble in almost a century. By every measure I follow, the US economy has not been in such desperate straits since 1929 - though of course in 1929, almost everyone (besides say, Joseph Kennedy) thought things were going just fine, thank you very much.

Clearly, the Dow has fallen 2000 points since October, and that is very bad news for the hopeful investors who have entrusted their life savings to the present generation of captains of government and industry.

Once again, I'm sorry, but people who talk and behave in such a manner as George Bush, Henry Paulsen and Ben Bernanke are simply not the kind of folks I feel inclined to trust, particularly in matters of money and finance (though I do trust Mr. Bernanke more than his predecessor, Mr. Greenspan, for what that fragile thread of difference is worth).

In short, we are presently enmeshed in the largest-scale multi-bubble debt-financed global economic predicament that has ever faced the world. (I'd be happy to admit to hyperbole here, except that I can find no shred of evidence to indicate that this manner of stating the facts is not simply the closest possible approximation to an objective description of the present truth.)

In short, investable assets (such as real estate, stocks and bonds) are hopelessly inflated in value, given the shaky economic fundamentals which presently underpin world markets. The market value of such assets is presently driven by the greatest bubble in world history as indicated by a series of highly objective measures.

As this "multi-bubble" deflates, our asset-dependent economy will inevitably unwind. Citizens will avoid further losses by converting their behaviour from borrowing (to enable them to spend more than they earn on investable assets), to conserving (spending less than they earn), and therefore saving.... again.... just as it used to be in the "old days."

Further, this dramatic turnaround is likely to happen quickly. In fact, the tipping point may possibly be very near in time, and almost certainly, nearer in time than our reassuring government and financial authorities presently indicate.

What is my response to the present reassuring talk and behaviour of our leaders?

I have never as an investor been so joltingly reminded of what I suspect must have been the eerie political, economic and emotional climate of 1929 prior to the legendary October 24 & 29 crash as I was today, in listening to the evening radio news. The hackneyed and faintly-reassuring-at-best public messages of our leaders offered only backward-looking encouragements that struck me as entirely inappropriate to our present economic emergency.

Based on this kind of last-ditch "more of the same" soothing talk from these so-called experts, I cannot shake the notion that the Dow Jones Industrial Average can certainly fall another 1000 points next week, and possibly... most or all of it as soon as Monday, January 21, 2008....

(January 21, 2008: Well, I think I called this one correctly, with one exception. World markets saw their worst rout in years today, including the precious metals sector, which I predict will recover and outperform the rest given the causative factors underlying present developments. However, the US markets were closed today for Martin Luther King, Jr. Day, leaving the Dow untouched! Otherwise, my sense that our authorities were displaying classic pre-crash behaviour seems to have been dead on the money.... So, let's see how things look in the US for Tuesday, January 22. My guess, not much different! Possibly... worse....)

(January 22, 2008: Ben bailed out the US market with an emergency 0.75% rate cut. Here's the problem. He's expending all of his ammunition in the opening round. Such a dramatic cut will certainly keep the hounds at bay, but in my view, not for long. As we know, the Japanese took rates down to 0% for over a decade, contributing to the fertilization of the ground for the global carry trade which has fuelled so much international speculative behaviour over the same period. In this most radical of all scenarios, Bernanke now has only 3.5% left to bargain with - and we're only three months off the Dow's historic October 2007 all-time high. Whoops! If this is a multi-year recession - or worse - much of the Fed's ammunition will have been spent in the first blink of Mr. Bernanke's eye. What will be left after this first salvo, but to slog through mud for many years to come?)

Also see my later posts: "More Pre-Crash Talk and Behaviour," "Only Yesterday," and, "There's a Tsunami Coming in Gold."
_

$900 Gold Is a Canadian Story Only So Far

13 January 2008

The absence of Headlines in the US press as gold has surged to record highs over the past few weeks has been both fascinating and disconcerting.

Record gold prices are clearly a story in commodity and mining-aware Canada. This weekend's headlines include the following Canadian story: "Gold futures surge to record US$900 an ounce on weak dollar, recession fears." The story conservatively estimates gold's previous record high in 1980 at an inflation-adjusted $2200. (It is no secret that a more realistic inflation calculation yields a figure on the order of $5000.)

So, salient though this story may be for Canadians, our American cousins to the south remain concerned, as of this weekend's business headlines, about Fed Chairman Bernanke's next plans to "aid" the economy (in my view, by throwing more gasoline on the fire to keep everyone warm for a little while longer); Mercedes' new SUV (how will gasoline rationing impact the sales and operation of this vehicle?); New York's state probe of Wall Street banks' subprime dealings (blaming the intermediaries and not the principal perpetrators in this top-down process of responsibility-diffusion); the difficulties of steering the Chinese economy (also floating on a sea of excess liquidity); Boeing's new Gulf Air 787 order (the rising jet fuel price is rapidly changing the air travel industry); Northern Rock's new (UK) boss (one of the earlier victims of the debt implosion; the Brits know their economy is in serious trouble, and it is a canary in the coal mine); the rescue of Citigroup by the unlikely duo of China and Prince Alwaleed (pumping yet more foreign currency into US equities to enable the continuation of the liquidity game); Macy's reduction of 271 jobs in the slowing midwest consumer market; Eurozone growth warnings (the problems are mounting in the loosely federated Eurozone); and Wall Street stocks falling as consumers cinch their belts (and we all know that the belt-tightening is only just beginning).

Valid business stories all, but - in my humble opinion - none so important as surging gold, and the changing economic fundamentals which underlie that surge (basically, the decay of all "paper" currencies due to burgeoning central government and central bank fecklessness). Steve Saville has pointed out recently that we prefer to blame the victims of the widening debt implosion for engaging in high risk behaviours that have been blatantly fostered by irresponsible central governments and central banks.

Mr. Saville wisely comments: "The huge quantity of money being recycled by the oil-producing nations and by China is, first and foremost, a symptom of the problem, not a stabilising force. Way too much money has been created over the past ten years and a significant chunk of this new money has ended up with the producers of scarce resources.

"From a short-term perspective it could be considered fortunate that the recipients of the money have turned around and sent it back from whence it came via investments in stocks and bonds, thus preventing some of the bad effects normally associated with high inflation from coming to the surface up until now. However, the fact that some of the traditional effects of rampant money-supply growth -- large increases in bond yields, for example -- were prevented from happening allowed the credit bubble to expand at a much faster pace than would otherwise have been possible. In other words, the so-called 'stabilising force' helped foment a bigger bubble and set the stage for the current debt crisis."

I note also that there has been a very recent upsurge in visits to my blog, an approximate doubling - literally within the past week - as gold has penetrated its former $887.50 nominal peak value. The search terms most often entered enquire why gold surged in 1980, what the inflation-adjusted price of gold was at that time, and why gold is surging now. Hopefully, the entries at this site, as well as the links I have listed (see the right-hand column), will provide visitors with answers to these questions and more.

As I have often commented, Canadian gold mining stocks continue to lag the rising commodity qua currency itself, but that pattern could now be changing, as Canadian gold stocks have been stronger than gold (possibly for the frist time since June 2002) during the early days of 2008. I think the Canadian dollar has run its course for now, and so is no longer providing a headwind to stall the movement of Canadian gold stocks.

My perception is that momentum has shifted from the commodity currencies, such as the Canadian Loonie, to the unwinding carry trade currencies - specifically the Japanese Yen and - my favourite - the Swiss Franc. Note that the Swiss Franc is only starting its recovery against the Canadian dollar. And, as the Franc rises in Canadian dollar terms, so too will gold, in my opinion.

If I'm right, then 2008 could be a friendly (if likely volatile) year for Canadian gold mining equity investors - perhaps the friendliest year since 2001 - which is the last time that Canadian gold stocks enjoyed a simple, steady, straightforward upwards climb for a full calendar year. Note that the Canadian gold-stock-to-gold ratio has not been so low since late 2000 - the year the current "stealth" gold bull market began. Canadian gold stocks could ramp a long way upwards from here, and still not be radically overbought against the surging gold price. Look for positive earnings reports from gold miners all year long through 2008....

My guess is that the current surge in gold tops out only when it surfaces and plays for a while - for at least a few weeks - in mainstream US headlines (and I don't mean page 13). I never imagined that the gold price story could remain so long submerged in the US business media, but affairs are what they are. It only implies that gold is going higher still.

Dare to imagine, if you will, a world in which Prince Alwaleed and an international consortium had decided to inject $10 billion in gold mining shares rather than the moribund Citigroup. This amount represents only 7% of Citigroup's recently halved - and still highly questionable - market capitalization (it would have constituted only 3.5% less than a year ago).

But $10 billion would buy all of Agnico Eagle Mines, most of Kinross Gold Corporation, almost half of Newmont Mining, or almost one-quarter of recently soaring world leader (and still excessively hedged) Barrick Gold Corporation.

The world I have just asked you to envision is coming, but we are not there yet. And the gold miners will be nowhere near so cheap as they are today when Prince Alwaleed and a coalition of sovereign wealth funds are eventually ready to buy them. (Bill Gates was smart enough to buy into 10% of Pan American Silver at bargain basement prices. Give him credit, he knows more about wise investing than he does about software design!)

Now let's wait and see how this one develops, but it looks like $900 gold is not yet even a story.

Watch the covers of Time Magazine, Newsweek and Fortune (which first featured gold in its January 2006 investor's guide). When you read the story there, again, not at its first surfacing - give it several more weeks or months to run - perhaps then you can collect some profits in return for your due diligence in investing in gold, silver, platinum and precious metal mining shares.

Old-Fashioned Saving Versus Asset Accumulation

10 January 2008

Stephen Roach used to write Morgan Stanley’s headline weekly investment column. However, Mr. Roach persisted in stating that the US was sprouting a series of asset and credit bubbles, and he was “promoted” to head the company’s Asia division – and “disappeared” (that’s a transitive verb) from the Morgan Stanley Global Economic Forum webpage as a perhaps all-too-convenient consequence. (I used to read this page weekly for Mr. Roach's column. I haven't been back since he left.)

All too inconveniently, however, Mr. Roach persists in writing the truth. The Financial Times, who have recently declared gold the “new” global currency, have also agreed to publish Mr. Roach’s current opinions in a timely article.

Unfortunately for his employer, who, like the other Wall Street investment banks (apart from Goldman Sachs), has recently written down billions of dollars (in this case, $9.4 billion in the last quarter of 2007 alone) in ill-considered subprime investment products, Mr. Roach speaks the words that give the lie to Morgan Stanley’s participation in the current international debt and asset bubbles.

Most troubling, Mr. Roach makes his case simply – in fact, too simply for the likes of his investment banking colleagues at Morgan Stanley.

Here is the very uncomplicated story, which basically explains all you need to know about global investing in the next ten fairly brief paragraphs.

1. In the “old days,” people saved by spending less than they took home in income. This is a very simple concept, which we shall refer to as “old-fashioned saving.”

2. In the present “new days,” American citizens have simply stopped saving. They now spend more than they take home, year in and year out. This is particularly anomalous when one considers the preponderance of baby boomers in the American demographic melange, who obviously should now be saving vigorously for their collective retirements.

3. What explains this bizarre behaviour?

4. It is actually very simple. Due to excess money supply generation (excess liquidity) and artificially low interest rates, it has become possible to grow assets by borrowing money at low interest rates and investing it in assets – stocks and real estate – which are growing in nominal value at a more rapid rate (reflecting out-of-control money supply growth, or “old-fashioned” money printing).

5. Thus, the more money that Americans can borrow at low rates, the more assets they can buy, which appreciate in value at higher rates than the interest payments on their ever-mounting debts. Thus, those who borrow $1 million make ten times as much on their asset investments as those who borrow only $100,000.

6. Again, this is because the value of the assets has been increasing more rapidly than the amount of the debts that were incurred to purchase the assets.

7. Therefore, there has been a veritable competition – a “horse race” if you will – to determine who can borrow and leverage the most, so as to buy into the most sizable asset gains. Paradoxically, those who are deepest in debt grow richest in the asset appreciation sweepstakes. And perhaps frighteningly, there may be more well-to-do individuals engaged in this very dangerous venture than has yet been realized or disclosed. Time will tell how many players, and at what levels of income, have been playing this high-stakes, high-risk game.


8. What a great system – known as old-fashioned “leverage” – until it doesn't work anymore. It stops working when asset prices for such investment vehicles as stocks and homes (including second and third homes, “spec" homes, etc.) stop increasing. Unfortunately, the time when the game doesn't work anymore – when asset prices stop increasing – has turned out to be now.

9. Why does the asset appreciation game stop working, and why now?

10. For the same reason that bubbles and Ponzi schemes everywhere have always failed. Eventually, there are far too many assets and no buyers left to purchase them with ever more borrowed money, the flow of which cannot continue infinitely without depreciating the value of money itself. The naïve and entirely unqualified subprime borrowers were the last ditch players, and their minimal assets, including their ability to borrow, have now been thoroughly exhausted. In future steps, the exhaustion will work its way upwards to the middle classes, and ultimately, even to the very rich.

The statistics cited by Mr. Roach are very frightening. Here are a few….

“America's massive current account deficit absorbs about 75 per cent of the world's surplus saving. (This deficit has been generated to fund the borrowing that has driven the US asset bubbles in equities and real estate.)

“Private consumption soared to a record 72 per cent of real gross domestic product in 2007. Household debt hit a record 133 per cent of disposable personal income. And income-based measures of personal saving moved back into negative territory in late 2007.

“None of these trends is sustainable. It is only a question of when they give way and what it takes to spark a long overdue rebalancing. A sharp decline in asset prices (a decline in the dollar will not accomplish this) is necessary to rebalance the US economy. It is the only realistic hope to shift the mix of saving away from asset appreciation back to that supported by income generation. That could entail as much as a 20-30 per cent decline in overall US housing prices and a related deflating of the bubble of cheap and easy credit.

“It is going to be a very painful process to break the addiction to asset-led behaviour. No one wants recessions, asset deflation and rising unemployment. But this has always been the potential endgame of a bubble-prone US economy. The longer America puts off this reckoning, the steeper the ultimate price of adjustment. Tough as it is, the only sensible way out is to let markets lead the way. That is what the long overdue bursting of America's asset and credit bubbles is all about.”

Let me tell you, if Morgan Stanley had listened to Mr. Roach, who used to be their so-called chief investment officer, they wouldn't have lost $9.4 billion in low-quality subprime "investments" in the 4th quarter of 2007.

Mr. Roach remains a voice crying in the wilderness within his own organization.

Mr. Roach's message has been too inconvenient for his employer, so rather than listen to their erstwhile star analyst, and his increasingly prickly pronouncements, Morgan Stanley silenced him by “promoting” him to a less troublesome position in the Asian hinterland. More’s the pity for Morgan Stanley, who, if they had followed Mr. Roach's sage advice many years ago, might well have been the most successful investment bank on Wall Street this year.

Unfortunately for Morgan Stanley, they refused to listen to Mr. Roach's wise words, and joined their fellow lemmings in jumping off the subprime cliff. (Only the folks at Goldman Sachs were smart enough to bail out of the subprime game before it tanked.)

So, in brief, what happens now?

Well, the US dollar isn't going to do well. As US assets decline in value, international investors will grow less interested in owning them. So the US economy will surely slow. That is a given.

As international investment in the US recedes, that will cause the funds available for continued borrowing in the US to decline. So debt-laden American investors will now have to unload their depreciating assets to stanch their losses and revert to a very old-fashioned behaviour – spending less than they earn.

After all these years, Americans will become savers again. This will bode well for the long-term future, but there will be an interim period of economic pain, possibly for many years to come.

This fundamental shift in American consumer behaviour will drive a “sea change” in the American economy, as rising consumer spending will no longer propel the economy ever upwards.

The interesting question will then be to determine if Asian savers shift their behaviour to become consumers of goods and services, rather than of devaluing US assets.


In short, with the inevitable decline of the American consumer, the critical question will be to determine if new consumers do or do not emerge, primarily in Asia. (Europeans, Canadians and Latin Americans do not have enough savings to compensate for the expected American reversion to saving.)

If Asian savers convert their behaviour to consumerism, their purchases of goods and services might keep the global economy moving forward at a fairly strong clip.

The critical point is that Asians can afford to consume much more than they do now while still spending less than they earn, as they remain “old fashioned savers.” But they will assume this new role as drivers of the global economy only if they choose to do so on a collective basis.

However, if Asian savers respond with fear and continued conservatism in the face of a substantial decline in the nominal (currency) value of US assets and an associated diminution in American international purchasing power, then an international retrenchment in consumer spending could provoke a severe global recession, or even a period of economic depression.

Here is the interesting part – it is really a question almost exclusively of human psychology and associated behavioural functioning.

That is, Asian savers probably have enough funds set aside to keep a consumer-led global economic boom surging for years to come. But the choice of saving or spending is strictly personal and psychological. If Asian savers do not increase their spending, they will join their American counterparts in riding the downside of the debt and asset bubbles of the last 2 to 3 decades.

I don't think anyone can forecast accurately what will happen, though those with a firm grasp of Asian psychology will certainly have a predictive edge.

In the end, all will depend on the cumulative decisions of perhaps 3 billion Asian savers. It will be a matter of mass psychology, Asian style.

Perhaps Mr. Roach was assigned to the correct location by his employer after all.

Record High Gold Price Does Not Register in Mainstream Headlines

8 January 2008

When profound developments are broadly ignored in a major field of investment, the lack of general interest confirms that the broad secular trend remains in its very early stages.

I addressed this topic in more detail on November 2, 2007, the day that gold moved above $800 for the first time in 27 years. The event hardly registered as a blip in national and international news coverage.

Today, a development far more profound than that of November 2, 2007 has occurred. Gold has registered its highest nominal value in history.

As I have written previously, "Gold did trade briefly at $887.50 on January 21, 1980 before collapsing in the 21-year bear market that took it to its dismal February 20, 2001 low at $255.00."

About three hours ago, the price of gold surged above $891.00 US dollars per ounce.

How have the media covered this groundbreaking event, for which gold investors have waited 28 years?

My primary reference is Yahoo.com. "Top stories," "world headlines" and "full coverage" make no mention of the story. OK, how about the business headlines?

Well Reuters Business has stories covering developments at Bear Stearns, Ford, AT&T and Countrywide Financial. But the gold story is not on the radar. You've got it.... An all-time record-high gold price is not even business news!

The good news, I suppose, is that the story registered on Reuters Canadian Business with two headlines: "Gold prices hit all-time record over US$875 an ounce amid rising oil prices" and "Gold company shares have room to grow as gold hits record, analysts say."

Therefore, the all-time record high gold price is at least of interest on the Canadian business scene, and this is not surprising, as Canada hosts more mining companies than all the rest of the countries of the world combined.

However, my guess is that mainstream Canadians, not to mention mainstream Americans, remain entirely unaware of this very significant story

The time will come when everyone will speak of the price of gold, but now is not that time.

When that time does come, the price of gold will be measured in the thousands of dollars.

Caveat investor.

What Went Wrong for Canadian Gold Stock Investors in 2007?

7 January 2008

Let's wrap-up 2007 for Canadian gold investors - quickly....

Gold in US dollars had a dramatic year, up from about $635 to $860 US. That's approximately a 35% gain. What a year for US-based holders of gold!

The Canadian dollar climbed from $0.86 to $1.01 US, for a 17% gain. Obviously this means that Canadian dollar-denominated investments underperformed US dollar-denominated investments - but in local terms only. The upside is that Canadians gained in the international purchasing power of our currency. Not a bad bargain for Canadian investors....

Interestingly, Canadian dollar-denominated gold also did well, moving up from about $735 at the start of the year to close at $830. That's a 13% gain. And, in terms of international purchasing power, the gains for holders of gold in Canada and the US were of course equivalent.

However, here is the rub - a problem I have been commenting on all year.

Canadian gold stocks could not begin to match the performance of gold, regardless of its currency denomination. The SPTGD gold stock index started 2007 at about $325, and wrapped up the year at $310, down 5%. That is a meagre performance for a sector whose primary referent has just nailed down one of its best years in history.

So, let's just say that Canadian gold stocks dramatically underperformed last year. And I mean dramatically!

So, how did gold stocks in the US measure up? Well, the Amex HUI "Gold Bugs Index" of unhedged gold miners managed to log one of its best years ever, right in step with gold. The HUI ended the year up 28% in US dollar terms, outperforming the Canadian SPTGD index by 33%.

In short, the US HUI index outperformed Canadian gold stocks by double the amount of appreciation in the Canadian currency (33% better than the SPTGD index, divided by the 17% gain in the Canadian currency).

If you want to measure the HUI in Canadian dollar terms, the gains were less dramatic, but positive, up from about $390 to $410, for a 5% gain - 10% better than SPTGD's 5% loss, when both are taken in Canadian dollar terms.

My prediction - Canadian gold stocks are set to rebound in 2008, possibly dramatically. And if I'm wrong? Well then, I'll just move back to the US and keep my investments in US gold stocks!

I'd prefer not to see another year like this one. Ever again!

Transparency and the Fed: How the Culture of Risk Was Created

6 January 2008

Henry Kaufman has written a profound piece that thoroughly deconstructs the chaos that has been unleashed by permissive US government institutions which have fostered a culture of ever-increasing risk-taking for the purposes of fee-generation and market penetration in the mushrooming industry of so-called financially inovative "derivative security creation" (in fact, this financial house of cards is almost entirely about ways to repackage ever-more questionable debt and sell it to the highest bidder as a "premium," higher-interest-rate product in a Fed-created artificially low interest-rate environment).

As Mr. Kaufman's article is entered as a blog "message," I am reproducing it here (in full) for posterity.

Transparency and the Fed
By HENRY KAUFMAN
January 3, 2008

Transparency is a hallmark of modern capitalism, and Federal Reserve Chairman Ben Bernanke has made transparency a hallmark of his new regime. Yet among our leading financial institutions, opacity, not financial transparency, has been on the rise.

The combination -- increasingly opaque financial markets and increasingly transparent monetary policy -- has created a dangerous brew of financial excesses. Unless both trends are reversed, financial stability will remain elusive.

The explanation for increasingly opaque financial markets lies chiefly in securitization -- the conversion of non-marketable assets into marketable obligations -- which has accelerated dramatically in recent decades.

In theory, securitized markets are supposed to operate on the basis of accurate and readily available prices, the clear assessment of credit quality, and objective analyses of these obligations by rating agencies and those engaged in trading and underwriting them. These virtuous mechanisms presumably have been reinforced by a host of new credit instruments, especially financial derivatives that mitigate risk taking. Securitization also has been supported by a dazzling array of new quantitative analytical techniques that are capable, according to practitioners, of defining risk probability down to decimal point levels.

So what went wrong? In the broadest sense, the structural changes in the financial markets encouraged participants to become short-term oriented.

Financial intermediaries quickly recognized that the process of securitization held the potential for enormous profits -- from underwriting, distributing and trading the newly commodified obligations, as well as from managing them for others. To many, the profit potential seemed virtually unlimited, because it stretched well beyond non-marketable assets (like a mortgage) and was global in scope. Thus securitization drove a massive wave of credit creation and helped lift the level of financial-market transactions to record levels.

The new credit entrepreneurship paid off handsomely. For nearly a decade -- up to mid 2007 -- financial profits outpaced the growth of profits in the broader markets.

But the fervor for profits from securitization also ushered in a host of less apparent, and less cheery, institutional shifts. Senior managers at a growing number of leading financial institutions either lost control of risk management or became its captives. In some cases, this happened as managers struggled to understand the dazzling complexity and diversity of the risks assumed by their financial conglomerates. And every institution, of course, felt growing competitive pressure to take on risk in order to maintain market share.

The glamour and profit of risk-taking insured that the risk-takers themselves gained more and more power within the structure of financial institutions. With the eclipse of partnerships on Wall Street, investment banks and other financial institutions are now owned by absentee stockholders, the vast majority of whom lack the information and the analytical skills needed to judge the risk portfolios of their institutions. In any case, it is the rare shareholder who will voice displeasure during favorable markets.

Power and decision-making increasingly resided in the middle ranks of leading financial institutions. Unlike top managers, who are supposed to take the long view and think strategically, those in the middle ranks -- traders, investment bankers and managers of proprietary activities -- compete in arenas that are by nature focused on the near term. They are the rainmakers. They and their institutions thrive on profits from securitized markets and on ever-expanding asset markets. They are biased to pursue ever greater levels of risk.

Incentive systems within financial institutions offer few restraints. It is possible, though rare, for top managers to be removed from office. But even then, judging by recent events, compensation packages for the deposed are more than generous. Middle managers are sometimes dismissed, but they too typically received generous termination payments as part of their contractual arrangements. Such arrangements are net losses for employers, for there are no claw-back provisions to recoup any of the losses incurred by the former managers.

As financial markets have become opaque and risk-laden, the Federal Reserve has touted its own growing transparency. Yet the central bank has made no real effort to compel financial institutions to follow suit.

When the Fed failed to put into place new disclosure requirements or otherwise penetrate market opacity, market participants took note and devised new ways to camouflage risk and create additional excessive credit.

Some of the Special Investment Vehicles (SIVs) that contributed to the recent hemorrhaging of the money market were an off-balance-sheet activity of bank holding companies -- and therefore subject to Federal Reserve supervision. But the Fed seemed satisfied to allow them, as long as it determined that the value-at-risk procedure employed by these holding companies fell within generally accepted parameters.

Rather than focus on the threat posed by the lack of transparency, the Fed has focused on mechanical deficiencies in the market. For instance, regulators tried to insure that the huge volume of trades would be cleared quickly and with correct documentation. This is worthwhile, but by itself cannot forestall credit abuses. By failing to acknowledge and attack risks posed by opaque financial practices, the Fed encouraged them.

Ironically, the Fed's own transparency -- as demonstrated by the new tenor of the central bank's open market pronouncements in recent years -- has tended to foster rather than dampen financial excesses. Perhaps nothing better illustrates the Fed's lack of pre-emptive restraint than what has become known in the investment community as the "Greenspan Put."

Briefly stated, this is the now-prevailing view that monetary authorities do not know when a full-blown credit bubble is upon us, but that they do know what to do once a bubble bursts. I have long argued this approach condones excessive credit growth. Massive infusion of new funds following a major market collapse can provide temporary relief, but it does not repair the long-term political, social and economic damage caused by the meltdown. How can this monetary approach not reduce market discipline before the collapse, or incite a quick return to speculative activities after the Fed rescue?

Consider another example of the Fed's transparency policy that is likely to backfire. In November 2007, the Fed announced that it will "increase the frequency and content" of its economic projections released to the public. Rather than twice a year, the Fed will announce them quarterly; and it will extend the forecast horizon to three years from two.

At first blush, these might seem like moves in a positive direction. But will they actually diminish market opacity or restrain market activity within prudent bounds?

This is highly unlikely. That is the case, at least, for the Fed's first, more-detailed economic pronouncement, which predicted moderate economic growth for the next three years, inflation to remain within acceptable bounds, and high resource utilization, as measured by the unemployment rate. In contrast, if the Fed were to project a significant escalation in the inflation rate or a sharp cyclical turn to a business recession, financial markets would recoil, and the central bank would be blamed for damaging the economy.

What would be more helpful is what is currently missing from the Fed's current repertoire: the central bank's assessment of financial developments for the next three years, and the specific interest rate range needed if the Fed is to achieve its economic targets.

At the heart of the Federal Reserve's diminished influence as a positive economic influence is its ambivalent core philosophy. During his long tenure as Fed chairman, Alan Greenspan ostensibly was an economic libertarian. This means not only that the market knows best, but that the market should decide winners and losers.

I say "ostensibly," because, like Mr. Greenspan and the central bank that continues in the shadow of his legacy, most Americans applaud competition while being uncomfortable with certain kinds of personal and institutional failure. There is no better example than our attitudes about the failure of large financial institutions.

With huge liabilities resting on a thin capital base, they are vulnerable giants. Yet they are the custodians of the public's temporary funds, savings and investments. They cannot be allowed to fail. The costs -- financially and economically, socially and politically, domestically and internationally -- are unacceptable.

So many economic libertarians such as Alan Greenspan live uncomfortably with the doctrine of too-big-to-fail. Nevertheless, one cannot be a true advocate of the philosophy by adhering to it when monetary ease is the order of the day, and abandoning it when market discipline punishes those who have committed financial excesses.

Even out of office, Mr. Greenspan continues to want it both ways. His best-selling memoir reasserts his laissez-faire philosophy, but in a recent pronouncement he advocated giving funds directly to needy subprime mortgage borrowers to permit them to meet their contractual mortgage obligations.

This would have three consequences. It would alleviate the immediate pain of the borrowers (who should not have been allowed to borrow in the first place). It would keep the façade of the financial system in place without disciplining excessive lending practices. And it would socialize the cost of the problem by raising the government's budget deficit.

Today, a shrinking number of huge, integrated financial conglomerates dominate markets. They offer a full range of financial services -- commercial banking, investment banking, insurance, credit cards, asset management, mutual funds, pension funds and so on. But annual reports, 10-K reports and other currently required reporting tools give us little idea of the true extent of their risk-taking activities.

My own preliminary efforts to calculate, for a book in progress, the proportion of risk exposure to tangible financial assets within these institutions suggests a ratio of dozens of dollars at risk for each one in hand. Our economy would be better off if the Federal Reserve focused its campaign for greater transparency on those leveraged giants, rather than making the kinds of pronouncements that encourage them to take on even more risk.

Mr. Kaufman is president of Henry Kaufman & Company Inc., an economic and financial consulting firm, and author of "On Money and Markets: A Wall Street Memoir" (McGraw-Hill, 2001).