Krugman: Don't Worry About Inflation

Paul Krugman is at it again. (Here's a picture of him with former President Bush) 

This time, he reassures us of two ideas: 1) all that money the Fed is creating won't push up prices, and 2) the US would never default on its debt obligations by inflating away the debt.

So, for Krugman's first assertion, while he is correct that the contraction in bank lending has counteracted the increase in money created by the Fed, it flies in the face of logic to think that the Fed can create trillions of dollars out of nothing and that this will have zero effect on prices. Doesn't it seem more likely that certain prices are being prevented from falling to their equilibrium level by the Fed's monetary mischief, thus distorting the price mechanism? 

See, the thing is, the US is approaching this psychological level, where the debt of the Federal government approaches 100% of GDP. This is only important because people often fail to see that the two can't be compared directly - GDP is a flow, like your yearly income, and debt is a stock, like the value of your stock portfolio (except in reverse!). So just as a person who makes $50,000 a year could owe $75,000, so it is possible that the US debt exceeds GDP, and nothing really changes from debt being 90% of GDP to debt being 100% or more. However, GDP is a good reference point for understanding the level of debt, because it shows our capability for paying back the debt, and also gives us a yardstick which adjusts for changes in the price level and economic growth.

Now there's this thing called denial. When a lot of people say "you don't need to worry about that," they're often saying, "I get why you're worried about that - you should be". Krugman's denial of inflation is similar to his denial of debt default. There's no way the US would default on its debt, he shouts. No way in hell! 

In other words, it's extremely likely. All signs point toward default: escalation in borrowing, continued current account deficits, falling dollar, rising yields.

Paul Krugman, I salute you. You're a great economist. You've made important contributions to the theory of international trade. You were right about the war in Iraq. But you're wrong on this: the US will default on its debt, and the method we'll choose is inflation. I'd suppose you have 5 or 10 years before you have to admit your mistake. 

I'll be waiting!

The Rise of Oil and Gold Is An Early Sign of Inflation

(This filthy-looking pool of oil is from the Exxon Valdez oil spill)

The Federal Reserve must be happy now; they're doing their job: fighting deflation by creating money out of thin air.

The oil price is over $65 now, and gold is over $978. This is an early sign of inflation. We're in an odd situation economically; certain items are in deflationary mode. Deals are

everywhere on housing, furniture, cars, appliances, clothing, travel. These are items that consumers are cutting back on.

Since oil and gold are investment commodities, they are seeing appreciation now because of fears of inflation and the desire to protect assets. A good way to get exposure to the oil price easily is through the oil ETF USO. (This is good for long-term exposure; USO doesn't always track short-term movements in oil prices accurately, because it is the target of arbitrage)

What about the ethics of investing in oil? My dad won't touch it; he says it's a dirty business. Similar concerns have been raised about gold, which is produced by crushing tons of rock into a fine powder, then using acid to dissolve the metal, a process that uses copious amounts of energy.

Each person's ethics come from within. For me, I don't rule out profits from oil or gold, because it doesn't seem helpful to me to say I won't invest in something but I will use other products. I own a car, I own electronics, I have gold in my teeth. If I touch it as a consumer, I'll touch it as an investor, where at least there is an opportunity to make a profit. These things have to be decided on a case-by-case basis. Every corporation is guilty of something, as is every individual.

As Treasuries Swoon and the Dollar Falls, Gold Advances

Gold has been on a tear the last few days, taking back its role as the bomb shelter of financial assets. During the tail end of the boom years (2006-2008) gold began to move in tandem with stocks. The market would be up, and so would gold. That was unusual.

Now gold is back to moving inversely to markets. As I wrote yesterday, US Treasuries are falling, causing yields to rise. (Check out ^TNX) As I write this, the market is experiencing a bounce as it absorbs the activity of the last few days. The dollar is also falling, and has breached the psychologically important 80 level.

Seabridge Gold (SA) is now up to $30.66. If you bought Seabridge Gold back when I said, your money would've grown to $11,927 by now. I see SA going to $40, so hold on to what you've got. I also own Exeter Resource Corp (XRA). Exeter is a small-cap gold mining company from Canada, which is home to many such mining companies. Many of these are unsound, and will get shaken down by the movements of the gold price, but Exeter is one that will remain, I think, as they have very low levels of debt and they seem to have a solid business plan.

It's a good idea to have some GLD, the exchange traded fund that holds gold bullion, as well as some SLV, and some physical gold and silver in your possession. Another good way to invest in gold is through Goldmoney.com.

Treasuries Crumple!

The price of the bellwether 10-year US Treasury note cratered yesterday, sending the yield skyrocketing.

This chart (^TNX) shows the yield of the 10 year US Treasury note. (As the price of a bond falls, the yield rises)

Look at the pattern of the last few days. The yield is up rather sharply. Keep in mind that this 10 year Treasury yield drives a lot of other interest rates, including mortgages. People often think that it's the Fed that controls interest rates. Not really. The Fed influences interest rates, and has been struggling to influence the yield on the 10 year US Treasury note, but the Fed is only one player in a big and very complex game. Sure, the Fed is one of the few players that can (semi) credibly print money at will, which is what they do when they want to push the 10 year Treasury yield down. They print money, then spend it buying Treasuries, which pushes prices up and yields down.

The Fed is losing a massive, behind-the-scenes battle. The Fed must keep this yield under control. But it must do it quietly. If investors get to thinking the Fed is the only buyer of Treasuries, they will sell, sending the price down even further. Also, it looks as though foreign central banks, which hold a lot of US Treasury debt, are starting to quietly edge toward the exit, and see the Fed's buying sprees as a good opportunity to sell off some of their holdings. The more money the Fed creates to manipulate markets, the more precarious becomes the state of the dollar, because it becomes more and more obvious that the plan is to inflate away the debt.

About the size of this market: check out the Treasury direct website. The total US Federal government debt is about $11.3 trillion. The US stock market, by comparison, is about $9.3 tril, as measured by the Wilshire 5000.

If money really begins to flee the US Treasury market, where will it go? Keep in mind that when someone sells a US Treasury note, they are paid in dollars. If the idea is to avoid the depreciation of the dollar, then the money must go into another currency or asset that is outside the ability of the Fed to depreciate. The obvious candidate is gold, but I expect we'll see continued movement into the Euro (note that the Euro is up strongly against the dollar recently, which tells us that many investors don't buy the rally. If the worst was over, why would the dollar be falling against the Euro?)

Interview with Robert Prechter

Here's a video from Feb 2008 with legendary investment advisor Robert Prechter, author of Conquer the Crash and founder of Elliot Wave International. His company uses a variety of data, but his training is in psychology, and you see the influence. He looks a great deal at how people feel on an unconscious level; he calls the approach Socionomics.

Barron's has a nice interview with Prechter in which he argues that we're entering a long-term recession with deflationary tendencies. He sees further declines in the stock market, based on the fact that P/E ratios have not fallen enough to mark a bottom. Optimism is also high.

I agree with his analysis in general, though I think the Fed will win the battle against deflation by creating trillions of dollars of new money, as they have been. So far the Fed has avoided all but a slight amount of deflation. Prices over the last year have been flat overall, despite large decreases in the price of housing.

My Family Was Madoff-ed

Investing with Bernie Madoff was, for the most part, a family tradition. By now nearly everyone knows that he was running a massive Ponzi scheme, paying out investors "returns" of 12% a year from the money coming in from new investors.

My step-mom, Saphira Linden, my dad's third ex-wife, had been investing with Madoff since the late 1980s. She believed in the fund and Madoff himself so strongly that she urged me to invest in it, even in my grad student days, when I was taking on large amounts of student loan debt. She gave me a gift once, $1000 that was invested with Madoff. She only asked that I add $100 to $200 per month to it.

The account was through a family friend named Richard Glantz, who got lots of people involved with Madoff. The pitch was always the same: this guy is a financial genius, and he doesn't take on new clients, but I can get you in. Ritchie was what later became known as a "bundler". It doesn't seem like he knew what was going on, but at the same time, it doesn't seem like he asked too many questions about where the money was coming from. This is the pattern all the way down the line: nobody asked too many questions. Why bother? The returns were there, the money was there. Until it wasn't.

My mother and stepfather, Ken Macher, were also heavily involved; they had all their assets with Madoff, and as Ken moved into semi-retirement, and then full-retirement, they lived off their returns. (My stepdad is also a talented musician, and he recently released his first album, which I highly recommend)

In the summer of 2006, I got worried about a financial crash, so much so that I gathered the family and close family friends together and delivered a truly apocalyptic lecture and slideshow about the risks to the financial system: spiraling consumer debt, corporate debt, and government debt, massive trade deficits, the weakness of the US dollar, etc. I recommended holding all or a substantial portion of assets in gold. I predicted the stock market would take a major hit. (I was thinking it would be on the order of 90% or more; which I still believe will occur). There was a lively discussion, and one of the questions was, how do we hold assets in gold when we're living off our returns from Madoff, which are steady and reliable, 10-12% a year, every year?

I said buy gold and sell a bit of it each month to live on. The gold price was about $550 an ounce back then. Any money put in gold would've nearly doubled, even considering the hit that gold took during the fall of 2008, when it fell to $700 from over $1000. But now gold is back, pushing against the $950 mark. No doubt we'll look back on the days when gold was below $1000 with awe, wishing we could go back in time and buy more at those prices. (Compare the performance of gold to the Dow, which went from about 11,000 in the summer of 2006 to over 14,000 before heading down to its current level of about 8500; over this period, a 23% decline)

The results of my slideshow were as much as I could've hoped: my family and friends took it very seriously, and began to explore the reasons for owning gold, immersing themselves in the economic literature which argued such a financial crash was a strong possibility, and in the end, they shifted 5-10% of their assets into gold and silver. (Ritchie wasn't at that lecture. I wonder what he would've said, or if it would've influenced him in any way.)

I never criticized Madoff directly; to do so was the question the financial acumen of the family, substituting my own. Each time I asked questions about what his strategy was, where the returns came from, it was a blank. I said that the investment strategies of the past would probably not work in the future, because what's coming is a new paradigm. I had no idea the whole thing was a fraud. I just knew I didn't like the secrecy. I had taken out the money my stepmom gave me (I never added anything to it).

My father and stepmom never got involved with Madoff. My dad never believed in the returns. He had worked in the mutual fund industry, and didn't really believe that the market could be beaten over the long term.

My mom and my stepdad, having lost everything except the gold (a small percentage), were philosophical. My mom said, "it's exciting to think about living more sustainably." They began growing vegetables and composting, and are exploring all kinds of different options.

When the news hit, back in December of 2008, I felt a lot of regret. Why hadn't I tried harder to learn more about Madoff? Why hadn't I done more? I should've been more forceful.

I'm proud of how my family has responded to the crisis. It's been hard, but they have used it as an opportunity to look within, to grow, to turn the trash into compost, out of which comes something alive and new. May we all learn to do the same.

WSJ: The End of Bling

Hey, remember what I wrote a while back about the End of Bling? Well, the folks at the Wall Street Journal must've read it, because today's headline says much the same: Culture of Bling Clangs to Earth as Recession Melts Rappers' Ice.

It seems rappers are turning to lower-quality (or even outright fake) gold and gems for their big necklaces and grills.

The article mentions Lil' Jon and his record-breaking, 5 lb gold and diamond pendant that says Crunk Ain't Dead, but to me, Damien Hirst's skull piece For the Love of God is even more emblematic of the era. If any piece represents the end of the first decade of the 21st century, this is it.

Green Shoots?

The other day I wrote that there are no green shoots of recovery. Perhaps that is unnecessarily dour. Like any living organism, the economy is continually growing and dying away at the same time. So at any given moment, there are green shoots, in the form of new businesses, new ideas, new innovations. At the same time, at any given moment someone is being laid off, a business is failing, and so on.

The phrase green shoots suggest that the winter of recession is over and the spring of recovery has begun. I don't think we're close to the recovery, because while the process of deleveraging is occurring, it's still incomplete. When household, corporate, and government debt burdens have been reduced to something like their historical levels, then I'd say the process of deleveraging has been completed. But we're far from that point now. Consider the graphs to the left. The top two show rapid rates of issuance of government debt securities, far in excess of economic growth rates. The third shows the escalation of debt within corporations, most of it led by the financial sector, which has made leverage into an art form. The last shows the debt burden among households. These last two show debt as a percentage of GDP, which corrects for increases in wealth, productivity, inflation, etc. What we see is basically a tripling of the relative debt burden of households, and even more of an increase in the corporate sector.

What must happen is a purging of bad debts. There is no way that all the debts that have been incurred by households, the various levels of government, and corporations will be repaid. That means lenders are in for a serious hit. The carnage we've seen in the financial sector (for example, look at the DJ Financial Services Index) is just the beginning. What is needed is a shift away from finance toward productive economic activity, a sort of de-financialization, to use a fancy term. (there's a nice post on this at Below the Crowd)

It's clear that massive bailouts to the financial sector will be costly failures. No amount of money creation can prevent de-financialization from occurring. If we test my thesis, it will only come at the expense of inflation. But high inflation would also threaten financial firms, for high inflation cuts into interest rates, lightening relative debt burdens in favor of the debtor, harming the creditor, making it more difficult to both borrow and lend. High inflation would also make nominal interest rates rise, encouraging further deleveraging.

Happy Memorial Day!

I don't know if it's right to say "Happy Memorial Day". It is a rather somber occasion, no matter how much beer you drink over the holiday weekend. I have mixed feelings about the day. On the one hand, I celebrate the idealism and sacrifices of the nation's soldiers over the years. People willing to die for their country, for the ideal of liberty, that is both noble and deeply moving.

At the same time, it seems right to recognize that some of these sacrifices were made in the name of extending the American empire. Many of the wars we've fought have been wars of choice, with horrific consequences.

In honor of the day, I want to consider what we spend on war; not just spending within the Department of Defense, but all spending that could legitimately be considered war-related, including the interest payments on past debts that are due to war, the spending on veteran's care (not part of the DoD), the spending on maintaining our nuclear arsenal (part of the Dept of Energy, believe it or not). In fact, when all the accounting chicanery is laid aside, we find that a surprisingly large portion of the US Federal budget is war-related. The pie chart, from The War Resisters League, is a categorization of the Federal budget that takes into account the various ways the government tries to hide the true extent of war spending.

I believe we'd honor our fallen soldiers best by decreasing our spending on warfare, recognizing that with a smaller military presence, there will be fewer conflicts and fewer lives lost in those conflicts.

Is the Price of Gold Being Manipulated?

A recent article by Brad Zigler at Seeking Alpha argues that it is not. Zigler runs a site called Hard Assets Investor, and has a lot of interesting things to say about commodities.

I like that Zigler marshals some evidence for his claim, by looking at some of the short positions relative to the long positions that banks take on.

But I find myself unpersuaded by his overall case.

Zigler argues that the ratio of shorts to longs in the gold futures market is 3.7 to 1, and that this is therefore hardly the strongest case that banks are manipulating gold. Perhaps they merely believe that gold prices will head downward. I agree with his skepticism in principle, but I don't follow his interpretation of the evidence.

Just to take the other side of the story, notice that 3 US banks hold nearly one-third of all short positions in gold. That seems at least a bit suspicious. Non-US banks holdings are much more evenly balanced between long and short. Why would these three banks do this? Perhaps they've decided that gold is overvalued, and they hope to reap massive profits as gold corrects downward. I don't think that will happen, but surely banks are allowed to lose money if they choose, right?

I'm surprised that Zigler didn't take a look at some of the arguments put forth by the Gold Anti-Trust Action Committee. For instance, a recent article by James Turk, author and President of Goldmoney.com, argues that central banks lent considerable quantities of gold (between 12,000 and 15,000 tonnes) to create what he calls a 'gold carry trade', where investors borrowed at low rates in order to invest at higher rates elsewhere.

Reading Turk's article, I'm struck by how sensible his argument is, but also by how little hard evidence he has. Yes, central bank officials have made statements in the press that they manipulated gold or should have; yes, Barrick Gold has admitted to assisting in such gold manipulation; yes, the motive is there: central banks want to support the value of fiat currencies, and gold is the main competitor. But where are the hard numbers? Where is the smoking gun?

All of this shows that it's very hard to prove that someone is manipulating a price of anything. So perhaps this argument will never be decisively won or lost, and people will take whichever side they find most convincing. It seems likely to me that the Fed and the Treasury are manipulating the price of gold through the cooperation of some of the big investment banks and gold producers like Barrick. But honestly, who really cares? Markets are behaving strangely these days.

In a sea of overvalued financial assets and fake wealth, gold will sustain.

China and Brazil Plan to Evade the Dollar

An important article in the Financial Times reveals that China and Brazil are working around the dollar.

It's interesting that the public denunciations of the dollar's reserve status are growing steadily more blunt, less circumspect, and now include China's unveiled ambition to replace the dollar. It is surprising indeed that the dollar has not reacted with more vigor to the news. Perhaps it's because it was not widely reported in the US, or because we seem to have a curious sense of denial about the future of the US$, which is clearly not bright.

In an earlier post, I discussed China's (non)-manipulation of the yuan, noting that Paul Krugman thinks China's position is weak. I wonder if it still seems so weak to him. Check out the chart of the dollar's recent performance in the broad dollar index, taken from Dow Theory Letters. Pretty exciting stuff - the dollar has fallen from 88 to 82 since March. It looks like the rally may not make it to 10,000 as I thought previously.

As I wrote recently, the status of the dollar is likely to be the next big blow to the financial system. When a currency depreciates, it causes severe stress on the financial sector, including panicked runs on banks, which are, of course, entirely rational given the fall in the value of the currency. Wouldn't you want to withdraw your assets from banks and put your money in some other currency, or even in commodities? Bank runs lead to bank failures, which lead to shocks to financial markets, and panicky interventions by authorities. Expect such interventions as we move into the next phase.

I've considered an ETF called UDN, which is comprised of dollar short positions, but I think that Seabridge Gold is the safer bet (and indeed, may have better upside potential), as it is a Canadian company, with assets in Canadian dollars, and perhaps more importantly, it is tied to gold which will almost certainly respond strongly and favorably to a decline in the dollar.

Bernanke on Financial Innovation

While there are legitimate financial innovations, e.g. the stock market, options, shorting stocks - many financial innovations are merely more sophisticated ways to gamble or rip someone off.

Fed chair Ben Bernanke offers an interesting argument about three financial innovations that he considers worthwhile and important. These are: credit cards, mortgages, and bank overdrafts.

There is a certain wolf-in-sheep's-clothing aspect to Bernanke's speech.

He says, in effect, gosh, some of these financial innovations haven't gone all that well. It's very challenging for regulators, because on the one hand, we don't want to stifle innovation, because that makes all our lives better. On the other hand, sometimes things get out of hand, we ought to consider how these innovations will react when they are "stressed", and recognize that regulation may be needed. Who could argue with these mild-mannered banalities?

Yet if we step back and ask the question, why should the Fed have a role to play in preventing people from getting fleeced? That doesn't seem like the Fed's role. People get ripped off all the time. It seems to me that a better defense against that than the Fed could ever be is this device called the internet. It sure seems like a great way to spread information to other consumers not to do things that end up being a huge rip-off.

And why would the Fed place restrictions on financial activity at all? We already have laws against fraud. What else is needed?

We have to recognize that the Fed has an impossible task: to prevent a house of cards from collapsing. The fractional reserve system is fundamentally insolvent. This is what creates a danger to financial stability in the first place. The reason that somebody not paying their mortgage may mean I lose my job is because banks are running the biggest fraud in history, an epic pyramid scheme that makes Bernie Madoff seem insignificant. And the job of the Fed is to oversee this fraud, to make sure that we keep it up, to continue to shovel an ever-increasing share of society's surplus value into the coffers of the banks. This is why it strikes me as rather disingenuous for Ben Bernanke to worry that complex mortgage products may not ultimately help the consumer. Talk about dodging the real issue.

Ron Paul Grills Bernanke

Here's a good video of Ron Paul giving Fed chair Ben Bernanke the business.

Much has been said about how Ron Paul sounds crazy, conspiratorial, etc., but at least he's up there questioning the economic guru of the day.

Ben Bernanke firmly believes that the reason the Great Depression happened was that the Fed did not act aggressively enough, and allowed monetary policy to tighten, worsening the Depression. In fact, the Fed was quite aggressive. Consider that the Fed flooded the banking system with liquidity, raising the money supply by 10% in a single week. However, this was counteracted by the contraction in bank lending, because banks were in the process of deleveraging.

If that doesn't sound familiar, it ought to.

The very same thing happened in the Fall of 2008. The money supply actually tightened, despite the Fed creating massive amounts of money and injecting it into the system. This is because the money supply is not controlled directly by the Fed, but rather it's a product of the fractional reserve system. If banks lend less, the money supply falls, perhaps as much as $10 for every $1 fall in lending. That's the magic of the fractional reserve system. Banks create and destroy money, and the process is not under the direct control of the Fed.

The Case for Seabridge Gold

(click on the image to enlarge)

Those of you who know me know that I've been recommending Seabridge Gold (SA) for some time now. (Just so you know, I hold a substantial amount of this stock) The company is designed to provide a leveraged investment which is tied to the price of gold. Their purpose is to turn cash to gold, rather than the opposite, which is what most miners do.

Let me now present a brief analysis of the value of Seabridge stock. (As of now, it is selling for $29.30 a share, so if you bought it yesterday when I suggested it, you've already made money.) Seabridge owns properties which contain gold and copper. When these holdings are considered at current prices, we find they are worth a rather large sum: about $63 bil. Of course, the problem with resources in the ground is that they have to be extracted and refined, a costly process. But even with very stringent extraction costs of $800 an ounce for gold and $1.80 a pound for copper, we find that the company's resources are worth about $9 bil. If we divide that by the total amount of shares outstanding (about 38 million, including stock options) we get a price per share of $234, a rather far cry from the price of the stock now. Even if we take only the reserves that have been measured, rather than inferred, we get $136.

This company is undervalued by the market, and hence it represents a great opportunity.

10 Grand: Sell DDM, Buy SA

The time has come to sell DDM (for now). I recommend Seabridge Gold (SA). Seabridge is a "resource hoarding" company, and their resource of interest is gold. They do no mining, but rather they buy the best gold mining land they can.

If you sold your 370 shares of DDM now, (for $29.45) you'd have $10,912.42 (assuming your trades cost $9.99; that is what I pay over at Ameritrade.) If you buy SA at $28, you can afford 389 shares (assuming you don't use margin, a wise move in these difficult times). You are now up 9.1%.

Only invest what you can stand to lose.

It Pays to Be Bipolar

This fellow Andrew Behrman, author of Electroboy, was paid $400,000 by Bristol Meyers Squibb to promote the bipolar drug Abilify. Not bad. I love the name "Abilify"; it's the perfect name for a drug: nonsensical, but with the right connotations. While drugs for bipolar conditions are no doubt helpful in some cases, it seems like the overwhelming majority of the time these drugs are used to mask symptoms that are important psychological and emotional signals.

The corruption of this system of paid shills who promote drugs via their own experience with it is unbelievable.

Microsoft Issues Bonds, Contemplates Drinking Own Urine

Microsoft has completed a new bond issue, its first ever, for $3.75 billion. The company says they have no real plans for the money, though the move has sparked speculation about possible acquisitions. They say they're just taking advantage of favorable market conditions.

Apparently some analysts think that the most likely use of the money would be a stock buyback, where the company buys its own stock, attempting to push prices up. Microsoft stock has been hit by the falling market, along with everything else. The stock was at $30 early in 2008, and it fell below $15 by March 2009.

The stock buyback is a corporate strategy that is emblematic of the first decade of the 21st century. Stock buybacks exploded during that time, as they did during the end of the 1990s. Of course, most buybacks are done with borrowed money. The tactic is considered an acceptable way of paying out profits to shareholders.

A company buying its own stock with borrowed money is doing something as sensible as drinking your own urine. At best, it keeps you alive in the desert. But it sure won't make you thrive. Borrowing money imposes an economic logic: you must pay back more than you borrowed. So if you're borrowing to invest, you'd better make sure that what you invest in has a higher return than the interest rate, plus some for inflation, and a normal rate of profit. How does a share buyback accomplish any growth whatsoever? If all goes well, and the stock price remains high, (far from certain in this volatile market) how exactly does that insure the future growth of Microsoft?

The real motivation for the skyrocketing use of buybacks is so that management can give themselves fat bonuses covertly, in the name of shareholder value. Now that the credit teat has been taken away, my guess is that we'll see far fewer share buybacks by corporations. It was a strategy of the bubble years, one that is doomed to extinction.

SNL on the Banking Crisis

This clip speaks volumes about how the Treasury Dept deals with banks.

Oil and Stocks

After skyrocketing to a high of $147, then crashing to $30, crude oil has rebounded to nearly $60 a barrel. (Some good analysis of the oil market can be found at wtrg.com)

Will this cause the economic "green shoots" to wither?

Nah. Unfortunately, there are no green shoots. And the oil rebound is a technical matter, caused by the rising stock market. This market rally is causing "mini-rallies" in other assets; this is because at the end of the great market boom of 1980 to 2007, every asset in the world had become severely overvalued, from stocks, to real estate, to commodities, to art; you name it, it was overvalued. An ocean of fiat money was pushing up prices in everything that could possibly be an investment good. The bear market in stocks has also been a bear market in all of these alternate investment assets, including the king of bear market commodities: gold. (Let me hasten to say that the fall in gold prices is a temporary phenomenon, a secular bear market within a bull market that began in 2002.)

Oil presents us with a paradox. Are prices rising because demand is stronger than we thought? That would be a good thing. Or will the rising demand quash consumer spending? I'd say neither. Look for oil prices to continue upward as the stock market rally continues, but I expect oil to correct down sharply as the rally ends. Of course, the long term trend of oil is up, both because of inflation and because of the geological reality of peak oil.

The Dollar

The financial system has weathered its greatest challenge in decades. The bear market has been as intense a decline as any since the Great Depression. (Yeah, I know, that comparison is getting to be a cliche.) But what hasn't happened is a fall in the value of the dollar. In fact, just the reverse has occurred. After years of swooning, the dollar had a sharp rise as the financial crisis hit.

The reason for the strength of the dollar was the process of deleveraging created an intense and immediate surge in demand for dollars. I think the deleveraging process has passed its first phase. The Fed has created trillions of dollars of new money, much of which has been absorbed into the financial system, into an immense hole of losses. But it has prevented insolvent firms from failing, and of course, each new dollar dilutes the value of the rest.

I think the end of the stock market rally may be caused by a fall in the value of the dollar. As the rally continues, stocks will climb "the wall of worry" until they fall, which I see happening around the 10,000 mark. We'll have to watch closely as the rally continues. Bear market rallies seem to go on much longer than you would think.

When Bad News Looks Good

As predicted, unemployment has indeed increased. The latest number from the Bureau of Labor Statistics is 8.9%, bringing the total number of people unemployed to 13.7 million.

The ranks of the marginally attached (those who want work and have looked in the recent past, but have given up and haven't been looking in the last 4 weeks) has been sharply increasing during the recession, and now stands at 2.1 million.

This is pretty bad news, but Wall Street seems to be giving it a positive spin; as the Wall Street Journal reports, job losses are "decelerating". Unfortunately, the slowing growth of job losses doesn't really count as good news, as much of the reason for the

lessening slack is new hiring by the government. Given the fiscal realities that the various levels of government are facing, it seems unlikely that government can pick up the slack for long.

The second piece of bad news is that the stress tests results are in: the Federal Reserve reckons that bank losses may be as high as $599 billion. It almost sounds like a sale, doesn't it? Act now, bank losses only $599, that's right, $599 billion!

The WSJ also has a poll, asking readers: Do the stress tests results paint an accurate picture of the financial services industry? When I checked the results, 88% had said no.

The table is from the Fed's report; it gives some of the assumptions that led to their results about the extent of bank losses.

The interesting thing about these numbers is how big they are. Under the baseline view, loss rates in subprime mortgages of 15-20%! That's the optimistic scenario! And 12-17% for credit cards - unreal. So given these huge loss rates, why didn't banks see it coming? Why did they make these loans? And why should they now rush in to lend more, with these kind of loss rates?

San Francisco Real Estate

San Francisco is the real estate market that couldn't fall. It has now fallen 45% from its peak in 2006. Here's a graphic that compares the three California cities in the Case Shiller Index to the housing market in SF if it had followed the increases in the Consumer Price Index. The reasoning here is that housing prices should roughly follow the growth in other prices, given no new technological changes in the cost of producing houses, as well as no unusual changes in demand.

Of course, weakened lending standards did lead to an unusual surge in demand, because millions of people who would not have qualified for mortgages under the old standards suddenly did, and they bought houses, bidding up prices.

The graph shows that despite spectacular carnage in the SF real estate market, prices still have not converged to the CPI. To consider another measure, prices have not reached the level of historical affordability either.

The median income in SF was $68,023 in 2007, while the median home (or condo) price was a staggering $830,700. The median home price to median income ratio was therefore 12.8, as compared to a historical ratio of about 4.5 to 5, (according to the Metro Affordability Study) which is already much greater than the national historical ratio of between 2.5 to 3. (This ratio gives rise to the old banker's rule that you never give someone a mortgage that is more than about 3 times their income.)

(Check out the Calculated Risk blog for some good analysis.)

Imagine what SF real estate would look like if median home prices here fell to their historical relationship. That would mean that the median home price would be $280k to $350k. That would be good news for people who don't want to leverage themselves into mortgage oblivion, creating an odd state of poverty by overconsuming housing.

The 2008 Cost of Living index for SF was 180.3, compared to a nationwide average of 100. This means it's about 80% more expensive to live in SF as compared to a place that tracked the national average (like Mongomery, AL, which has an index value of 97.3).

It seems logical to me that in the boom years, cities do extremely well. Wages and incomes rise, along with real estate and asset prices. But in the bust years, the situation changes. I have an anecdotal sense that SF is losing young people. I hear about them moving to places like Portland, or less dramatically, moving across the bridge to Oakland.

Will SF go through an abrupt reversal, seeing declines in the cost of living that are far sharper than declines elsewhere? We'll see.

Stocks Continue to Rise

The Dow had a good day today, rising 101 points to break the 8500 mark.

If you bought 370 shares of DDM at $26.93 when I recommended it, you'd now have $10,807, an 8.3% return after trading fees (assuming $9.99 per trade).

It feels like the conventional wisdom is that the market has bottomed, and a new bull market has begun. A substantial minority opinion holds that the Dow is in a bear market (or "sucker's") rally. But the big money seems bullish, judging by a recent Barron's survey finding that 59% of money managers are either "bullish" or "very bullish". Since big money drives the market, it is wise to heed what the big money managers are thinking and feeling. As the rally continues, their doubts will fade, and bullish sentiment will increasingly dominate.

The strategy I'm proposing is a risky one, requiring some vigilance to carry out. I believe that the primary trend of the market is bearish, so this strategy looks to the secondary trend, which is even less predictable than the primary trend. Use caution, only invest as much as you're willing to lose.

At some point, when the market rally is nearing its end, we'll want to switch to DXD, which moves inversely to the Dow.

Workers Own the Means of Production

The government's proposal that the United Auto Workers take their pension-fund payment in Chrysler stock gives the labor union a 55% stake in the company, making the union the effective owner of the company.

It's interesting that the UAW only gets 1 seat out of 9 on the Board of Directors. That immediately weakens their authority.

From a Marxian economic perspective, this is a case of workers owning the means of production. As some cutting-edge Marxian theorists have argued, ownership of the company may not be the same thing as appropriation of the surplus value created by the workers. In the modern joint stock company, there is a separation between the owners (the shareholders) and the appropriators, a responsibility which is given to the Board of Directors. While shareholders interests are supposedly represented by the board, it is unusual for shareholders to get involved in the appropriation process. If they do, they are labeled activist investors, like Carl Icahn.

An insight from Marxian theory is that there is always conflict over the distribution of the surplus, no matter what class structure exists. For example, there is conflict over the surplus within a corporation between the management and the shareholders. How much of the corporation's profits go to dividends or share buybacks vs new investment in the firm?

For the UAW, being an owner could create a new kind of thinking. Instead of being focused on higher wages, better retirement packages, better benefits, etc., they could begin to focus on the labor process and think in larger terms about what would be in the interests of the workers. That would be an interesting shift.

GDP Plunges, Unemployment Remains High

The Bureau of Economic Analysis reports that GDP contracted at an annual rate of 6.1% last quarter (the first quarter of 2009), following on a 6.3% rate of decline the quarter before.

Meanwhile, unemployment seems to be headed for further increases. The latest number from the Bureau of Labor Statistics is 8.5% for the headline unemployment statistic, which the BLS calls U-3. If workers who are "marginally attached" and underemployed (that is, they have given up searching for work, or they would like full time work but are working part time) are counted you get an unemployment rate of 15.6%. Incredible.

What ought to be done?

Given the circumstances unique to this recession, we ought to cut government spending, remove subsidies, cut taxes, refuse to prop up failed and insolvent corporations and banks, and simply allow the market to reach equilibrium.

Creating a system of sound honest money that is tied to a commodity (I favor gold) would stabilize the international monetary order, though it would cause some immediate pain in the short term. Abolishing fractional reserve banking would immediately solve the banking crisis, allowing banks to begin lending.