Gold Prices Continue to Climb

So far in 2009, the S&P 500 is up 21%, while gold is up nearly 25%. Gold and stocks have been moving in tandem for much of the year, an unusual situation, to say the least.

The rising stock market has been one of the few bright spots of the economy. While it’s difficult to say what causes short-term movements in stock prices, the year’s increases in the stock market is probably not connected to the performance of the economy, actual or perceived.

I say this because the rally has not been driven by outside events. At the low of the market, in March 9, 2009, the sentiment was bleak. Analysts who had previously been known as solid bulls began to say, “the sky is falling!” News since then has been solidly bad, with continuing job losses, rising unemployment, trade deficits, budget deficits, and a rising disillusionment with the Obama Administration. Now sentiment has reversed; everywhere the talk is of green shoots and growth; all experts agree: the recession is over. They point to the performance of the stock market and the recent rise in GDP (mostly driven by debt-funded government consumption).

It seems more likely that the rally is a correction of the long slide in stock prices that took the Dow down 7500 points over a period of about 17 months. The nature of markets is action and reaction, movement followed by countervailing movement. The stock rally of 2009 is simply a long counter-movement, where the market recoups a portion of its losses. The general rule to look for is a counter-movement of 50%, though it may be as large as 75%. The former has basically been achieved. That means extreme caution is warranted about future market moves. Indeed, it seems to me that the sentiment has become so uniformly bullish that the only possibility is a sharp downward movement, even an eventual violation of the lows of March 2009. This possibility is not driven by sentiment alone, but by the fundamentals of a weak economy coupled with the multiple threats to the dollar’s reserve currency status.

Right now it seems unthinkable to nearly all observers that the dollar could be displaced. That alone should give us pause. The last two years have been a time when most observers have been disastrously wrong. Most did not foresee the crash of October 2008. Most did not foresee the rapid downturn of February 2009, nor the rally that began in March. Early in 2009, when oil prices dove to below $40, most analysts predicted they would stay there; instead, they doubled within the year, in the face of worsening economic deterioration.

Yet India’s purchase of 200 tonnes of gold from the IMF at near-record prices shows that nations are increasingly distrustful of the dollar. Individual investors should take note.

US GDP Swings to Growth

For the first time during this recession, US GDP is registering solid growth of 3.5% for Q3 of 2009.

Declining businesses inventories played a large role, but much of the growth was caused by increases in consumption spending: 40% of the increase in consumption was cars, driven by the cash-for-clunkers program, and another big slice was new home construction, driven by the $8,000 first time home buyer credit.

Those of us who were skeptical about these Federal programs to prop up consumption, may now be shown the rising GDP numbers as proof that these kind of government actions work. Well, yes, they work. But at what cost, and for how long? When the government borrows in order to give money to home buyers and car buyers, not only is that a dubious redistribution of resources, it causes a distortion in prices and in perceived demand. It causes sales from the future to happen in the present, inflating both automakers’ view of demand for cars and homebuilders’ view of demand for new homes.

It’s painfully obvious that the government cannot keep borrowing in order to funnel money toward consumption. When it ceases to do so, growth will fall, perhaps to negative territory.

Federal spending was up sharply, though state and local spending fell, due to declining revenues. States have a budget constraint that the Federal government doesn’t have.

Though the weakness in the dollar pushed up exports by 14.7%, imports increased by 16.4%, underscoring Americans’ addiction to low-priced foreign goods. The tendency to buy imports is true for cars as well as clothing and electronics: an often-overlooked feature of cash-for-clunkers was the fact that people often bought Hondas and Toyotas, which helps to stimulate Japan’s economy more than the US (with the exception of those Hondas and Toyotas produced in the US).

The Obama Administration claims the $160 billion that has been spent (of the $787 billion stimulus bill) has created or saved 640,329 jobs. Do the math: that’s $249,000 per job. That seems a bit expensive to me. For that price, we could’ve given 3.2 million Americans $50,000. Of course, the number of jobs ‘created or saved’ is already a bit dubious. Could it be that the government agencies who received stimulus funds had an incentive to say more jobs were ‘saved’ then actually was the case, to secure future stimulus funding? The Bureau of Labor Statistics doesn’t have a category for jobs saved, but it does have a category for net job creation, which has been massively negative for nearly 2 years, adding up to a total number of jobs lost of over 7.2 million. Given that the Bush administration also did a stimulus of $170 bil in Feb 2008, if $330 bil gives us only 640,329 jobs, how much would have to be spent to give us 7.2 million jobs? The answer is a staggering $3.6 trillion.

The reality is that the massive stimulus efforts have produced only small numbers of jobs, which have been swamped by the restructuring occurring throughout the economy. But such restructuring is necessary and unavoidable, and should be allowed to happen quickly rather than being dragged out through massive government consumption schemes.

Greed vs Fear

Treasuries and gold are fear investments. Investors have bid up the price of 10-year Treasury bonds, driving down the yield to 3.178%. Fear. Gold has just hit a new high, $1038. More fear. Stocks are a greed investment, and stocks are looking tired, moving sideways after a 7 month rally. As the rally has continued, volume has seen a mild but steady decline.

If Wall Street is torn between greed and fear, what about Main Street? Unemployment continues to rise, hitting 9.8% as of last month. The economy seems to be continuing to shed jobs, albeit at a slower pace. Incomes are falling, as is the average workweek. More are working part-time when they’d like to have full time jobs. The housing market continues to decline, offering a benefit for some Americans: falling rents. Thousands of condos that cannot be sold, and thousands of homes that were bought by speculators who don’t want to sell at current prices but need cash to pay the mortgage hit the rental market, have pushed rents steadily downward. In addition, people are consolidating, doing with less.

People are even borrowing less. Total consumer credit has declined by 3.6% during this recession. Comparable declines haven’t been seen since 1991. Even with those declines, the consumer remains heavily mired in debt, so it seems reasonable to expect it will take consumers some time to lower their debt levels, as seems to be their preference. Many consumers are saying now that they wouldn’t return to their ‘spend now, pay later’ ways.

Corporations are facing the shock of billions of dollars of worthless assets clogging their balance sheets, or, even worse, these toxic assets are not on the balance sheet, because they are not being valued honestly. New accounting rules have allowed corporations more flexibility in their amortization of gains and losses, i.e., less transparency for investors, meaning more risk. Corporations have been hollowed out by two decades of mergers, acquisitions, restructurings, layoffs, and re-brandings. The CEO and upper management—facing little opposition from the Board of Directors, shareholders, workers, or other stakeholders—have looted the corporation. New models of leadership will be needed for corporations to move forward. I expect the wild executive compensation of the boom years will swiftly fade away.

Meanwhile the various levels of government struggle with massive revenue shortfalls and budget deficits. Most states are cutting spending and raising taxes. The former is good during a recession, the latter, disastrous. Many are following California’s example, turning toward debt to put off their budget problems. In the face of all this, the Federal government considers a health plan that will fine people who don’t have health insurance, and we debate over whether to call this a new tax or not.

In the battle between greed and fear, there is no contest. Indeed, I’ll believe in the recovery when I see some genuine signs that greed has returned.

Economic Stimulus and the Banking Sector

The incoming Obama administration has been steadily increasing the size of the proposed economic stimulus, which now stands at $850 billion. Thus far, much of the debate has centered around the question of how big a stimulus ought to be, and what should be the mix of tax cuts versus government spending. This week, discussion has centered on what kind of spending would be desirable, and while the proposal of ‘green tech’ and repairing infrastructure is appealing, the criticism has been raised that since 97% of construction workers are male, and most are white, infrastructure projects leave out many of the most vulnerable poor, among them women and minorities.
The size of the stimulus will no doubt continue to grow as economic conditions worsen, particularly in the job market, where job losses appear to be accelerating, with 524,000 jobs lost last month. As for the overall effect of the stimulus package, Macroeconomic Advisers estimates that the Obama stimulus will increase GDP growth by 3.2%, and reduce unemployment by 1.7% by creating 3.3 million jobs.
Given the sudden reluctance of consumers to spend, it seems likely that the $275 billion portion of the stimulus package that is tax cuts will effectively disappear into savings or toward paying off household debt. But if lenders receive payment, they can make new loans, right?
I wonder. So far lending has fallen by $133 billion since October 2008, which means the money supply is contracting just as the stimulus is put in place, perhaps by as much as $1.33 trillion, assuming a money multiplier of 10. The big question is if banks continue to reduce their lending. It seems likely that banks will have reduced demand for loans without the mergers and acquisitions boom, and with de-leveraging occurring on all sides. If lending falls by another $100 billion in 2009, it means another $1 trillion decrease in the money supply, which would easily swamp the stimulus. This is one of the great weaknesses of the fractional reserve system: it tends to destroy money at exactly the wrong moment.
Think of the classical quantity theory of money: MV = PQ. The money supply is falling, and it seems likely that the velocity of money is also falling, as consumers spend less and save more. (It’s hard to measure the velocity of money directly, and it is typically inferred by measurements of the other variables.) This leads to falling prices and economic output. The adjustment process shouldn’t take long, if left alone: a year or two at most to purge failed ideas and business models, to de-leverage and move toward saving.
But of course it is hardly being left alone. Instead an ocean of money is being created and borrowed, all to prevent the natural adjustment of the economy back to a sustainable course. This adjustment cannot be prevented, though it may be delayed, it may be drawn out. The casualty of all this will be the US dollar, which is in its last days of being the world’s reserve currency.