Financial topics

[mannfm11]

The banking system is an accounting system and little else. The Fed doens't print money, it exchanges notes like any other bank. The banking system ledgers are made up on the debit side of loans and on the credit side of deposits of varying types, long term debt, paid in capital and retained earnings. You could also say that the cash a bank has on hand is also a debit entry, but it might have a corresponding credit entry or more likely it was the result of a credit entry against another asset, most likely a treasury bill or other high quality asset bought by the Fed in return for the cash. The Fed has a corresponding asset for every dime of cash it put out, thus the private sector has to give up its interest bearing assets for non-interest bearing cash. Finally we have parity as the rate on t-bills don't earn enough interest to pay for printing and accounting for them.

When a bank deleverages, it destroys the money supply. I take that back to a point, but in a general sense, this is true. You might read Irving Fishers theory on this linkhttp://londonbanker.blogspot.com/2008/0 ... great.html. It is clear that Bernanke is attempting Fishers solution, but in short, Fisher decides that in deleveraging, the system makes every dollar more dear and the debt more absolute as it is done. The banks net worth today is likely tied up in assets that are of dubious value at best while its liabilities, the deposits are absolute. Thus if all the people that could pay did so, what would be left would either be no money supply or better yet, deposit liabilities supported by bad debts. What the Fed is probably doing with Citi is allowing them to divest themselves of this crappy paper they have in order that they retire their $400 billion in fed funds liabilities. I believe this is the majority of the money that the banking system wouldn't lend to each other, as Citi basically owed the other banks around the world $400 billion it needed to borrow back. The Fed will probably buy this stuff with a 10% haircut and a government guarantee and allow Citi to get out of this liquidty bind they are in.

Here is the paradox. IF the government gives the banks cash for their stuff, what they have is cash to back the deposits they still owe. This does absolutely nothing to the net worth or solvency of a bank and most likely at this time they are going to either wish to hold what the Fed wants to buy or better yet, if they really need to get rid of it, I doubt they are going to get back into the mess they just got out of.

[freddyv]

IN with the Freddy and Gordo debate:

Unless you just like to trade there really is no debate if you believe the market is going down significantly farther. Anyone who thinks this is not in a secular bear market is entitled to their opinion but it seems that even the most optimistic of people know that we are in a bear market that won't just turn around overnight.

If you think this is is secular bear market then the easiest and safest way to play it is to stay out and wait for better days. Conserving capitol is sometimes the best strategy.

If you want to try to profit or are willing to expose a certain amount to loss, as I am, then it makes all the sense in the world just to buy one of the short ETFs such as SDS and hold until you see some data from people who know what the are talking about, ECRI is easily the best provider of solid economic indicaters, IMO. http://www.businesscycle.com/news/press/1251/.

The SDS has outperformed Gordo by a good deal and that's if you just bought and held, if you jumped out when they reached ridiculous levels and then back in you could be up by about 100% right now from the top of the market in late summer of 2007. I suppose many missed the top but it seemed pretty clear to me at the time and I know plenty of other people who could see the problems on the horizon so it's not like I'm all that brillant. The bottom may be a little harder to spot so rolling your profits from your short position to a long position over time should be a good strategy.

This is a simple strategy that does not expose one to timing errors. Even a monkey would have made money with this strategy in any good market downturn and even a little profit looks pretty good when you consider that most people have lost close to 50% of their portfolio so far. Just keep an eye on the ECRI data and listen to the few people out there who know what they're talking about (if you think Jim Cramer is one of them, please stay in cash), and don't forget, "bulls make money, bears make money, pigs get slaughtered".

--Fred

[freddyv]

...It wasn't Paulson that created this mess, it was Rubin and the Clinton administration. i was looking at a graph of the trade deficit this morning and you could see where the money machine opened up wide in 1995, the year Rubin took over. The guy got Glass-Stegal overturned...

Yes, that was another big gaping hole that was opened up. There is plenty of blame to go around and we should probably start by looking in the mirror. But right now Paulson is the guy handing out money and not even letting us know who it's going to. My point is really this: at what point does the public start to demand blood and who is going to provide that blood?

--Fred

[australia]

Hi John,

I have been following your weblog and read a few from the past. Very true and accurate wish I have read it before the Australian Dollar drop like a rock.
Just wondering what do you think the trend would be for the Australian or currency floated against the US since they have drop it to zero.

Australia

[StilesBC]

mannfm11,

What do you think about this: http://www.youtube.com/watch?v=_LDBOPcHpeo

about 2:40 in is the meat.

[freddyv]

I think its hilarious when I hear arguments that the market can't possibly go up with P/E ratios where they are. "The market" doesn't care what the P/E ratio is. Depressions have massive counter-trend rallies. P/E is a dangerous (worthless?) thing to trade on. As earnings disappear, P/E goes higher, but that ALONE is not a reason to be bearish. Its much more meaningful to use P/PE (peak earnings instead of current earnings) which is what Dr. Hussman uses. At our market Low last month, we hit a P/PE of 9. It hasn't been in single digits for a VERY LONG TIME. By the way, that P/PE 9 matches where Japan is after their horrific 20 year bear market with >80% decline. That P/PE is also below average, indicating an "undervalued" market. But please don't get me wrong, in fact John & I definitely have one thing in common - we both know things are HIGHLY likely to overshoot to the downside. That P/PE could easily go to 5 or 6, and our markets could ultimately get cut in half from current levels (possibly worse than that).

Actually a peak earnings valuation is mainly useful for telling you when the market has dropped too much within a secular bull market. Within a secular bear market using peak earning indicators are a disaster.

Take a look at this page:
http://www.hussmanfunds.com/wmc/wmc061106.htm

...and notice that there is no data from the 1930's. Considering that that is the last time we dealt with a economy similar to ours you should consider what would have happened if you applied "peak earnings" valuations during the drop from 1929 to 1932.

Of course if you don't think we are in a secular bear market then peak earnings will serve you well.

Any type of P/E valuation from 1929 on would have led you to ruin right up to the moment when earnings actually vanished. That is, if you had used it on its own. Using any valuation on its own is a fools errand.

Dismissing standard, time accepted data such as P/E ratios in a big red light for me and suggests that you are looking for data to match your beliefs. No single source of data is enough but using standard valuations such as P/E and book value, data from the ECRI and studying history should be the foundation for every investor. But notice I said "investor", speculators and traders are not investors.

--Fred

[Gordo]

The SDS has outperformed Gordo by a good deal and that's if you just bought and held...

What are you, my accountant?? Hahah. What is my ROI? What timeframe are you talking about?
SDS is down 40% from its high, and if the market just rallies another 20%, which is certainly possible, SDS will go down another 40% from these levels. Not saying that is definitely going to happen, but I don't like the odds on the trade right now. While I HAVE been both long and short this year, I've made far more on the long side - its always easier to make money on the long side. I've had multiple 100% gain trades this year. But I never put all my eggs in one basket, so my total return is not extreme.

As for comparing today to 1929-32. I agree with the comments that its very hard to compare these periods. Sure there are some similarities, there are also a lot of differences. There was no FDIC back then, and we were "stuck" on a gold standard (AFTER the market bottomed FDR devalued but even then we remained on a gold standard - totally different environment than today), they also had a dust bowl to contend with.

The thing I'm most fascinated by is the inflation/deflation dynamic. There are many hard core deflationist that say it is IMPOSSIBLE for the Fed+government to spur inflation. I guess we are going to find out. I'm not firmly in either camp to tell you the truth. I personally stand to benefit GREATLY from deflation, so its in my own best interest if that’s the direction we are going to go for a while (years). But for whatever reason it just seems very implausible to me – I can’t see the massive bubble in treasuries doing anything but popping, and I can’t see massive government spending (not to mention the mystery $2 trillion that just magically appeared on the Fed’s balance sheet) as anything but inflationary. Of course this is against the backdrop of overwhelmingly deflationary forces that otherwise exist in the economy right now.

It wasn't long ago that John was whining about Malthusian population nonsense, and now farmers can't pay for the equipment they just bought because food prices have been cut in half. People may go hungry, but its certainly not because we can't grow enough food! Will these new low commodity prices spur demand? I think that has already begun, but it’s a slow process. Who would have thought that a 2.7% decline in demand for oil would cause prices to fall 75%? Well it doesn't, most of that price was based on pure speculation (this is another thing I had a beef with John about, he didn't think any of those ridiculous peak bubble prices were related to speculation, he thought or at least implied that the world was suddenly running out of resources, haha).

[Gordo]

Actually a peak earnings valuation is mainly useful for telling you when the market has dropped too much within a secular bull market. Within a secular bear market using peak earning indicators are a disaster.

NO VALUATION model alone is useful for short term trading! That's the first thing we should agree on. I don't use any valuation based indicators to make trading decisions (unless in combination with other factors).

Take a look at this page:
http://www.hussmanfunds.com/wmc/wmc061106.htm

I've read every article Hussman has ever published on his website, and I've had retirement accounts invested in his fund for about 8 years. I know a thing or two about his investing philosophy.

...and notice that there is no data from the 1930's. Considering that that is the last time we dealt with a economy similar to ours you should consider what would have happened if you applied "peak earnings" valuations during the drop from 1929 to 1932.

You linked to an article from 2006. I could have sworn he recently published an updated chart going back from the 1800's to present but I can't seem to find it right now. However, the data was published 10 years ago in this Baron's article, here's the chart:

Price/Peak Earnings

Hussman has also commented on this data from the '29-'32 period in this recent article:
http://hussmanfunds.com/wmc/wmc081110.htm

It is important to note that even in the Great Depression, it took until 1931 for the price/peak-earnings multiple on the S&P 500 to drop below 11. [Gordo Note: We just hit 9 in our market last month!] That did not occur after the 1929 plunge. Moreover, the peak earnings level in 1929 reflected a spike that (aside from a brief period in 1917) was unusually high in the context of normal earnings. I can't possibly overemphasize how important it is to gauge valuations on normalized earnings, not spike peaks or spike troughs. On normalized earnings, stocks were still overvalued at the 1929 trough. It took until 1931 for stocks to look cheap even on the basis of peak earnings from 1929. To see what was going on, here is a picture of S&P 500 earnings (Cowles Commission data prior to 1921) from 1895 through 1950.

Note that the earnings plunge that accompanied the Great Depression was transient, so in the context of long-term discounted cash flows, it had little effect on the long term value of stocks. The same is likely to be true today. The strongest determinant of market fluctuations is change in the valuation multiples that investors apply to normalized earnings, not major shifts in the long-term earnings power of U.S. corporations .


So buying now, strictly on valuation, could be kind of like buying in 1931. Investors buying then got absolutely HAMMERED over the next year, but one year after that, they had net profits! I could see something similar happening again today.

[John]

Dear Gordo,

> It wasn't long ago that John was whining about Malthusian
> population nonsense, and now farmers can't pay for the equipment
> they just bought because food prices have been cut in half. People
> may go hungry, but its certainly not because we can't grow enough
> food! Will these new low commodity prices spur demand? I think
> that has already begun, but it’s a slow process. Who would have
> thought that a 2.7% decline in demand for oil would cause prices
> to fall 75%? Well it doesn't, most of that price was based on pure
> speculation (this is another thing I had a beef with John about,
> he didn't think any of those ridiculous peak bubble prices were
> related to speculation, he thought or at least implied that the
> world was suddenly running out of resources, haha).

You make one error after another, and whenever I correct one of your
errors, you apparently think it's "whining." I guess Gen-Xers must
think it's "whining" whenever any Boomer corrects their errors. Well,
I'm about to "whine" again.

Here's the exchange we had in July:

> Food prices are dropping. Commodities are well off their highs.
> Even August gasoline was down over 20 cents a gallon this week -
> you will see this at the pump soon. We also saw record plantings
> - and record sales in farming equipment.

> You know that I know how hard rising prices have been for those on
> the margins. My only point is that we did not reach some kind of
> Malthusian breaking point, population has not declined and yet
> food prices are now falling and I believe they will continue to
> fall. It amazes me that the old "they aren't making more land"
> line is still used to justify bubbles - the same thing was used to
> justify the housing bubble all over the world. Funny thing is the
> same reasoning was also used to justify housing bubbles in areas
> like Florida even way back in the 1920's. The commodities bubble
> is popping just like all other bubbles have popped.

> YOU:"Yes, of course, but that's not going to happen."

> John - food prices have come down and the food riots ended.

> And you know very well when I talked about food prices coming
> down, I didn't mean a short term correction. When food prices get
> down to their 2000 levels, or even their 2005 levels, then we can
> talk.

> I base my analysis on years and decades of price trends, and you
> base your analysis on a few weeks of price trends. I think I like
> my approach better.

> You and I both agree that there's a bubble. You and I both agree
> that the bubble will pop, and prices will come down. In fact, I
> expect prices to come down very sharply, falling below the
> historic trend line, by the Law of Mean Reversion.

> What we disagree about is the consequence of the prices falling.
> You expect the prices to fall in an orderly manner. I expect the
> prices to fall in conjunction with a major financial and war
> crisis.

I said that food prices will fall very sharply, in conjunction with a
major financial and war crisis.

I guess you don't yet realize it yet, but we're in the middle of a
major financial crisis.

The world's trade and transportation is grinding to a halt:

** World wide transportation and trade sink farther into deep freeze
** http://www.generationaldynamics.com/cgi ... 15#e081215

China's economy, and other Asian economies, are collapsing rapidly:

** Rapid Chinese economic collapse spurs desperation measures
** http://www.generationaldynamics.com/cgi ... 28#e081128

There's no major war crisis yet, but my expectation is that the world
is close to one.

In other words, what I wrote to you is exactly what's happening.

As for the fall in the price of oil, what's really hilarious is
that you've got it completely backwards.

When oil was at $140/barrel, there was no hoarding of oil, and oil
futures prices were similar to spot oil prices, so speculators could
not have caused the rise in oil prices. What it was, of course, was
huge demand from China, which is now crashing, along with oil prices.

But the hilarious part is that hoarding is going on today:

> Oil Tankers Camped Out in Hope of OPEC Slashing Production

> Wednesday, December 17, 2008

> According to Bermuda-based shipping company Frontline, owner of
> one of the world’s largest fleets of oil tankers, between 20 and
> 25 oil supertankers have been chartered for floating storage over
> the last few weeks – equivalent to something in the region of 50
> million barrels of oil.

> The host of very large crude carriers (VLCCs) are camped out at
> various locations across the globe including: the U.S. Gulf of
> Mexico, the North Sea, in India and also in Malaysia. Royal Dutch
> Shell, BP and Koch Industries are among the companies thought to
> be stock-piling reserves in hope of a Christmas bonus, if OPEC
> price cuts send prices rising once again.

> More sensational – yet unconfirmed – reports have estimated that
> there are in the region of 300 vessels floating, like sitting
> ducks, outside of the port of Fujairah in the United Arab Emirates
> alone.

> In addition several state oil companies, from countries such as
> Iran, are thought to be behind the surplus storage activity. The
> speculation has stemmed from three of Iran’s supertankers: Noah,
> Dena, and Manah, having all been at, or near, the country’s Kharg
> Island loading facility since before the beginning of December –
> according to AISLive ship-tracking data.

> The Organisation of Petroleum Exporting Countries (OPEC) is
> meeting in Oran, Algeria, on Wednesday to discuss the its latest
> round of production quota cuts in an attempt to arrest declining
> prices, which have fallen almost interrupted since mid July.

> Olivier Jakob, Managing Director of Petromatrix GmbH, in
> Switzerland, said: “For OPEC there’s too much oil in storage and
> to have it floating is also more problematic.

> “OPEC cutting production is not good for shipowners because you
> will have less vessels being used,” added Mr. Jakob.

> As a result the International Energy Agency (IEA) stated in its
> widely-read monthly oil market report: “The increase in floating
> storage has developed as a result of abundant prompt supplies
> having a hard time finding customers, further supported by lower
> freight rates.”

> The IEA estimated that the hoarders are currently baring the cost
> of around $0.90 a barrel per month with an additional $0.30 a
> barrel to cover capital costs, insurance, and such.

> The increased activity in tanker markets, according to Jens
> Martin Jensen (acting Managing Director and Chief Executive
> Officer of Frontline), can be directly attributed to the oil
> market's contango structure –where near-term futures contracts are
> cheaper than contracts further into the future. Such an upward
> sloping forward curve provides producers with the incentive to sit
> upon crude supplies so to secure higher anticipated returns in the
> future.

> http://www.oilvoice.com/n/Oil_Tankers_C ... b80f6.aspx

In other words, speculators are operating TODAY, trying to boost the
price of oil -- and FAILING.

So you had it completely backwards.

Sorry to "whine," but there seems to be no other way to correct all
your errors.

Sincerely,

John

[Gordo]

When oil was at $140/barrel, there was no hoarding of oil, and oil
futures prices were similar to spot oil prices, so speculators could
not have caused the rise in oil prices. What it was, of course, was
huge demand from China, which is now crashing, along with oil prices

[Rolling eyes] We already had this debate, so why repeat? I still don't know why you believe hording is a requirement for rising commodity prices from speculation. It isn't. I already explained this to you. Need another example? Lets say we live on an island and there is only one farm, no one else can plant food (no one has seeds lets say). I go to the farmer and buy 100% of his future crop (a futures contract). You start to get hungry. You go to the farmer for some food. He tells you he already sold all the food. Uh oh, you think, food shortage!! No, you are wrong of course. You just have to buy the food from Mr. Speculator now. And guess what. Mr. Speculator knows you're hungry. He also knows he can charge almost any price, and you will pay, because you can't get food anywhere else. Mr. Speculator never horded anything. In fact, he never even took delivery. Bada bing, bada boom - massively rising food prices!

This is CLOSE to what actually happened with nearly ALL commodities over the last 3 years until the game ended (although speculators are not and never will be the majority traders of futures contracts, they don't have to be to influence prices). The game ended when there was a slight decline in demand (as I noted, oil demand is only down 2.7% and yet we got a 75% drop in prices). There was also an increase in supply from producers looking to make a buck, enticed by bubble prices.

Many hedge funds were speculating on commodities, and now we are hearing more and more stories about them blowing up. You had people like Jim Rogers trotting all over the globe telling investors everywhere that they MUST BUY COMMODITIES. He also was (and is) running his own commodities fund, and still pumping the investment everywhere. You had the founder of paypal also launch his own hedge fund, betting on peak oil. He made a ton of money at first, and this got him a lot of press, probably sucked a lot of new money in too. Wonder how that worked out?

p.s. I don't know why you made a comment implying that I was expecting some kind of gradual decline in commodities, I never said that. Most bubbles pop very suddenly and violently.