Futronomics: contrarian analysis of global macro trends, commodities, currencies, equities

Happy Holidays

2009-12-24T08:53:00.000-08:00

I'm taking a much needed few days off over the holidays. Thus, there will be no weekend commentary this week.

I'll be doing some in depth posting over the next few weeks, so stay tuned!

Let me wish my readers a happy and safe holiday season.

Best,

Matt

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Technical Update 49.09/European Woes

2009-12-20T11:50:00.000-08:00

Another week of gains for the US dollar was met with general indifference from equities around the world. Commodities also turned their cheeks to the currency market action, reminding us that correlations long-adhered to can break. Last week we were expecting a bit of a retrace in the dollar index and commodities which would allow for equities to put in new highs. That is still my working assumption. Yet with option expiry hangover, combined with 2 weeks of very low volume upcoming, I suppose anything is possible.

The weakness in the Euro is being blamed on sovereign concerns around the periphery of the EMU (European Monetary Union). Specifically, Greece, Ireland, Spain, Portugal, and Italy are the focus of most observers. But bear in mind that these issues are not somehow "unforeseen" as most imply with their surprise. Greece did not accumulate a 12.4% budget deficit overnight. Nor did Italy find itself with a total debt 1.14x its GDP. These have been very long-term problems. I, as well as many others, have been pounding the table with the untenability of this situation for a long time. And I ruminated back in the spring that the next round of this crisis would originate in Europe.

Social mood may have turned with the recent attention to these long-standing problems. And we know the kind of contagion that will result should this escalate. Let us not forget the issues facing Ukraine, Hungary, Romania and the Baltics. All major european financial institutions have exposure to these toxic emerging markets in addition to their hidden exposure to US subprime CDOs.

Below is a table from STRATFOR that details each Eurozone country and their debt burdens. Remember that the Maastricht Treaty forbids any country from surpassing a deficit of 3% of their GDP. Nearly every nation has completely ignored this. Germany's supposed new "conservative" coalition threw in the towel this week, suggesting they would escalate their deficit spending. If nothing else, this proves the uselessness of international regulations. When push comes to shove, any nation will look after their own asses first. It is this mentality that will, in my opinion, eventually lead to the breakup of the EU and the dissolution of the EMU. This process may have begun already. Or it may be dragged on for a decade or more longer. But the endgame is already written. A Euro will eventually be worth less than the "lowly" US dollar.

I recommend readers monitor CDS spreads closely as an indicator of the seriousness of these problems. Over a week ago, when stories started breaking about Greece's problems after a Fitch downgrade, their CDS premiums shot up to 232. Since then, Greek officials have said there is "no possibility" of EMU withdrawal or sovereign default. Yet, the assurances have not seemed to gain traction. Greek CDS now stand at 279. Intraday top movers in CDS premiums can be found at CMA Market Data.

Below is a chart of the Euro's performance. This makes 3 weeks straight of declines and essentially wipes out any of its gains from the previous 3 months. What's done can be undone in short order. Equity speculators should take note.

I am also including a number of charts from eastern European currencies relative to the Euro. Last winter, some of these currencies began blowing out. But assurances from the IMF managed to ease the fears - for a time. At issue are loans made in these countries (Latvia, Poland, Czech Republic, Hungary, Bulgaria, Romania, Ukraine, Russia) but denominated in other currencies (primarily the Euro, Swiss Franc and US Dollar). The availability of loans at very low interest rates; prospects of continuance in the decade long appreciation of local currencies; and eventual induction into the EMU were the primary forces driving asset bubbles in these countries. When the bubbles popped along with asset bubbles all over the world in 2008, their central banks began printing money to "stimulate" their economies. This had the effect of depreciating the local currencies and thus increasing the debt burdens of those who borrowed in foreign currencies. Default prospects increased, jeopardizing the solvency of their western lenders. This is where the IMF stepped in and gave some very vague guarantees with some very unknown preconditions. Most likely they instructed the eastern central banks to stop printing and told their finance ministries to instead introduce austerity measures. I wonder how long populist oppositions will stand for the rising unemployment that goes along with this? At what point will they simply say, "to hell with the western bank's losses, we default." Or, "to hell with the EU and the Euro, we're inflating our way out!" Either way, losses will eventually be realized on these malinvestments.

Hungarian Forint/Euro:

Polish Zloty/Euro:

Russian Ruble/Euro:

Ukrainian Hryvnia/Euro:

There are also potential issues in Bulgaria and Latvia, where currencies are pegged to the Euro. They were both scheduled to enter the EMU by 2012, but that now seems unlikely. If they decide to forego entrance, their pegs break and any loans made are essentially wiped out.

Ambrose Evans-Pritchard has another Euro-skeptic piece detailing the unsustainable nature of these austerity measures in southern Europe. Enduring deflation is the natural way out of things for the US, UK, Canada and essentially any country whose debts are largely domestically originated. But when this path is dictated by foreigners who got you into the problem in the first place, I can see how the political impossibility would lead to its failure.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Response to Robert Murphy

2009-12-14T09:17:00.000-08:00

Robert Murphy of the Mises Institute had a good article out this morning titled, "A Case For The Inflation Camp." He talks about why he expects consumer prices to continue to rise. I recommend my readers have a glance over this.

As my readers know, I have a different take on matters. Below is the brief response I left in the comments section of Murphy's post. Feel free to weigh in with your own take.

The primary arguments in favour of deflation look less at consumer prices and more at asset prices, bank lending, debt/income or debt servicing ratios, demographics and social revulsion of excesses.

Many things can contribute to consumer price changes. This year we had a very large drop in inventories and capacity utilization which eased downward pricing pressures significantly in spite of falling consumer demand and reduced credit availability. We also had commodity prices rising from leveraged speculative bets by hedge funds.

The first two are like bullets in a six shooter. They can only be used once. I suppose the commodity speculation could be considered the very early beginnings of a "crack-up-boom," but other than gold, there seems to be little panic buying in the more "emotional" of these commodities (grains, energy). And it is precisely this fear (OMG, I might not be able to feed my family, "I'll take 10 sacks of rice!") that characterizes the CuB.

Until I see that kind of fear and still no willingness to quash it from central bankers, speculation of runaway inflation is premature.

One thing we can likely all agree on is that deflation "should" happen. We have too much debt and asset prices are too high to be supported by our incomes. And the easiest solution to this problem for those without access to a printing press (small businesses and consumers) is deleveraging. Considering they compose the largest sectors of the economy, their actions will determine the overall outcome.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Technical Update 48.09

2009-12-13T11:53:00.000-08:00

Most major stock indices were flat around the world last week, even as the US dollar continued its push higher and commodities sold off significantly. The followthrough on the US dollar was something we were looking for last week as a key to the topping process we have been tracking for months. It has traced out a very nice looking 5 waves up (the Euro has done the inverse) and should now retrace that move in 3 waves down.

The blue chip stock indices have been the most resilient over the past few months as the FIRE sector (Financials, Insurance, Real Estate) has lagged behind considerably. It was a credit based bubble that popped in 2008 and it has been a credit based recovery. To me, this suggests that the overall structure of the economy has not changed. Therefore, weakness in these areas, much like during the 2007 rally, should be considered a leading indicator for the overall market. I am expecting the major indices to make marginal new highs next week, as the US dollar retraces but fails to make a new low. This should be the final non-confirmation prior to embarking on a monumental decline. This likely sounds like a broken record by now. We've been monitoring this process for months. Bears are now, to be sure, tired of waiting. I know I am. But to keep things in context: after a 53% rally in 6 months, the S&P 500 has rallied only 8% in the 4 months from August to the present.

The past few weeks have seen painstakingly quiet markets, reminiscent of John Kenneth Galbraith's account of the 1930 rally which he described, "as placid as a produce market." Despite the historical context of nearly all major bear markets retesting their lows to some degree, I have been able to find few market analysts/pundits willing to entertain that possibility. The idea of going back to where we came from is as preposterous to most now than dropping below Dow 10,000 was to most in 2007. Sure, many are expecting a correction, but little more than 10-20%. This is an incredible amount of confidence considering we have rallied more than 65% in just 10 months. I'd wager a guess that this is unprecedented confidence. Below is the Bull/Bear ratio, as determined by the Investors Intelligence survey.

The S&P 500 has traded within a 3.5% range over the past 5 weeks.

Crude oil has an opportunity to extend to the downside. Any continuation below Thursday's low substantially damages this chart.

As previously mentioned, the Euro has put in its most significant decline since June. A fairly swift retrace back up to 148-149 should occur prior to a resumption of the downward trend.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Sovereign Default Risk Puts Floor Under US Dollar

2009-12-09T11:35:00.000-08:00

Note to readers: The following post originally appeared at Examiner.com. I have recently taken a position as their Canadian Economy writer. I will still be contributing to Futronomics, but some of the articles will be cross-posted. You will notice a difference in the style of writing in such articles, but I pledge to stay true to the spirit of my work to date. Naturally, the work will be a little more "Canada centric," but most will still have relevance for my American readers. Feel free to visit my Examiner page often and subscribe to my posts if you wish. I am paid minimally based on article views, subscribers and comments. However, this is more of a resume boosting endeavor, so we will see how it goes...

When Dubai World, the state backed infrastructure company, warned of its inability to meet obligations without assistance two weeks ago, some analysts noted that it had the potential to spark fears of other susceptible nations to do the same.

This week, markets have been tentative after rating agencies confirmed those fears with downgrades in Europe.

Greece, widely known to be the weakest among major EU economies, was the first to be given a downgrade by Fitch. Its rating was slashed to BBB+ and reiterated that further cuts may be in the offing. Standard and Poor's also expressed heightened caution a day earlier, stating that they have a "negative" outlook on the future direction of ratings. Ratings were also lowered on Greek commercial bank debt.

Ratings downgrades are considered significant events because certain investment institutions (such as pension funds) are only allowed to invest in debt that is considered investment grade. A downgrade could force selling of government bonds, pushing interest rates up and exacerbating the problems.

Fitch noted that the historical record of fiscal management in Greece had been poor and that they are, "not convinced that the substantive pension reform and other measures necessary to contain public spending pressures and broaden the tax base will be sufficiently strong to materially reduce debt."

Credit default swap contracts (the cost to insure against default) on Greek sovereign debt has risen substantially over the past two days to 232 basis points.

Spanish sovereign debt risk also rose, as Standard and Poor's put the nation on "watch negative."

Fears of greater contagion have put higher risk premiums on almost every European nation. As a result, the euro has fallen by 3% against the US dollar in the last week. Over the past few years, the US dollar has strengthened when risk aversion increases. The reaction could prove detrimental to other currencies like the Canadian and Australian dollars, which have also benefited from risk seeking investors borrowing money in the US and taking it abroad.

Willem Buiter, professor at the London School of Economics, and incoming economist with Citigroup, suggested that a bailout by the European Union may be a last-resort option at some point for Greece. But certain German officials have warned against this, asserting that it could set precedents for other EU members such as Ireland, Italy, Spain, and Portugal to expect the same.

Watch a Bloomberg interview with Buiter below. Interested parties can follow daily CDS movements here.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Technical Update 47.09

2009-12-05T10:12:00.000-08:00

Most indices posted large gains on the week, with previously underperforming groups (Semis, Small Caps, Transports, Utilities, Asia) taking the baton from the previous outperformers (like the Dow). Sector rotation is a signal of market strength and should not be ignored by market bears. Many of the negative divergences we have been tracking for months disappeared this week, showing a lack of ability for bears to capitalize on weakness.

There were, however, a few signals on Friday that may prove to be important for the bearish case. Nonfam payroll data was released, which beat expectations by a large margin. But after a short spike higher on the open, markets sold off for much of the rest of the day. This again proves my oft cited opinion that it is not the news that matters, but rather the reaction to it that we must give heed to.

The US Dollar was the big story on Friday, however. It posted its biggest gain in many months as the Euro and the Japanese Yen especially put in major reversals. It is my belief that the direction of the dollar holds more sway on equity markets than anything equity specific (carry trade), so it is not necessarily "cognitive dissonance in action" to ignore the many positive price movements in equities in favour of the evidence being displayed in the currency markets.

There's a lot to like in the chart above. It has decisively broken its down sloping trendline from March after briefly poking through 3 times in November. The RSI has, as pointed out over the past few weeks, displayed improving readings as the dollar has slowly drifted lower. It now pushes past the 50 barrier convincingly, which has proven to be the high water mark of the latest decline.

The weekly also displays some interesting signals. The MACD has crossed into positive territory along with the histogram. And stochastics are also looking bullish. The decline has been an 81% retrace of the previous advance, which, from an Elliott wave perspective, is not uncommon for a "wave 2" correction. This would imply sharply higher prices in a 3rd wave higher, which would greatly surpass the previous levels. Elliott waves are not always a useful tool, but when their patterns are as compelling as they are right now for the currency markets, extra attention is definitely warranted. Also of importance to the bullish outlook on the dollar is the current extreme sentiment against it, despite the fact that it is above where it was 18 months ago.

In fact, looking at the monthly chart, the extreme bearishness against the dollar looks even more unwarranted. It only sits a few percentage points below where it was in the early 90's. I'm fairly certain that if a survey of laymen were done and asked, "where is the USD relative to 17 years ago," the answers would be far lower, based on the steady barrage of "dollar doom" media coverage. I was recently forwarded an article where an interviewee responded with this intellectual gem:

As far as the "short dollar trade being too crowded," I'd dismiss it as nothing more than Nazi-style propaganda with no basis at all, only an underlying motive of trying to scare people out of their gold and silver positions so that the "bad guys" can take it from them.

I nearly hit the floor in hysterics.

As the near inverse of the dollar index, the euro also posted a large reversal day. The 50 day EMA remains as a barrier to lower prices, holding on all previous declines since the spring.

The Japanese Yen also had a sizable loss on Friday, giving up most of its previous gains of the past few months. Something looks like it went KABOOM here, and it would not surprise me at all to hear of hedge funds caught offside, betting against continuing correlations.

As always, followthrough will be the key to the importance of Friday's reversal. Over the past few months, we have documented dozens of opportunities like this for currencies, commodities and equities to change course. And in an almost comical ineptness, they have failed every time. We will know early this week, whether this is just another head-fake or the early stages of a resumption in trends that began 18 months ago.

Have a great week!

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Dubai Podcast and Comments

2009-12-02T09:25:00.000-08:00

Michael Surkan of the Optimistic Bear again invited me on his radio show to discuss the ongoing issue with Dubai and its potential knock-on effects around the world. As I mentioned in my technical update on the weekend, this issue itself is not likely large or relevant enough to cause a global bout of deleveraging. But it may contribute to a loss in the prevailing optimistic tone toward the ability of some sovereigns to make good on their debts. The assumption is that any sovereign in trouble will be bailed out or assisted by another sovereign, the IMF, etc.

But this may be a premature assumption. Explicitly guaranteeing the debts of other sovereigns may increase the perception of systemic instability. German finance minister Peer Steinbrueck learned this last year when he blurted something about not allowing any Euro member to go belly up. He later backed away from that statement, surely after being made aware of the implications: if Germany were to guarantee the debts of all euro nations, they themselves would be perceived as ultra high risk. Abu Dhabi is certainly aware of this potential issue, hence their reluctance to immediately back Dubai.

The next assumption is that many heavily indebted sovereigns will attempt to pay off their debts through traditional measures (tax revenues, inflation, austerity, etc). Many times these measures are not politically possible. So strategic default starts to become a legitimate way out. Once this begins, it is difficult to stop in its tracks. Nobody wants to be stuck paying interest on debts while their competitors operate debt-free. Eventually, this will happen. New political parties will be elected and will view the debt burdens as "obligations of previous regimes."

Right now they continue to play extend and pretend. Extend the duration of obligations and pretend that assets are worth more than they really are. That will work only so long as it appears beneficial for everybody involved (ie. rising stock market). Soon, the sheer mathematics overrun the ability to continue this. As Steve Keen put it so well recently, and as Karl Denninger continually posits, the world's debt burden relative to our productive output is too high and is only poised to rise. And the percentage of our incomes required to service this debt is also too high. This has a corrosive effect on our ability to invest in productive capacity which lessens the other side of the ledger (output). All of the above puts upward pressure on risk premiums (ie. interest rates), which self-perpetuates the worsening servicing ratios.

This is the "Minsky moment" we experienced briefly last year. Confidence was high that it could be prevented. We are now in the process of testing that theory. In my opinion it will fail and another Minsky moment will soon occur - this time with dramatically less confidence in the ability of central bankers to postpone its effects, and less political capital to act as they did before.

Listen to the podcast below (run time about 20 mins).

As always, comments are appreciated.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Technical Update 46.09

2009-11-29T09:33:00.000-08:00

A holiday shortened week and some wild swings toward the end were not enough to move the major indices very far from the unchanged mark. On a weekly basis they closed flat in North America and Europe, although Asian markets finished considerably lower.

The inability of Dubai World to repay its debts is what gets the blame for the late week selloff. But I am more inclined to believe it was simply jumpy speculators, fearful of losing their gains before the end of the year. Whether or not this event proves to be of any longer term importance largely depends on market participants' willingness to see that Dubai is not alone.

In fact, Dubai is a relatively small shoe among those waiting to be dropped. Excessive debt levels are everywhere. In many cases debt levels and leverage are higher than they were prior to the 2008 credit crisis. The only thing that has changed is sentiment. Popular sentiment is that governments will bailout banks that get in too much trouble; that large companies will be assisted in rolling over their debts; that overleveraged companies will be able to "earn" their way out of their problems in a recovering economy; and that increasing debt servicing burdens do not pose as barriers to any of the above.

As soon as perception is changed, the deleveraging of 2008 will continue anew. None of the problems were actually dealt with expediently. They were merely swept under the rug - given "lifelines." But those lifelines expire. So when the sheer mathematics of the situation meet the expiring lifelines that were given in the panic of 2008 and early 2009, the result will be unsurprising. (Abu Dhabi gave a similar "lifeline" to Dubai last year)

Dubai could serve as a stark reminder of this reality. Or it could be again rolled over and swept under the rug for another year. We've seen warning shots like this before. Remember back to June of 2007, when two Bear Stearns hedge funds blew up. This was quickly made to disappear while stocks continued higher for a few more weeks. Then another big shock in August. And again new highs for stocks into October. Thus, I would avoid taking this recent event as the long awaited "catalyst" for a move lower. I would instead watch for signals of contagion in credit markets. Are CDS spreads blowing out on other sovereigns early this week? Greece, Ireland, Spain, Italy, Mexico, Pakistan, Latvia, Saudi Arabia and numerous eastern European nations should be given extra attention this week.

Unless credit contagion is plainly visible early next week, I would be wary of a short covering rally that takes us to immediate new highs. But if nothing else, this recent incident has given us confirmation to the existence of a massive US Dollar carry trade. On Thursday night, the US Dollar spiked higher as speculators got spooked. Nothing else was spared. Gold was down $60. S&P futures were down more than 40 points. Oil dropped $5. And the phenomenon was worldwide.

Considering this is a technical update, I'll post a few charts before closing out.

First up is a chart of sentiment. It is the Investor's Intelligence bull:bear ratio. As you can see, the percentage of bulls relative to bears has reached a new extreme for the rally. This is typically a contrary indicator. (note: numbers are as of Nov 23rd)

Last week, I pointed out that the BKX (Bank Index) was underperforming and was poised to make a large move. It again underperformed this week. Below is an hourly chart of the past 3 months. Below its November lows, things start to get ugly for this index. Signs of credit stress should show themselves in this index first. Falling share prices in the banks will beget talks of more writedowns (not to mention coming accounting changes at end of year). And more writedowns will beget talks of further government assistance. The mere mention of this will absolutely crush improving social mood. And I don't believe further assistance will be politically possible. The big banks remain insolvent. That is the way they will inevitably end up. Attempts to paper over this reality appear to be unravelling.

I mentioned the Aussie Dollar last week as a carry currency. It weakened further this week. But the New Zealand dollar, while considerably less liquid, is also one to watch for signs of tense carry traders vacating their positions. It got creamed on Friday and is deserving of some attention in the event of followthrough.

Japanese banks are some of the most susceptible to falling asset prices. And they still have not worked through the bad debts racked up in the 80s. The Japanese Nikkei has been falling while the Yen rises to new highs. This is extremely painful to Japanese exporters and there are serious cracks between the new Japanese government and the central bank. Something could crack here too.

Have a great week!

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Canadian Real Estate Goes Wacky

2009-11-26T16:56:00.000-08:00

Consider me one of those that never expected the Canadian RE market to rebound after property values began to sink in 2008. But as we have been reminded by numerous bubbles over the years, parabolic blowoffs can last a lot longer than most imagine. Such is the case in Canada's two primary urban markets, Vancouver and Toronto. A concoction of factors has contributed to rapidly rising prices and euphoric expectations about the future.

Of course, when one has messages like the following being printed by newspapers almost daily, it should be no surprise that Canadians have been duped into believing the unbelievable:

“People are re-entering the market – they have the confidence to take advantage of bargain-basement prices. There's been a release of pent-up demand, and that has a long time to play out. Prices have gone as low as they are going to go.”

The above statement came from Gregory Klump, Chief Economist of the Canadian Real Estate Association. Astute readers may equate those statements with those of David Lereah who held the same position with the National Real Estate Association in the US. Lereah later admitted that his analysis was greatly compromised by the position he held - or in not so nice terms, he was a paid shill for the housing industry in the US. Regardless of this unsurprising revelation, the media here in Canada have no problem quoting Gregory Klump as if he were a legitimate expert worth listening to.

But the parallels don't end there for media treatment of the Canadian and American housing bubbles. Time magazine infamously called the top of the real estate market with their magazine cover titled, "Home $weet Home: Why We're Gaga Over Real Estate."

That was June of 2005 - what later was revealed as the top of the national bubble. It continued in some areas thereafter, but the writing was on the wall. In early November, an eerily similar picture arrived on my doorstep in the local Vancouver paper The Georgia Straight.

Intrigued and terrified I proceeded toward page 19, where the feature article lay. Along the way, I was inundated with full page ads for condo developments and just as many for luxury furnishing. The story started out documenting a 24 year old Indo-Canadian pharmacist's experience in buying his first condo. That was fine. But four paragraphs in, journalistic integrity took a back seat to complete fluff. Quoting the pharmacist:

"One of my friends who I used to live with in university, he's like, 'I feel since you bought your place, you've matured. You've completely changed in the way that you are. Before, we used to live the student lifestyle. Now, you're always cleaning your place. You have plants. You look after them. You've even got a cat now. It's like you're an adult.'"

Pass me a bucket. This reminds me of the disgusting marketing tactics used by penis enlargement pill pushers.

But that isn't all. The article goes on, defining the term "puff piece," quoting the most prominent figures in the local real estate market. First up was Cameron McNeill, real estate marketer:

...McNeill, whose company sold more than a billion dollars worth of real estate in the hot housing market of 2007, told the Straight by phone that he thinks the Olympics will keep a spotlight on Vancouver and magnify positive fundamental factors driving demand. According to him, those factors include low interest rates, a shortage of downtown land, good provincial government stewardship of the economy, and a safe investment climate.

McNeill added that it doesn't make sense to compare Vancouver-which has broad international appeal-to other Winter Games host cities. "Who wants to live in Salt Lake City?" he asked. "Lillehammer? I didn't know that town existed until the Olympics happened."

"I think the Olympics creates a euphoria, he stated. "But honestly, I don't think prices are going to spike preceding or post-Olympics significantly. I believe the real benefit of the Olympics is going to come in one, two, three, four years down the road."

Prices rose uncontrollably as soon as the Olympics were announced. It is something that has contributed to Vancouver becoming the most unaffordable city to live in in the Anglosphere with exception of some coastal paradises in northeast Australia (based on price-income ratios). McNeill also speaks of the oft-cited "land shortage." There is no land shortage - not even in downtown Vancouver. Where more square footage is required, we can build skyward, like any other city. There are blocks upon blocks of tired old buildings just waiting to be bulldozed and redeveloped. The map below is downtown Vancouver. Outlined in red is a huge chunk of largely underutilized land. Light industrial warehouses consume most of it. Century old rail yards take up much of the rest. Limited creativity is needed to see how existing land can be converted for other purposes.

Next up was Bob Rennie, another real estate marketer. Naturally, he echoed McNeill's sentiments:

..."It's after the Olympics that we're going to see the impact on real estate." ... "I don't believe that anyone ran back to Turin or Lillehammer or Salt Lake City... to buy a secondary residence or to move the family to safety or to move some money to safety. Vancouver is on the map. We're a world city. We're a brand."

The above statements will come across to most readers as unparalleled in arrogance. In fact, it is common sentiment here in Vancouver. This is best reflected by the Provincial Government's recent change in our provincial slogan from "Beautiful British Columbia" to "British Columbia: The Best Place On Earth." This, along with the above statements from Rennie and McNeill articulate perfectly the peak social mood this city is in. Despite 24 hour rain and eternal darkness for at least 6 months of the year, these folks can't see why anyone would choose to live elsewhere. Completely lost on them is that nearly everybody in the world is somehow passionate about where they are from, just like they are.

Don't get me wrong. Vancouver is a beautiful city. After traveling to over 20 countries in 5 continents, people ask me where my favourite place is. I answer "home." But while the combination of mountains and the ocean is my idea of paradise, I realize it may not be for others. There may be some wealthy visitors coming for the Olympics, but to contend that enough of them are going to want to buy houses to make an appreciable and lasting impact on the market is disingenuous. They will come and spend money. A tiny fraction will actually buy property, something which the market has already priced in.

But the opposite is also liable to occur. A wave of investors that have been holding supply off the market in anticipation of this event could flood the market just before the games, driving prices down and causing panic in those depending on a bonanza. Keep in mind that prices are still down in an 18 month period. This was not in the plans of investors who assumed prices would rise all the way up to the games. Now that this hasn't happened, industry promoters suggest prices will rise after the games.

The article goes on to quote more of these promoters, continually offering only one side of the story. It is never mentioned that even with mortgage rates at all-time lows, most borrowers are spending in excess of 40% of their incomes on minimum mortgage payments. And it is never mentioned that it requires up to 9 times the average household income to purchase a home in many parts of Vancouver (depending on how income is counted). There is only one explanation for statistics like these, many standard deviations from their historical norms. And it is the same explanation almost anytime we see prices divorced from their fundamental values.

Credit Expansion Fuels The Bubble

Like all other bubbles, the major contributing factor to this one is easy credit availability. In order to protect the Canadian manufacturing industry from a rapidly rising currency, the Bank of Canada has recklessly slashed benchmark interest rates to 0.25% and has left them there.

But the real driver of credit expansion can be traced back to the CMHC - the Canadian Mortgage and Housing Corporation. This is a government owned corporation which offers mortgage insurance and buys securitized mortgages in order to keep interest rates low and allow more Canadians to "afford" a home. From the CMHC's website:

CMHC plays a significant role in sustaining a healthy housing market and supporting access to low-cost mortgage financing. Generations of first time homebuyers who have limited down payments have been able to obtain mortgages at rates comparable to those with higher down payments due to our mortgage loan insurance products.

This has been the great enabler. And very much like their cousins Fannie, Freddie and the FHA down south, their very existence serves to accomplish precisely the opposite of what they intend - to make homeownership more affordable. They artificially stimulate demand, pushing up prices in the process. This fuels the notion that prices always rise, causing fearful prospective buyers to make poor economic decisions.

A revealing article was brought to my attention that confirms what we already knew. The CMHC along with the Conservative government were fueling a bubble in order to prevent the housing market from correcting to its natural level. More than $100 Billion in mortgages had already been guaranteed by the federal government, guarantees that would quickly turn into losses should prices fall considerably. Naturally, the solution was to make the problem even bigger. Guarantee even more mortgages, fix prices higher, and hope it all blows over. Murray Dobbin writes:

The facts are that over 90 per cent of existing mortgages in Canada are “securitized” -- that’s the practice of pooling mortgages (or other assets) and then issuing new securities backed by the pool -- MBSs, or Mortgage Backed Securities. That’s what happened with the sub-prime mortgages in the U.S. which (because the whole pool was so diversified) received triple A ratings by the rating agencies. Losses around the world amounted to hundred of billions of dollars.

Credit is still tight in the U.S. because no private investor has the stomach for such risky MBSs. That’s because those losses were private and not back-stopped by any government. In Canada, mortgages have been securitized for years. The Canadian-issued securitizations are called National Housing Act, Mortgage-Backed Securities. Unlike the failed U.S. pools, says Lepoidevin, “In order to find buyers for securitized mortgage pools, the Government of Canada has put guarantees on them” by directing CMHC to guarantee all Canadian mortgages.
...
By the end of 2007 there were $138 billion in NHA securitized pools outstanding and guaranteed by CMHC -- 17.8 per cent of all outstanding mortgages. By June 30, 2009, that figure was $290 billion, a figure Lepoidevin says “…exceeds the total value of mortgages offered by CMHC in its 57 years of existence!” CMHC’s stated goal was to guarantee $340 billion by the end of this year and is on track to reach $500 billion by the end of 2010. Total mortgage credit in Canada will grow by 12-14 per cent of GDP in 2009.

In an effort to prop up the real estate market in 2008 (when affordability nosedived) the Harper government directed the CMHC to approve as many high-risk borrowers as possible and to keep credit flowing. CMHC described these risky loans as “…high ratio homeowner units approved to address less-served markets and/or to serve specific government priorities.” The approval rate for these risky loans went from 33 per cent in 2007 to 42 per cent in 2008. By mid-2007 average equity as a share of home value was down to 6 per cent -- from 48 per cent in 2003. At the peak of the U.S. housing bubble, just before it burst, house prices were five times the average American income; in Canada today that ratio is 7.4:1 almost 50 per cent higher.

This high-risk policy actually prevents the natural playing out of the recession -- that is, the purging of the excesses of the previous boom period. CMHC’s easy-money resulted in a 9.3 per cent increase in Canadian household debt between June 2008 and June 2009.

Even bank economists admit to being concerned about a housing bubble. In a September research note, Scotiabank economists Derek Holt and Karen Cordes said, “…lenders have been scrambling to get enough product to put into the federal government’s Insured Mortgage Purchase Program over the months, and that may have translated into excessively generous financing terms.” Holt suggested that in two or three years -- or whenever the Bank of Canada increases interest rates -- many of these mortgages would be at risk.

The banks themselves have taken on virtually no new risk. According to CMHC numbers in the two years from the beginning of 2007 to January 2009 Canadian banks increased their total mortgage credit outstanding by only 0.01 per cent. Fully 90.5 per cent of all growth in total Canadian mortgage credit outstanding since 2007 has been accounted for by Mortgage Backed Securities. Of course, the banks have no interest in saying no if you have qualified for a securitized CMHC loan -- because they bear no risk if you default.

If that sounds like sub-prime mortgages, it should. Sub prime is any loan below prime. If a bank refuses you a loan, and CMHC gives you one, the loan is sub-prime. As Lepoidevin says in his warning letter, “Every single U.S. lender specializing in sub-prime has gone bankrupt. The largest sub-prime lender in the world is now the Canadian government.”

Hundreds of billions in government backed guarantees are driving prices to unsustainable levels in Canada. Like all other interventions into the market process, this too will fail. Instead of being on the hook for manageable losses, realizing that mistake and doing away with the CMHC, Prime Minister Harper and Finance Minister Flaherty have tripled the size of the problem, making its inevitable failure as systemically dangerous for Canada's financial system.

Unsubstantiated claims by industry hucksters of "pent-up demand" and foreigner buying sprees suggest prices will forever rise into the sunset. Common sense and a little bit of digging indicate otherwise.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Technical Update 45.09

2009-11-21T18:53:00.000-08:00

The S&P 500 is up a little over 7% since early August. It certainly feels like more. The last 4.5 months have been trying for market bears, sucking out volatility premium and refusing to respond to typical measures of extreme market sentiment. The major indices have again reached a point where they can capitalize on the visibly "weak hands" that are propping up the advance.

Judging from the sentiment on the various "bear blogs" I visit, it seems that most are now unconvinced that a top has been reached. These same venues were all quick to jump on previous declines and tops were called confidently. Now, however, with five distinct selloffs that ultimately failed, bears are more apprehensive. This is typical behaviour and indicative of the market taking the "path of maximum frustration." It seems that it is systematically trying to stretch and squeeze bears as much as possible, making as many as possible insolvent in the process.

But despite the seeming lack of conviction among the bearish camp, progressively more and more evidence is piling up in their favour. Every subsequent leg of this advance has been weaker than the previous and the most recent 3 day decline holds even more potential than was evident in mid-October. See the S&P 500 chart below with the VIX (volatility index) overlaid. It has registered a positive divergence relative to the index. RSI and MACD have each registered progressively weaker readings. And we can also see that volume has steadily declined throughout the course of the decline. These are all classic signals of a bear market rally losing steam.

Also of importance is the non confirmation among secondary indices. The Dow, S&P, Nasdaq, FTSE and Wilshire 5000 have each exceeded their October highs. Every other major index has failed to do so. As I wrote two weeks ago:

Tops are a process, while bottoms are an event. And this topping process appears to be no different. Especially bearish would be for certain indices (like the Dow) to make a marginal new high early next week, while the others fail to confirm. The bearish divergences noted in these pages two weeks ago would become even more pronounced.

This is exactly what has happened. So the appropriate stance would be to become MORE bearish given these developments. But that is not the way sentiment typically works. The emotional "pain" that one experiences being proven repeatedly wrong disables the ability to view market action for what it is. The same was true for bottom callers throughout 2008. By the time they were vindicated, few had the conviction to capitalize.

Below is the banking index. The academic consensus is that banks have recovered immensely since the panic lows of last winter. Naturally, they should be making immense profits with their interest spreads the way they are. But share price action tells a different story. They have been the weakest sector since the early spring rally, and the weakest sector over the past month. Could the market be telling us something different via the underperformance in this key sector? Could the balance sheet issues I have been raising for years continue to weigh on share prices? Or worse, is it possible that as many have alluded to continuously that most if not all of the world's major financial institutions are technically insolvent?

Do note the convergence of the moving averages on the chart below. Typically, when this occurs, a large move in one direction or another is imminent.

The terrible performance of small cap stocks should be worrying for bulls. In a healthy advance, small caps typically outperform larger cap stocks as smaller companies are more leveraged to prospects of future growth. With big cap names like IBM, MCD and JNJ leading the way with small companies lagging way behind, the hesitancy of bulls in this recent rally becomes easily apparent. Big name money managers have been distributing their shares of small companies to retail holders while they accumulate shares of safer names. We've seen this game before, and we know how it ends.

This can also be illustrated by the relatively few stocks that made new 52 week highs in November compared to those that did in October. Plotted on the chart below and smoothed as a 10 day moving average, the weakness be seen clear as day.

On the currency front, we see similar divergences. The Canadian dollar has backtested its rising trendline and turned back down. This is textbook Elliott Wave behaviour, with the break of the trendline being wave 1 and the retest of the underside being a wave two. So long as the trendline is not regained, the bearish case remains intact.

A similar case can be made for other currencies that have benefited the most from the US Dollar Carry Trade. Most notably the Aussie and Kiwi Dollars, the Brazilian Real and to a lesser extent the Euro. They are all in rather precarious positions, and a technical breach of very obvious support levels will most likely illicit further selling and an unwinding of these speculative positions.

But all of these currencies are moving inversely to the US Dollar Index - whether they are part of the index or not. So it is the big kahuna. And when it breaks above, we can be assured that the rest will break below in sympathy. Below is a chart of the US Dollar. Most notable is the trendline dating back to early March. It has been briefly exceeded twice this month (Nov 3rd and last Friday) but failed to close past that mark. Also of note is a parallel trend channel dating back to June. The upper band of this channel correlates roughly with that Nov 3rd high, giving us a fairly good idea of where resistance resides. 76.81 is the number to beat. If we get two consecutive closes above that number, I'd have a high degree of confidence to call the bottom for the dollar. A spectacular advance would be the result.

That's all for now.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Steve Keen Speech

2009-11-20T09:43:00.000-08:00

Steve Keen, the Australian economist, gave a brilliant 30 minute speech last week that can be watched in its entirety below.

We are in agreement that debt levels have likely peaked relative to economic activity and that the likely course forward is an unwinding of this debt back to historical norms. I discussed this at length in my last post, "Missing the Forest for the Trees."

edit: the embedded video led to a repetitiously agonizing 16 second trailer for Michael Moore's "Capitalism: A Love Story." The actual speech can be found at the following link:

Full Speech Here

Although Professor Keen and I would likely agree on more than we would disagree, I have doubts that he would endorse the solutions I proposed in that post. He does not believe, it seems, in the benefits of mutual voluntary exchange, instead electing to cling to the absurd Marxist notion of 'capitalist exploitation' over susceptibly 'irrational' actors. To this extent, he is dead wrong. Keen fails to understand the difference between the neoclassical "rational expectations" thesis (that underpins the EMH) and the more Austrian "rational action." Rational expectations, we would agree, are impossible. To be able to foresee exactly how any action will result, one must operate with perfect information, or in other words, omniscience. This is absurd. No individual or group of individuals can make a claim to this ability - government central planners especially. But rational action is something else completely.

Rational action implies that at the time of decision making the actor will always elect something that he/she believes to be beneficial. Otherwise, no action would be taken. For example, if I were sitting on my couch feeling hungry, I may find the idea of expending energy and money to walk around the corner for a hamburger. Upon my completion of this task, whether I found the result of my action satisfying or not, my thought process was rational. It could have been insufficient and given me a tummy ache. I would then have experienced loss on this transaction. But my action was still rational. Rational action can lead to either profit or loss - two necessary potential outcomes for any action.

It seems that modern economics has been consumed by a utopian desire to eliminate "loss" from the realm of possible outcomes in voluntary exchange. To do this, the central planners seek to minimize our ability to engage in voluntary exchange, making more and more exchange involuntary. The justification for this is that people suffer from irrationality and require decisions to be made for them.

No greater folly has poisoned the minds of humankind.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Missing The Forest For The Trees

2009-11-18T08:59:00.000-08:00

With the 65% rally in stock indices, the idea of actual reform of the financial system seems to have been put aside from serious consideration. Law and policy makers are instead holding out in hopes that 2008 was all just a bad dream, a rogue wave that nobody could have expected, or some sort of other metaphorical platitude designed to distract us from the reality of what happened.

Senator Chris Dodd introduced a bill that supposedly will reign in the financial industry. The bill would have been worth reading, and perhaps even worthy of taking seriously were it not over 1100 pages long. The length of the bill tells me everything I need to know - it is filled with loopholes, concessions, and incentives to ensure that any meaningful change can be interpreted away by the best cunning team of lawyers freshly printed money can buy.

Karl Denninger has a pretty good takedown of the bill. That's not to say it's all bad. But the instances of actual reform (like eliminating regulatory arbitrage) will be outweighed by the damage inflicted by the perception of stability being falsely instilled in the minds of all market participants (ie. everyone). This is the single biggest problem I have with regulation. Lawmakers dance around pronouncing how safe and secure everything is, typically exaggerating such stability to make themselves look better, and people take their word (even if they know otherwise), knowing that it is someone else's ass on the line should all go awry. "Moral Hazard" in other words.

Ron Paul's "Audit the Fed" bill (HR 1207) is also under attack from partisans of the status quo. Mel Watt, a congressman from Bank of America's district, has put forward an amendment to the bill that essentially kills it dead. In politics, apparently you don't have to vote against anything. You simply water down what you don't like to the point of making it meaningless. This way you end up with thousands of pages of laws that cancel each other out, confusing everybody except the aforementioned lawyers who's jobs rely on said confusion. Somehow I don't think this is what was in the minds of those who crafted our systems of government, but I digress.

The point is, despite all sorts of cage rattling, nothing is actually being done. And there is mounting evidence that the opposite is happening: the institutions primarily responsible for the crisis have been given the keys to the city with the hopes that they rescue the system on their own accord. Good luck with that.

But as I implied earlier, doing nothing would be a better outcome than creating the perception of doing something while in fact doing nothing. That way, at least people would remain skeptical of the entire framework and reject its further expansion, thus reducing the potential damage.

But can we really expect anything that will actually have a stabilizing effect to be done given that almost nobody understands what caused the crisis in the first place? Obviously not. If you start with faulty assumptions, your analysis is bound to have faulty conclusions. Right now the assumptions are that:

- Banks were always well capitalized - it was just a lack of confidence that put them in jeopardy - and now that confidence is restored, everything will be fine.
- The lack of confidence caused people to save money - thus dampening consumption from its "normal levels" - and with enough "stimulus" there will be a disincentive to save, spurring consumption and helping boost GDP
- There was not enough regulation - new derivatives and bank activities managed to circumvent existing regulations - and with bigger or newer regulations these activities will be brought under control
- Pay incentives for financial executives encouraged unnecessary risk taking - changing the incentive structures for executives will help eliminate excessive risk
- The lack of a resolution authority was the reason why more big banks did not fail - the creation of such an authority will ensure systemic risk is limited
- The present financial system serves a social purpose by providing access to credit which encourages growth and prosperity

All of these assumptions are false. And there are many others. The decisions being made now are based on these assumptions, and therefore their chance of success remains zero. Just as the avoidance of crisis was in 2007.

What are the real problems?

The problems noted above and their accompanying "solutions" have one thing in common: they disregard debt (credit) as any sort of problem. This should come as no surprise, because those who put forward their interpretation of the issues and those who seek to legislate solutions to them nearly all subscribe to economic ideologies that dismiss credit growth as potentially destabilizing for an economy.

But credit growth is the central problem. And the inability for credit to grow further is what caused the crisis. Again, this was a mathematical certainty to occur at some point. One needs only a calculator and 6th grade math to reach that conclusion. When credit growth is compounded at annual rates between 6-15%, it does not take long for the parabolic advance to reach a breaking point. We reached that breaking point when our debt servicing to income ratio began to rise faster than our incomes and the equity in our primary assets (homes). Credit expansion slowed and asset prices, which had already priced-in years of future credit expansion began to be re-priced to levels more in line with our incomes.

Credit is the central cause of the crisis - the disease (if we are to characteristically resort to medical metaphors). The symptoms of the disease are many, a few of which are listed above. By addressing the symptoms we will not reach a paradigm of increased stability over the current system. It will be inherently unstable. Such has been the case for a century. And something that post-Keynesians like Hyman Minsky and many Austrian economists have been arguing for about as long. The only question revolves around what the "redline" is. What level of debt can be sustained by an economy? Of course, this depends on many factors: interest rates, income growth, productivity, etc. Because it is unknown at what level of debt an economy begins to "choke," we cannot say with 100% certainty that it has been reached. But we can make an educated guess, based on the events of last year, that we crossed that level.

Below is a chart of total public and private debt outstanding in the US. As you can see, total debt is now 4x the size of the entire economy - far more if one factors in unfunded future obligations or if one considers the guarantees issued for suspect financial instruments. (chart courtesy Market Ticker).

Economy bulls believe one of two things:
(1) Debt doesn't matter and this could continue rising for decades, or
(2) We can grow our way out of the problem via productivity advancements and income growth (I'm still yet to find anyone that feels this to be likely).

I have my eyes and ears peeled for any signs of (2), but I just don't see the necessary actions taking place to allow for this (deployment of savings on CapEx by businesses, competitive wages, proper demographic influences, etc). To the contrary. This economic "rebound" is not being led by productive deployments of capital, rather asset price speculation. This is the same reason that led me to believe that the '03-'07 expansion was mostly illegitimate. I was correct then, and I have no reason to believe my analysis was wrong and I just got lucky. The crash in asset values and seizure in credit that I hypothesized would be the result of an illegitimate expansion, happened - only more violently than I thought likely.

As I mentioned above, (1) is false and rooted in fallacious economic theory (Keynesian and Monetarist). While I suppose a temporary expansion of debt levels is possible (so long as interest rates remain low or continue falling, debt servicing ratios don't rise much), my intuition is that the max level was reached in 2008 and there will be neither demand nor supply of credit to allow for further expansion.

The combined factors above lead me to believe that we are on the cusp of another credit seizure and collapse in asset prices for the same reasons it happened last time. Such a collapse is unavoidable. The solution is to let it happen in an orderly fashion, in accordance with the law, and most importantly, with a viable framework for what a replacement financial system will look like once the unwinding is complete.

Discussion on what this system should look like need to begin immediately. If it is not in place prior to the unwinding of the current system, the unwinding runs the risk of being disorderly and vulnerable to being accompanied by the nasty side effects of such a disorderly collapse (ie. starvation, rioting, lawlessness, war, etc).

Simple Proposal For A Sound Financial System

Primarily, it needs to be acknowledged that unbacked credit expansion serves only the needs of a select few (the issuers) at the expense of everyone else. A future system shall make the extension of said unbacked credit a criminal offense. No new laws are required for this. Most western judicial systems have laws against counterfeiting, misappropriation and misrepresentation. As they are written, they need only be applied to the financial system as they are to any other person or industry. Lending anything that one doesn't already possess is a violation of all three laws.

With this one simple interpretive adjustment in the application of our current laws, we can eliminate nearly every adverse symptom of our modern day economies (failure is not an adverse symptom, thus cannot be eliminated). In order to facilitate the above and to structre our financial system in a manner consistent with the law, the following would also prove necessary:

1) Convert all credit obligations for common equity
2) Liquidate the remaining debts that are not backed by existing equity
3) Eliminate legal tender laws
4) Financial institutions will elect to become one of three types of institutions:
i) Depository Institutions - The banks take deposits for safekeeping of a predetermined measure of deposit (dollars, gold, oil, wheat, land, whatever is accepted by the market) and facilitate electronic or physical transactions between like institutions. A fee is charged to depositors for these services.
ii) Lending Intermediaries - These institutions facilitate the matching of lenders and borrowers. A rate of exchange is settled by the two parties at the prevailing market rate. Should the borrower default, the lender experiences loss. The intermediary is responsible for the collection of regular payments and collateral in the event of default. A fee is charged for these services. No risk is ever taken by the intermediary.
iii) Investment Firms - These firms pool capital on behalf of willing investors and use it to speculate or invest on whatever they choose. Returns are based on entrepreneurial intelligence rather than who can take the most risk with borrowed money.
5) Eliminate regulatory redundancies (eg. capital ratios)

There is no social benefit in large, multi-purpose, ultra-leveraged financial institutions. Economies of scale in banking are typically left at municipal lines. Furthermore, our relatively new means of electronic transactions drastically reduces our need for indirect exchange (the use of money). Small transactions can easily be achieved with specie and dollars need only be retained as a unit of account. "Capital" will always be something tangible and the abolition of legal tender laws will encourage the monetization of more types of capital (primarily, the most irregular of commodities).

These changes are not an effort to tame or eliminate the business cycle. Not a "utopia." But it must be acknowledged that much of the business cycle we currently experience is due to the expansion of unbacked credit. Other business cycles will persist based on demographic, social and environmentally driven changes in values (among other factors). These cycles will most often be mild, but sometimes severe. But under the system outlined above, they need never be systemically jeopardizing. Success and failure should be embraced as equal sides of a smoothly functioning economy, neither embraced nor scorned. Yet failure that does occur will be on account of poor entrepreneurial judgement, rather than as result of others' excessive risk taking and systemic collapse.

I challenge the reader to explain coherently how our current financial system serves any greater social function than what I have briefly outlined here. And I furthermore request the reader to address the morality and logic of a financial system so complex as to be incoherent to the average person, while such a simple alternative presents itself.

If anyone has any details to add, I encourage you to do so in the comments section. I was purposely vague on certain areas of my "solution" so as to elicit further discussion.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Technical Update 44.09

2009-11-15T14:40:00.000-08:00

Major averages again failed to confirm their numerous bearish divergences with increasing selling pressure. The modest declines were not enough to instill a significant amount of fear in traders and dip buyers took advantage of the indecisiveness. Again, we turn to my list of factors that I feel will be sufficient to turn the tides. Some were achieved in the previous decline but not all. We will again have to endure higher prices and monitor continuing divergences prior to incurring more definitive sell signals.

1. Consecutive daily declines of 2.5% or more. This hasn't happened since the rally began (if so, only marginally).
2. Weaker internals than previously displayed during the rally via 10 day moving averages of a) put/call ratio b) advance/decline issues c) advance/decline volume.
3. A considerable increase in the US Dollar Index. A crossover of the 20 day EMA over the 50 day EMA is something that has not yet occurred since early April.
4. Divergence between major indices. Dow, S&P, Nasdaq, Transports, Banks. We should see significant divergence between some of these indices at a major top. There have been divergences present at various points, but they have quickly resolved themselves. Specifically, I am looking for underperformance in the transports, banks and/or the nasdaq.
5. A complete Elliott Wave '5' down on more than an intraday basis.

While it may feel like prices will inevitably rise higher, and perhaps in a final parabolic manner, it should be noted that among the divergences present at both the September and October highs, those same divergences are persisting and even more pronounced at this time. While the Dow has powered higher, only the S&P, NDX and FTSE indices have confirmed that new high in November - and each of those three have only managed it by a few measly points. For a technician that follows the Elliott Wave Principle, this is problematic. A recovery high after an initial decline (ie. a '2 wave'), cannot exceed the beginning of wave 1. This forces the technician to interpret the various indices differently until they confirm. And while there is nothing wrong with doing this, my experience is that when there are so many equally valid interpretations of the price structure it is best to focus on other technical measures until the pattern reveals itself more clearly.

So while there remains possibilities from an Elliott standpoint to continue higher, more conventional technical analysis still argues for lower prices. Significant RSI and MACD divergences as well as pathetically low volume should be warning signs to those of bullish inclination.

One index that does appear to be divergent with the US Dollar Carry Trade is Shanghai. As much as this differs with my overall take on China's dependence on US exports, the technical pattern is very compelling. The Shanghai market appears to have put in an impulse 5 wave pattern into the summer, and a one month correction thereafter. If this holds, the best outlook for the future is that Shanghai has put in two consecutive 1-2, 1-2 legs higher, setting up for a 3rd of a 3rd of a 3rd. In Elliott Wave terms, this is a holy grail setup and argues for MUCH higher prices. A drop below 2900 would invalidate this thesis, creating a somewhat low risk entry on the long side. Sometimes the technical patterns that do not jive with one's fundamental biases are the best trades. Mindful of this, I have taken some long side exposure in FXI as a hedge to my S&P puts.

Good luck this week!

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

The US Dollar Carry Trade Explained

2009-11-12T10:05:00.000-08:00

The US Dollar Carry Trade has now broken through to mainstream consciousness. This blog, and many others of course, have been talking about this for years. Formerly disparate markets have slowly been converging for the past 10 years. The reason behind this is, quite naturally, unbacked credit expansion.

When there is no or dubious collateral behind a loan, it is only natural that the borrower will seek to speculate recklessly. The consequence of default is not the loss of anything tangible to them, only a poor credit record for a few years. And the rewards are huge if the speculation pans out. As this mentality among borrowers became entrenched, it had the effect of driving all asset classes that were typical recipients of this easy money together. Stocks, bonds, commodities, real estate, art, etc.

The source of this unbacked lending is difficult to pin down. We know that Japan was very active in pursuing credit expansionary policies in order to drive down their currency and support their export market. They lent to foreigners, and foreigners exchanged their Yen for other currencies and bought assets elsewhere. Japanese investors also took to investing abroad and gaining not only on asset appreciation, but on the depreciation in the Yen. This, known as the "Japanese Carry Trade" unwound spectacularly in 07-08. The Yen rose over 40% in 18 months, while the asset markets they were speculating in dropped by at least as much. Most who speculated in this trade likely lost 70% of their capital - all of it if they used any leverage.

Why was Japan the obvious choice for this? Because their interest rates were at near zero for years and there was no indication that they would be raised any time soon. Sound familiar?

It should, because that is the exact perception in the US. And that perception is probably correct. Benchmark rates will not be going anywhere soon. And now that the Fed has involved itself in many other markets (agency paper, money market funds, commercial paper, etc) there will be many moves to unwind these programs prior to raising interest rates. So there is no risk to this trade, right? We know better. So does everyone else. Everyone thinks, however, like the Japanese housewives playing in the forex markets, that they will be able to get out first once it begins to unwind. Simple mathematics tells us it is impossible. Like how 90% of drivers rate themselves as "above average."

In the minds of most, this doesn't matter. All that is important to today's ultra-short term minded investor is "how long will it last" and "how much money can I make?"

Often, once a trend has become common public knowledge, it is already over. This is the logic behind the magazine cover contrary indicator. Sometimes, however, the trend needs to become manic prior to exhaustion. In my opinion, we have already reached this point. Most others see the potential for it to last longer and run deeper. I suppose they could be right. Thinking back to early 2007, it looked fairly apparent that the Shanghai market was going to put in a top and was getting ahead of itself. It went on to double itself from those levels. It then lost 73% - halving those initial 2007 levels. Bubble callers were vindicated in the end but likely lost in three ways: shorting too early, missing a huge run-up, and being too shy at the real top.

There is a fine line between early and wrong. It is the same line between profit and loss. The flipside is that markets have an uncanny way of convincing you you're early, right before they turn around. I call this the path of maximum frustration.

The US Dollar Carry Trade is a bubble - just like all the others. It will unravel. I'm doing my best to hedge in the case of being too early in order to ensure I can participate in the unraveling process, which promises to be a doozy.

I look forward to the day when investing is again more about increasing productivity, wealth, prosperity, and less a game of Jenga. But when life gives you oranges...

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Technical Update 43.09

2009-11-08T10:39:00.000-08:00

The S&P 500 posted gains on all 5 days this week to retrace nearly 61.8% of the prior decline. The advance was achieved on extremely low volume, and with decreasing participation. The Russell 2000 managed to retrace only 43% of its decline, while the larger cap Dow 30 made up 83% of its previous fall. The generals are charging up the hill while the troops lag behind, paralyzed with fear.

Tops are a process, while bottoms are an event. And this topping process appears to be no different. Especially bearish would be for certain indices (like the Dow) to make a marginal new high early next week, while the others fail to confirm. The bearish divergences noted in these pages two weeks ago would become even more pronounced. But that is not necessary. The oversold conditions have been worked off by both time and price and should not be hindered from continuing their descent from fantasy land. New highs in all the indices would indeed be frustrating (recall August to October 2007). But the technicals all point in the same direction, and evidence mounts almost daily that market action is conducive to lower prices, not higher.

Below are hourly charts of the Dow Industrials and Russell 2000 respectively. Notice the extreme divergence.

As mentioned earlier, the internals of the week's advance were extremely weak. Below is the up/down volume ratio. The blue line is a 10 day moving average of the ratio. Lower readings above zero indicate weaker participation on rallies.

The commodity complex has been weakening despite Gold's continued strength where a non-confirmation in silver may prove difficult to surmount. Below see the CRB index and Silver.

That's all for now.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Crisis in Colombia Brings Opportunity

2009-11-05T16:07:00.000-08:00

I often talk about generational cycles having major impacts over long-term trajectories in markets, and societies in general. To most, it sounds like a very fatalistic way of looking at things: no matter how hard we try, we're destined to repeat our failures. This was proven true again in 2008 as markets tumbled after debt levels rose uncontrollably for decades, securities fraud was rampant and corrupt politicians and regulators did their best to cover up these problems - and in many cases perpetuated them themselves. It was like a carbon copy of what led to the Great Depression.

But generational cycles are not always bad. Like all cycles of their sort, they have expansionary and contractionary periods - very much like the seasons. So while all signs point to much of the western world (more accurately, any nation that participated in WWII) being in the thick of a generational crisis era, there are other parts of the world, that are in different points in their own respective cycles. This may prove to be important for investors, looking for growth around the world as their own asset markets experience much needed corrections.

Many South American nations fit this description. Specifically, Argentina, Brazil, Chile, Colombia, Peru and Uruguay.

Whenever I am in conversation with other investment managers and economists, bringing up these countries as ideal areas for investment results in scrunched noses and shaking heads. After all, they have recent histories of hyperinflation, corruption, drug lords and brutal dictatorships.

"Precisely," I answer.

The recent histories of these nations are awful. Just 20 years ago, nearly all were controlled by corrupt dictators. Senseless killing was a way of life. Political opponents would simply disappear or fight guerilla wars with government armies. Socialist price fixing schemes left food and medical care in short supply.

In 1985, the military dictatorship was overthrown in Brazil. In 1988, democracy was restored in Chile. Pablo Escobar was killed in 1993 and the drug cartels that terrorized Colombia were nearly completely destroyed a few short years after. Argentina's "Dirty War" ended in the early 80's and democracy was restored. Unfortunately, continually poor economic policy has led to recurrent crises. Regardless, the standard of living has continually risen since 1990.

The recent memory of these issues provides the perception that South American countries were always this way and always will be. But this is not the case. Argentina and Chile in the early part of the 20th century were some of the wealthiest and most advanced nations in the world. European wars led to an influx of educated immigrants that embraced the resource rich lands and prosperity abounded. "He's as rich as an Argentine" was a popular expression.

After spending 5 months during '06-'07, primarily in Chile, I feel like I can offer some insight into how they have definitely changed their ways. The Chilean people are incredibly well educated. And they are consistently ranked as having the most economic freedom of any country in the developing world. One particular observation stuck: the Chilean's commitment to higher education. Riding on the subway in Santiago was the best way to experience this. In much of North America, the banner ads in the station and train cars are full of chewing gum, television shows, deoderant and other useless gimmicks. In Santiago, most are occupied by post-secondary schools. And if one were to ride the subway in the evening, many of the commuters are not going home from work, they're on their way to night classes. Chileans are intently focused on the future. And when one talks about the future there, one talks about 10 years, not 10 months.

The reason behind this can easily be found in demographics. In conjunction with the end of major crises and the beginning of new freedoms, people tend to be fairly jubilant, resulting in baby booms. And in the late 80's/early 90's most of these nations I've mentioned experienced enormous baby booms. Today, they have some of the youngest populations in the developing world with - according to the CIA world factbook - between 23-29% of their populations 14 years old and younger. China, in contrast, has only 19% (and enormous issues with male/female disparity). Germany and Japan sit around 13.5%. Other nations with higher ratios of young populations are typically marred by high infant mortality rates, famine and/or HIV.

With such a burgeoning young population and the recent memory of brutal dictatorships still ingrained in the memories of their parents, these societies are naturally disinclined to extremism, protectionism, violence and corruption. The best analogy for this is America in the decades following WWII. The generational High and generational Awakening eras are typically favourable eras for investment due to the natural increasing demand from younger generations. They are also characterized by something else: utter paranoia of the bad times returning. Again, think of America in the 50's and early 60's. Nuclear war with the Soviets was thought of as an inevitability. And every recession was met with fears of a depressionary repeat of the 30's. Each bout of this pessimism was met with large stock market declines, only to be followed with breathtaking rallies, innovation booms and a rising standards of living.

With that in mind, I came across an article yesterday about Colombia that typifies this mentality. The content of the article is not all that important (the Colombians are having continuous issues with neighbouring Venezuela and their lunatic dictator Hugo Chavez). But the fact that so many are fearful of this escalating into a broader conflict is typical of a generational Awakening era. These are the types of events that dampen positive social mood, creating huge selloffs in asset markets and allowing for low-risk entries into burgeoning markets.

South American stock markets have indeed come under the same allure as other emerging markets from the US Dollar carry trade. And they will likely succumb to similar panics when this inevitably unwinds. But the favourable demographic positions of many of these nations will have me buying dips in anticipation of continued future prosperity, stability and an eventual leadership role in world affairs.

South America is often lumped in with other emerging markets as part of the same US consumer dependent globalization trade. I have reason to believe their growth is based on firmer foundations.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Technical Update 42.09

2009-11-01T05:00:00.000-08:00

Today will be a more in-depth post covering the equity and currency markets.

The largest one week decline since early May and the breaking of numerous important trendlines has shifted the odds in favour of the bearish camp. While near term technicals provide good cause for an early week bounce, last week's change in character suggest that this should be used to lighten long positions as opposed to the previous norm of buying dips. The list of indicators I have been using to confirm this move is not yet complete, however. There remains a few holdouts. Presumably, a significant push below the early October lows (1019) or the September lows (991) would satisfy these requirements.

First, the list of indicators I have been tracking, posted as it has been for the past few weeks:

1. Consecutive daily declines of 2.5% or more. This hasn't happened since the rally began (if so, only marginally).
2. Weaker internals than previously displayed during the rally via 10 day moving averages of a) put/call ratio b) advance/decline issues c) advance/decline volume.
3. A considerable increase in the US Dollar Index. A crossover of the 20 day EMA over the 50 day EMA is something that has not yet occurred since early April.
4. Divergence between major indices. Dow, S&P, Nasdaq, Transports, Banks. We should see significant divergence between some of these indices at a major top. There have been divergences present at various points, but they have quickly resolved themselves. Specifically, I am looking for underperformance in the transports, banks and/or the nasdaq.
5. A complete Elliott Wave '5' down on more than an intraday basis.

Below is a weekly chart of the S&P 500. It has breached its trendline from the March lows significantly. However, it is common practice for price to test the underside of that line once broken. Notice the negative divergences on the RSI. Also note the imminent MACD crossover.

Weakness in the secondary indices is one of the signals I have been watching for at a market top. We had a failure in many of these indices to surpass their September highs, even as broader indices did so. And now we have these same indices underperforming on the way down. This is textbook relative weakness. And it is exactly what one would expect to see at a top. In addition, we have RSI divergences, MACD crossovers, trendline breaks, increasing volume and important moving averages being broken over the past week. I don't know how much more clear-cut this could be. In order of appearance below we have Dow Transports, Dow Utilities, Russell 2000 and the Semiconductors Index.

Please do not read into this that a crash is imminent. As we have seen countless times, such divergences can persist for longer than most expect. Throughout the 2007 topping process, we had such persistent divergences in many indices even as the broader indices continued higher. Each push higher resulted in even stronger divergences while slowly convincing people that they were not important. As soon as attention dissipated, only then did they manifest into significant declines.

As for market internals, we had been experiencing progressively weaker market breadth and advancing volume as the indices marched higher from their July lows. As expected, many of these indicators are now displaying their weakest readings since the March lows. Below see the put/call ratio, advancing/declining issues, advancing/declining volume and daily closing TICK (the lone holdout).

The confirmations I have been expecting in the currency markets have been mixed. The USD strengthened by over a percent this week and trendlines were only moderately violated. Continued weakness in the Canadian Dollar and the Euro are the keys to confirming a bottom in the USD. Support for these currencies is wearing thin, however, and failing a swift turnaround, the stage will be set for an unwinding of the "US Dollar carry trade" that would eventually send it significantly past its March high.

The Canadian Dollar specifically appears to be at a very important crossroads. It has experienced some of the most speculative flows during the so-called 'recovery.' As this hot money unwinds in the stock and commodity markets, the Loonie could get hammered significantly. I am using the Loonie as a barometer for risk appetites and watching closely.

The Euro, as I have repeatedly mentioned before, does not have any better intrinsic value than the US Dollar. Yet for some reason Dollar bears have latched on to the currency as some sort of safety hedge. In my opinion, this is quite ignorant to the enormous problems present in the European banking system, their exposure to risky loans in Eastern Europe, and the political issues between the more stable Northern European government balance sheets and those in Ireland as well as the PIGS (Portugal, Italy, Greece, Spain) all of whom are running massive deficits in violation of the Maastricht Treaty.

Technically, it has only marginally broken its trendline, a situation that upon reversal could become a "pinocchio" buy signal. Again, increased attention is warranted.

Good luck next week!

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Podcast #2 With The Optimistic Bear

2009-10-31T10:55:00.000-07:00

I had another interesting discussion with Michael Surkan of The Optimistic Bear on Friday. Among issues touched upon were the last week's stock market performance in the face of primarily positive economic numbers; foreign currency issues and their effects on globalization; emerging markets and whether their outperformance is genuine; the positive nature of various malinvestment liquidations; nanotechnology; the effectiveness of fiscal and monetary stimulus and quite a bit more. Interested readers may wish to have a listen:

Thanks again to Michael for having me on the show.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Deflationary Forces Still Hard At Work

2009-10-28T07:59:00.000-07:00

Today will be a quick post on some of the more deflationary forces that have been going on under the surface over the past few months. It has been fashionable of late to speak of how central bank monetary stimulus and government fiscal stimulus has "brought us out of recession." Tomorrow morning we will get US Q3 GDP numbers, and they will surely be positive. The media will sing the "recession is over" tune until they are hoarse. But they will be wrong. As per usual.

To be sure, many companies and individuals have used the relatively favourable conditions in the bond markets to build capital, refinance their debts and a select few are even acquiring new assets and R&D funding. But this is the exception, not the rule.

What is easily seen by casual observers is that governments and central banks went on a shock & awe campaign in a "war against recession." News happened to stop getting progressively worse around the same time, and the layman assumes one caused the other. They conveniently forget that both fiscal and monetary easing started more than a year and a half prior to the March lows in the stock market. So did these policies all of a sudden go from failure to success overnight? Or had the stock market simply gone "too far, too fast" and needed time to sort out the good from bad?

It is my contention, that it has been a mere correction in the mood of investors and not in the actual health of the capital markets. I have discussed my opposition at length to the money multiplier model of monetary expansion used by central bankers. I believe that their models are incorrect. They state that if they (the central bank) is to deposit $1 of newly created 'money' at a member bank (Bank of America, for example), then BofA will then go and lend $10 to others. As has been discovered by numerous economists over the course of the past few decades, this is precisely backward. Banks lend out money first, based on their belief in the ability to make a profit on their loan. Thereafter, they acquire deposits to meet capital requirements. This explodes the myth that any of the Fed's asset swaps or QE has somehow inflated the money supply. They have merely shifted the existing supply around, hoping that in its new home it will multiply. It hasn't. And it won't. Because it can't.

Below is a chart of the past 60 years of commercial and industrial lending measured as a percentage change from the prior year and as a percentage of total GDP. Despite the hockey stick graph that so many like to point to as evidence of impending hyperinflation, the banks that have been given this so-called "printed money" are not lending it. Lending is falling off a cliff to businesses and shows no signs of turning around. (Chart courtesy Econompic Data)

Why aren't they lending? Are they just being greedy and keeping the money for themselves as the many populist cries imply? Or is something preventing them from lending? Glad you asked. For those with a short memory, the panic of 2008 was caused by people defaulting on mortgages. With a 50% rise in the stock market, one would assume that problem has at least dissipated slightly, right? Wrong. Mortgage delinquencies continue rising. See Exhibit A (from Calculated Risk):

That doesn't look like much in the way of improvement to me. Fannie is in the same bind. And the FHA, which has been recruited by the government to pick up the slack in doling out garbage mortgages, is even worse. Below we can see that although home prices may have ticked up in response to HAMP (cash for cabins), foreclosures (blue bars) have not yet caught up to delinquencies (red bars).

What does that mean? It means that banks cannot foreclose on properties fast enough. Alternatively, they may feel that they can modify these loans or that those that are delinquent will get their jobs back in due time. That is wishful thinking. Not even the flaming optimists see employment turning around anytime soon, and banks have already found that more than 60% of loan modifications re-default within mere months. Either way, there is massive supply of homes that are soon to be bank owned and liquidated.

So I suppose that would explain why banks can't do anything with their "excess reserves." Also keep in mind that much of these reserves are on temporary loan from the Fed in exchange for other garbage securities.

But it is not just the banks that aren't lending. Trade Credit is falling sharply also. As defined by Wikipedia:

Trade credit exists when one firm provides goods or services to a customer with an agreement to bill them later, or receive a shipment or service from a supplier under an agreement to pay them later. It can be viewed as an essential element of capitalization in an operating business because it can reduce the required capital investment to operate the business if it is managed properly. Trade credit is the largest use of capital for a majority of business to business (B2B) sellers in the United States and is a critical source of capital for a majority of all businesses

Chris Whalen of the IRA Analyst interviewed two of the leading corporate credit ratings firms, Jerry Flum and Bill Danner. Below are some excerpts, but the whole interview is worthy of a read.

The IRA: So what are you seeing at CRMZ in terms of corporate credit, accounts receivable and the data you gather?

Danner: The dollar value of accounts receivable we collect are down sharply. In general vendor credit is down much more than the drop in bank lending.

Flum: Not only that, but you've got to remember that the rate of gain and the expansion of bank lending is down. If trade payables are also down, then there is no grease for the real economy.

Danner: Yes, to put a finer point on it, trade credit is down bigger than bank lending. Remember that commercial receivables are huge, something like 3x commercial bank loans. This is the real economy's lifeblood, but trade credit is down more than the decline in sales and down more than the decline in bank lending, including metrics you guys track on banks like exposure at default ("EAD").
...
Flum: I have been doing this for 40 years. Started in the financial business after working at a law firm. I got my head handed to me in 1973-74 in my hedge fund and had to learn how markets behave. When I boil what I've learned all down to one factor that drives the markets and an economy, it is debt. Debt vs. GDP, for example. Every dollar of debt moves a future purchase into the present.

The IRA: In a fiat money system, there is no money, only credit.

Flum: Correct, and as credit grows we spend more of it now. So, if you look at debt vs. GDP, we are already at record levels. We can also look at incremental debt vs. incremental GDP. In the 1950s, it took $1.50 in debt to produce an incremental $1 of GDP. Today it takes more than $6 in debt to produce a $1 of GDP, so we are approaching the end of the game. This economic inefficiency is a sign of being closer to the top than the bottom and a new beginning.
...
The IRA: So the efforts to restore the commercial paper markets and add liquidity to the markets has not trickled-down? The Fed would tell you that they have restored normalcy

Danner: The numbers we are seeing on A/R and trade credit volumes are continuing to get worse, not better. A big part of that is financing.

So much for monetary stimulus. Behind the smoke and mirrors from the central banks and the flashy lights in our financial media, absolutely nothing has been achieved by these measures. That is, if one chooses to ignore the unintended consequences.

But what about the government stimulus measures. Surely the various programs and stimulus cash is having its effect on the economy? Not likely. Again, the models that suggest that this works suffer from a similar affliction: they ignore debt. And in a credit inspired recession, adding more debt does nothing good. Sure, it can be good for some people who are direct recipients of the loot. But for the rest of the taxpayers and businesses, the implied future rate of taxation rises in lockstep. This is something that I have mentioned before, but I had not heard anyone else take up the cause. Until yesterday when I happened upon a fairly wonkish post from Rob Parenteau. In it he makes the same observation:

DoctoRx next considers a contradiction in using policy responses to debt deflation dynamics that require higher government debt. He suggests we best think of the government balance sheet as consolidated with the domestic private sector balance sheet, since Treasury debt is an obligation that ultimately must be paid by taxpayers. This of course is a variant of the Ricardian equivalence argument, whereby fiscal stimulus is deemed to be ineffective at inducing economic growth since the households receiving higher income from deficit spending simply save the entire proceeds in expectation of future tax liabilities of equal magnitude. DoctoRx is probing along similar lines when he observes, “after all, the private sector has to debit its bank account to send the funds to the government in order to buy the debt. All that is really happening is that the private sector had cash, and now the government has the cash with some repayment terms.” Fiscal deficits are, in other words, just an asset swap.
...
Money and finance are not neutral with respect to real economic outcomes, nor is money simply a veil for real exchange, as is taught in mainstream economics and as is held as holy truth by contemporary central bankers. Read a little Fisher or a little Minsky, and then reflect on recent events. Did we destroy some productive resources, lose some technical knowledge, or otherwise experience an exogenous productivity shock to drop into the deepest recession of the post WWII period, or was the drop in real economic activity in no small part a result of a highly leveraged private financial and nonfinancial sector encountering some very drastic financial conditions as fraudulent loans and fraudulent debt ratings were exposed? Does the government need the private sector’s money to “fund” its expenditures when a) the nonbank private sector cannot create money, and b) the government creates the money the private sector accumulates to pay taxes and buy bonds? Under what conditions can the business sector as a whole accumulate tangible capital without issuing financial liabilities, and are those conditions we observe in the real world around us?

Again, read the entire piece. Have a drink beforehand as it runs deep to the present situation. Parenteau, the Austrians, and followers of Minsky's Financial Instability Hypothesis understand that debt is the problem. They understand that either shuffling it around (as are central banks) or creating more of it (as are governments) is not a viable way to combat credit deflation, while it may 'work' during a run-of-the-mill overcapacity recession.

The equity and commodity markets are acting as if there is no difference between the characteristics of the two separate types of economic contractions, responding as they would to the expected recovery from undercapacity. As we can see from the charts above, the deflationary forces that began the crisis two years ago continue to accelerate.

Bernanke and Geithner are trying to fit a square peg in a round hole. Vegas odds are 1:1 on them succeeding.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Technical Update 41.09

2009-10-25T09:17:00.000-07:00

Another interim top has materialized. Like all of the other tops along the way, it will require a significant change in market character prior to allowing for confirmation of the primary top I am expecting. For the past few weeks I have outlined a number of factors that would help make this distinction.

1. Consecutive daily declines of 2.5% or more. This hasn't happened since the rally began (if so, only marginally).
2. Weaker internals than previously displayed during the rally via 10 day moving averages of a) put/call ratio b) advance/decline issues c) advance/decline volume.
3. A considerable increase in the US Dollar Index. A crossover of the 20 day EMA over the 50 day EMA is something that has not yet occurred since early April.
4. Divergence between major indices. Dow, S&P, Nasdaq, Transports, Banks. We should see significant divergence between some of these indices at a major top. There have been divergences present at various points, but they have quickly resolved themselves. Specifically, I am looking for underperformance in the transports, banks and/or the nasdaq.
5. A complete Elliott Wave '5' down on more than an intraday basis.

We are seeing early signs of divergence in certain indices, but not others. And market internals seem to be getting progressively weaker on any push higher. On an anecdotal level, I can sense mood shifting toward pessimism again. Earnings reports, while still very weak, have largely blown away analyst 'expectations.' Yet for the most part, this has not resulted in favourable reactions in the overall market. The US Dollar remains subdued, falling marginally with the market this week.

On March 3rd, I wrote about certain stocks and sectors that had been displaying relative strength in opposition with their November lows. Indeed, most of the stocks mentioned have enjoyed more than 100% gains from their lows. Of course, one would have done better buying some of the worst performing sectors, but picking the winners that experienced 1400% gains over those that only got 14% was impossible to determine at the time. Back in March, there was little that would suggest Fifth Third (FITB) would drastically outperform Keycorp (KEY), but momentum chasing of the former allowed this to happen.

I am currently tracking a list of stocks and sectors that are showing relative weakness to the overall market. Similarly, there may be greater downside potential found in those that have made the greatest gains over the past 7 months, but with those comes also greater risk. Trading in high beta sectors is a double edged sword. Below are some sectors that have failed to confirm the market's new October high. If I were looking for short opportunities, these sectors are where I believe the lowest risk will be found.

Transports and particularly the railroads have shown some of the most notable underperformance. For the week, both finished down more than 5%.

The solar energy sector topped in June and has been meandering sideways since then.

The biotechnology sector happens to be one of my favourites from a long term fundamental standpoint. But it is now also an underperformer over the past month, giving back more than 6% last week alone.

It is no secret that the problems with the banks are yet to be resolved. For much of the rally, bank share prices have been the leader in hopes that eventually "everything will work itself out." But they are not leaders any longer, showing weakness over the past two months and only able to marginally achieve new highs despite better than expected earnings numbers.

But weakness can be seen even more in Canadian financial institutions.

Another area that has received heightened attention by central planners is the housing market. It is believed by most contemporary economists that if home prices would just start rising again, then all the problems will go away. This comes from a fallacious interpretation of what went wrong last year, but it hasn't stopped them from trying all sorts of policies to fix home prices. Regardless, the homebuilding industry is now also displaying weakness. "You can't fool all the people all the time..."

Have a great week!

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Podcast With The Optimistic Bear

2009-10-21T08:43:00.001-07:00

Last night I participated in a podcast with Michael Surkan of The Optimistic Bear.

We discussed a number of issues ranging from international banking, the inflation/deflation debate and health care to generational cycles and the secular changes I see developing in attitudes toward risk. You may listen to the full interview in the player below.

There were some other issues that I was hoping to touch on. For instance, I did come across as quite the pessimist in the interview. In fact, I see myself as more of an optimist. I view the contraction of credit and falling asset prices as positive, not negative. In order for organic productivity-inspired growth to occur, the dead waste needs to be cleared first. So I don't view the onset of depression as "armageddon," rather as the first stage to future prosperity.

If time were never an issue, I could have also elucidated some areas I believe will be kind to investors in the intermediate term. I am very positive on the prospects of South America. Much of the continent has far more favourable demographics than other emerging markets. And from a generational perspective, many nations have put their dark histories with dictatorial governments behind them (eg. Pinochet). Chile, Colombia, Uruguay, Brazil, Peru and eventually Argentina (when they get their house in order) should all be ideal investment areas over the coming decades. I am also very positive on the eventual application of nanotechnologies, and I believe this will be a spectacular area of growth once the required investment resources are freed from their current wastefulness.

I'd like to thank Mike for being a great host and having me on his show. Hopefully my readers find it to be worthy of their time. It was the first time I have attempted something like this, so any feedback on the subject matter or even my communication abilities would be much appreciated!

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Technical Update 40.09

2009-10-18T14:29:00.000-07:00

The major indices finished the week higher, a feat achieved 24 of the last 34 weeks (70.5%). Rising stock prices seem to be ingraining themselves into the collective conscience of market participants even as confidence measures remain somewhat benign. It tells me that while many do not believe the economic recovery story, they have become exhausted with trying to short it. Many have taken a similar posture as myself, waiting for confirmation of a move before committing capital to shorts or liquidating longs. Being a person constantly looking for contrary indicators, my own emotions and those of others typically provide clues to changes ahead. Perhaps this is one of those times...

It is a market driven by momentum. In talking with various colleagues, I try to get a handle of how much conviction buyers seem to have. I don't get the feeling that many of those holding substantial long positions would tolerate much of a decline before checking out. Where are the stops? A 10% market decline? If many are indeed acting under this sort of a mentality, a selling panic could easily ensue once this line is crossed.

But that is subject for another day. Today, we have a climbing market to chart. Other than a nasty underperformance this week in banks, transports and the nasdaq, we have not yet come close to satisfying the qualifications I am waiting for.

1. Consecutive daily declines of 2.5% or more. This hasn't happened since the rally began (if so, only marginally).
2. Weaker internals than previously displayed during the rally via 10 day moving averages of a) put/call ratio b) advance/decline issues c) advance/decline volume.
3. A considerable increase in the US Dollar Index. A crossover of the 20 day EMA over the 50 day EMA is something that has not yet occurred since early April.
4. Divergence between major indices. Dow, S&P, Nasdaq, Transports, Banks. We should see significant divergence between some of these indices at a major top. There have been divergences present at various points, but they have quickly resolved themselves. Specifically, I am looking for underperformance in the transports, banks and/or the nasdaq.
5. A complete Elliott Wave '5' down on more than an intraday basis.

The recent push from the early October low of 1019 has certainly been achieved with declining participation. See the divergence below:

The ratio of the Dow to the S&P seems to move contra-cyclically. The Dow underperformed on the way down and now outperforms. A divergence in ratios like this, as well as with the Nasdaq may provide a window to the market's internal happenings.

I'm also watching the ratio between the VIX and VXV. This monitors the premium/discount of 3 month volatility to that of the present. As future volatility gets sucked out of future option prices, the ratio falls. For months, option traders were willing to pay a premium for September or October options. Due to seasonality it seems that many had been forecasting a market turn by either of these months. With October expiry out of the way, any distortions this may have created may be free to resolve themselves.

I do find it interesting that such an enormous consensus exists in utter hatred for the USD. Nearly everyone has been sold the story that the Dollar is destined to soon become worthless. But what is really interesting is that this has occurred while the dollar index remains well above its prior lows. I am anticipating a sharp move higher one of these weeks that will trigger quite a bout of short covering.

Have a great week!

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Market Breakout, Bonds, Oil and Earnings

2009-10-15T09:20:00.000-07:00

Third quarter earnings have been seeping out this week, mostly to critical acclaim. Thus far, profits from the big financials appear to be mostly concentrated in proprietary trading (again). And once again, there's very little transparency to the banks' actual balance sheet due to the suspension of mark to market accounting. The plan is that these rules will be reinstated by yearend, and the consequences to earnings are quite obviously ground-moving. Cynically, it should be assumed that these banks will throw untold millions at lawmakers to have the rules postponed again. But the real question is not necessarily the rules themselves, rather the willingness of speculators to take the risk.

Risk appetite trumps fundamentals.

I wish I could be bullish on the economy. But I do not see the proper characteristics for sustainable economic growth. Money is being piled into the old bubble sectors (FIRE - Financials, Insurance, Real Estate), which themselves produce no wealth. Meanwhile, small businesses, startups and individual consumers are starved for both capital and access to credit. I struggle with how this could go on for so long, but I then think back to '07 when everything was similarly levitating in the face of the blatantly obvious. The necessary deleveraging was also avoided in '01-02 and continued for years. So while I prepare for the possibility that this lasts much longer than anyone expects, I don't foresee it doing so.

One thing I do expect is confusion. Lots of it. I expect to see some major separation from previous positive correlations. For instance, long term interest rates have risen substantially over the last two weeks (30 yr treasury yield up 43 basis points), and I have a feeling that this may be a more permanent sort of move. I would not be surprised if the long bond starts trading as a risk asset on any subsequent market decline. Rising rates are also something that has the potential to kill what many are calling a bottom in the housing market (I think not).

Oil may also be something that finds some separation from its recent 'beta' with the stock market. It seems like forever, but there was a time when rising oil prices were seen as a bad thing, and every tick higher in crude was matched by a tick lower in stocks. Oil broke out above new highs this morning above my long standing cited resistance around $75, many technicians see it with little resistance up toward $100. Whether the market reacts to this negatively or not, it is going to start putting big pressure on consumers. And if there is one thing that angers populations more than anything, it is rising gas prices. It would be sweet irony if rising oil prices, at first thought to be a harbinger of economic growth, eventually killed the rebound in social mood and sapped the willingness of consumers to consume - just as we edge into Christmas shopping season.

Traders and investors become married to correlations. When they break, they cause chaos for weeks at a time while managers reposition their portfolios for what seems like the "new normal." The present correlations have held for quite a while, likely lulling many into complacency. Watch them carefully.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Technical Update 39.09

2009-10-10T09:44:00.000-07:00

The material change in market character we were looking for did not materialize. As suggested, the first whiff of this led to bulls piling back on and quickly retesting the previous highs. Without significant followthrough from last week's decline it was readily apparent by Monday that dip buyers had not exhausted themselves and the risk seeking behaviour we have witnessed over the last seven months would reassert itself.

The Elliott Wave structure was confirmation of this after failing to register 5 full waves to the downside. The most probable counts now show the S&P rising in either a 5th wave to ~1120 peak or a 1st wave of something far more bullish (projecting to over 1200). The rally obviously intends to destroy as many bears as possible prior to reversing. Maximum ruin indeed.

Two weeks ago I outlined 3 indicators I was watching for confirmation of a rally peak. I will expand on that this week with a few more and will continually track them as the weeks pass. Readers can feel free to add their own.

1. Consecutive daily declines of 2.5% or more. This hasn't happened since the rally began (if so, only marginally).
2. Weaker internals than previously displayed during the rally via 10 day moving averages of a) put/call ratio b) advance/decline issues c) advance/decline volume.
3. A considerable increase in the US Dollar Index. A crossover of the 20 day EMA over the 50 day EMA is something that has not yet occurred since early April.
4. Divergence between major indices. Dow, S&P, Nasdaq, Transports, Banks. We should see significant divergence between some of these indices at a major top. There have been divergences present at various points, but they have quickly resolved themselves. Specifically, I am looking for underperformance in the transports, banks and/or the nasdaq.
5. A complete Elliott Wave '5' down on more than an intraday basis.

All or most of these factors should be present in the first 10% decline from the highs. Until then, it should be considered that the bull trend remains intact. It seems that too many are focused on calling the exact top (I'm guilty of this sometimes) rather than waiting for confirmation. Keeping it simple is typically the most prudent course when using technical analysis for timing entries and exits. And most of the best known traders adhere to this principle. Giving the market 10% on either side of a large move still allows one to participate for 80% of the move.

The German DAX has a very logical target denoted by the blue line on the following chart. The 6100-6200 area has proven to be a point of inflection numerous times over the past few years. And it is also where the Mar-Jun wave A would be of equal size to a wave C peak.

Finally, it needs to be pointed out that the US long bond experienced two consecutive days of intense selling to close out the week. What is it trying to say? Is it sensing a potential rise in the Fed Funds rate? Is the long bond now trading as a risk asset class? Is the cessation of Fed POMO activity being reflected by interest rates rising to a more natural level? Nobody knows for sure, but the activity is certainly deserving of attention.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Weighing In On Fractional Reserve Lending

2009-10-06T11:32:00.000-07:00

Mish and Karl Denninger have been having an interesting back and forth on the topic of fractional reserve lending. There is vast disagreement on this subject even within various schools of economic thought. It does not seem to be an ideological debate, but rather a juridical one, which makes it less emotional and perhaps worthy of debate.

Both Mish and Karl bring up good points about what is fraudulent about our financial system. Mish feels it is more systemic and Karl thinks it is a lack of regulatory will (due to capture, corruption, etc). I have stated previously that with a proper legal foundation, no regulation is necessary. So I would have to agree more with Mish. I sent him an e-mail this morning, which I will republish here:

Mish,

The best arguments against FRL I have read can be found in Jesus Huerta de Soto's Money, Bank Credit and Economic Cycles.

You touched upon this, but de Soto has a better way of explaining it through a historical (dating back thousands of years) understanding on the nature of contract law. When a depositor gives their money to a bank, they are doing so under the impression that the bank keeps their money safe. If this were not the case, people would buy bonds or some other investment. Historically, the act of keeping money safe was a service that depositors would pay for. By lending money out that has been promised to someone else, the bank is abrogating their contract with the depositor. In order to do so, the bank must consider the deposit as an asset, something the depositor simultaneously believes he has. Very simple contract law states that two separate entities can not claim ownership to the same asset. Thus, the bank is guilty of misappropriation by promising safekeeping of something they do not possess.

The confusion seems to surround the difference between two distinct types of contracts: the Monetary Irregular Deposit and the Monetary Loan. Below is a table copied from pp. 19 of Money, Bank Credit and Economic Cycles, contrasting the two types of contracts:

Economic Differences:

Monetary Irregular Deposit: 1. Present Goods are not exchanged for future goods. 2. There is complete, continuous availability in favour of the depositor. 3. There is no interest, since present goods are not exchanged for future goods.

Monetary Loan: 1. Present goods are exchanged for future goods. 2. Full availability is transferred from lender to borrower. 3. There is interest, since present foods are exchanged for future goods.

Legal Differences:

Monetary Irregular Deposit: 1. The essential element (and the depositor's main motivation) is the custody or safekeeping of the tantundum [deposit]. 2. There is no term for returning the money, but rather the contract is "on demand." 3. The depositary's obligation is to keep the tantundum available to the depositor at all times (100 percent cash reserve).

Monetary Loan: 1. The essential element is the transfer of availability of the present goods to the borrower. 2. The contract requires the establishment of a term for the return of the loan and calculation and payment of interest. 3. The borrower's obligation is to return the tantundem at the end of the term and to pay the agreed-upon interest.

Similar to a monetary irregular deposit would be the storage of crude oil in large tanks. The depositor of the oil pays the storage company a fee. The storage company cannot now go out and sell the oil - that would breach their contract.

Time and time again, throughout history, bankers have attempted to turn monetary irregular deposits into monetary loans in order to speculate with their customer's deposits. Throughout history, from Ancient Greece to the early 20th century it has been determined in courts of law that this practice is illegal. We have institutionalized it. We have created all sorts of fancy schemes in order to cover up this misappropriation (think FDIC). And we have central banks who attempt to mandate positive inflation which encourages depositors to seek return rather than safety with their life savings.

We need a banking system that clearly separates the two kinds of contracts: Depositary Institutions and Loan Intermediaries. With such a system, the central bank's ability to perpetually inflate will be castrated and a truly free-market would be able to prosper (something we have never had). Note that this does not require a gold standard for discipline. A currency could be denominated in anything so long as the legal principles of the monetary irregular deposit were upheld.

Addendum:

To elaborate on the last point. I am not in favour of a legislated gold standard. Although I do believe gold would have a role to play as a medium of exchange if it were permitted (ie. if legal tender laws were repealed). Many of gold's detractors fail to discriminate between Gold Exchange Standards, Bimetalism and 100% reserve gold standards. The latter has very few historical examples of any length. But this is conjecture. I am in favour of multiple competitive currencies which may be freely exchanged electronically, provided 100% reserves are kept and available at any time. There is no reason, with our current technology, for this to be prohibitively complicated. I walk into a bakery to buy a loaf of bread. I elect to pay at the cashier from my account with wheat. If the baker doesn't want wheat, he can program his account to immediately convert wheat to gold or land or whatever she chooses. The intermediary charges a small fee each time this occurs.

Separately, other intermediaries may provide participants the ability to borrow from others who are in the market to lend. Rates would vary according to the risk taken and a term would be agreed upon prior to the transaction completed.

Some Austrians argue that this would effectively end the business cycle. I disagree. There would still be a very noticeable boom/bust cycle because entrepreneurs will always display a herding behaviour and fail regularly. However, the busts would not be systemically jeopardizing due to the lack of leverage. Banks would be mere service providers, not permitted to speculate themselves. Thus, their ability to create loans prior to finding lenders, essentially playing arbitrage on current asset prices vs. inflation adjusted asset prices, will be nixed.

The giant vampire squid's blood funnel would be cut off.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.