Saturday, July 13, 2013

When Growth Is Fueled By Nothing But Debt

In 2003 Richard Russell encouraged his subscribers to buy gold stocks, particularly NEM. I took his recommendation and bought NEM at around $23 a share. I accumulated more NEM over the next couple of years. It paid a good dividend as well, something I had forgotten stocks did back in the late-1990's when I rarely kept any stock longer than a 8-9 weeks. When the exchange traded fund GLD was created around 2005 I bought shares, more and more shares. I blogged about one of my final, big buys.

It is no secret on this blog that I have been heavily leveraged in the GLD/SLV/NEM sphere of things.

In 2012, unannounced on this blog, I sold every share of GLD I owned at about $168 a share. In the fall of 2011 I sold my entire position of NEM at about $69 a share, managing to hit that one near its peak. In this general timeframe, I also sold my position in SLV but left the profits invested. The phrase "take profits" seems strange to me. It seems more prudent to "take invested capital" and leave your profits in the investment. As I see it, then you have nothing to lose. If profits generate further profits - great, but if profits falter then you are not losing your investment. You are merely losing a bit of what you made on your investment. You still have your original money.

It felt odd owning no GLD or NEM after accumulating so much for so long. Indeed, I owned no stocks but for those in some mutual funds. After a few weeks, when GLD slipped considerably, I started making buys back into the ETF, along with a heavier emphasis on SLV. Before all this selling took place this portion of my portfolio consisted of about 56% of my investable assets. By selling almost all of it and by gradually buying back in a little as prices came down and seemed, at the time, more attractive, this portfolio became more like 15% of my assets. I was very cash heavy again, except for some mutual funds that Jennifer had gotten us in to beginning in 2011.  Those have been profitable.

Now gold and silver have crashed. After a long (and uncorrected) bull market run which I personally rode for about nine years, things suddenly turned sour, went south, whatever. No bull market lasts forever and perhaps I got too greedy or too complacent with the management of my holdings. While I have made more money than I have lost overall, it is no great joy that I have lost thousands of dollars (on paper, I have not sold any of the "newer" GLD or SLV positions) in this gold crash. It just goes to show you...nobody knows what will happen.

For weeks since it happened I have tried to understand the reason(s) for this historic crash. I do not believe the many theories of manipulation. It is true, however, that Goldman Sachs shorted the hell out of gold while JPMorgan inherited an enormous silver short position from now liquidated Bear Sterns. Apparently, those positions are now covered. My understanding is that JPMorgan is now buying back into gold.

The best answer to the crash, in my unschooled opinion, is it is not a crash. The Gold Sphere has been long overdue for a correction. It is a case of turbo SnapBack, combined with Wall Street investment bankers knowing how to manage their vast amounts of money, combined with a bullish stock market (lack of fear devalues gold), combined with the association of Ben Bernanke's Fed Policy with the devaluation of the US dollar (as QE ramps up gold goes up, but the gold price dropped on the idea of a QE-less world). All that created a perfect storm for gold and gold stocks and silver to go down. Way down.

Most now believe the great gold bull market has ended. If, in the coming weeks, I feel they are correct I will look to exit and take my losses as an expensive lesson. That is certainly an option. But gold is way (way, way) oversold right now and overdue for some sort of rally even if this is the beginning of a gold bear market. It behooves to sell into rallies when the bear is around. But the advisers I have followed most closely these last several years disagree. They think this is an overdue correction and the gold bull market will continue. Of course, no one knows WHEN.

So, I am taking Douglas Adams' brilliant advice. Don't panic. I will likely hold on to my little piece of the gold and silver universe. I might sell it all again, however, if I get no indication that the bull market will resume in the near future. Or I might buy more while the price is of greater value (assuming the bull is intact). Who knows? I am not confident enough to add to my gold right now, but I am not ruling out future buys as it (probably tentatively) makes its way back toward the $1500 mark.

For the record, gold peaked in the late-summer of 2011 at about $1900. A historic high. It recently fell to about $1180. While my trading last year meant I didn't experience some of that decline, gold's recent action hurts. Gold sucks right now which just goes to show I don't really know that much. Of course, that doesn't stop me from acting on what I think is going to happen. In the end, I'd rather be lucky than good. So far, I consider myself very lucky in spite of the recent pain.

So what do I think is going to happen? Investing is supposed to be analytical, dispassionate, and measured. Dow Theory is a great guide in that regard. As I mentioned in January, that theory has given a bull signal for stocks and, as of this post, the primary trend according to that time-tested theory is bullish.  Jennifer’s mutual fund bets have prospered.

But I have adopted an economic philosophy over the last two decades. As I have always blogged, long-term debt is bad. I have an admittedly blind faith that an economy can't have massive gains in growth and wealth fundamentally fueled by the creation of debt. Yet that is precisely how the capitalistic west has driven its consumer culture since the end of World War Two. The final ripples are now coming to China and India. Maybe one day to central Africa.

Eventually the markets fueled by central bank debt place such a weight on the pristine market forces themselves that capital becomes....what?

That is the question. What becomes of capital in this debt-ridden situation? De-leveraging in the private sector means more capital for the consumer culture. Does this force outweigh the amassing of central bank debt? The answer to this question validates either inflation or deflation. Or possibly stagflation. Gold wins only in an inflationary world, or at least in fear of potential inflation. In deflation everything goes down as the value of the dollar rises. In the debt game the last thing we want is deflation because a strong dollar makes the weight of public debt feel heavier. Which, it seems to me, ultimately makes inflation the most likely outcome.

Dave Stockman, former head of Ronald Reagan's Office of Management and Budget, summarized the situation in this recent video: "What happened in September-October 2008 was a drastic, horrendous, historical mistake. It was a Rubicon because it was done by a republican White House and it was done by a republican congress and administration. And so, if they are going to throw out all the rules of free markets, if they're going to throw fiscal rectitude to the winds, passing the $700 billion TARP, if they're going to basically say that markets don't work and therefore anything that is big and interactive can't be allowed to fail, that is financial institutions, when it makes mistakes...when all of that happens you can't go back to Kansas anymore. It's gone. Free markets are gone. Fiscal management is gone. Any kind of notion of central bank prudence is gone after Bernanke increased the balance sheet of the Fed, and this is a startling fact, Bernanke increased the balance sheet of the Fed between Lehman, September 15 and October 27, that's roughly seven weeks, by $900 billion...the reason I bring it up is that the first $900 billion of the balance sheet of the Fed had taken 94 years to produce....Bernanke replicated it in seven weeks of panic. And then he tripled it in 15 weeks through the end of December, that got it to $2.3 trillion and now you know where it is today, $3.4 trillion and even if they start to taper, if they can figure out what they're doing, we're going to end up in the $4-$5 trillion range. So this is a central bank that is a rouge institution, run by hopeless Keynesian academic zealots, who don't understand that interest rates are the price of money, and they're not smart enough, those 12 geniuses on the Fed, to figure out the entire market of the world and everything that moves back and forth by the nanosecond ought to be priced. But that is what they are doing today. It is a mission meant to blow-up, explode, create a massive dislocation and failure and it is only a matter of time. The good news is that Bernanke is going back to Princeton in a few months. The bad news is that Yellen is worse. So, if any of you have hope, don't, because it’s not merited."

Now, I don't agree with how Stockman categorizes the start of the Great Recession. He basically dismisses fragility to debt exposure as a myth and says there was never such a thing as contagion. As I blogged elsewhere, good reporting has been done on this topic and it would contradict Stockman's perspective. But in the particular matter quoted above Stockman is absolutely accurate. What I think has happened is we have crossed the Rubicon. It is an amazing time to be alive, because I feel debt economically changes the world at least as much as growth.

Debt is the assumption of someone else’s capital in order to acquire things, whether a consumerist item or a corporate expansion, with a promise to pay back the capital, plus interest-capital, in the future. Since 1945 there were steady global increases in overall public and private debt via the expansion of credit into the general population. The assumption of debt has traditionally been rewarded with overall economic growth, which generates new capital which pays off debt and allows for further assumption of new debt which, in turn, feeds new capital growth.

That paradigm shifted beginning in Japan in the 1990's and in the western world in the 21st century. Growth no longer generated new capital. Instead, growth generated nothing except demand for more debt. New capital generation came not from growth itself but from an expansion of credit alone. As soon as credit expansion (predominantly via central banking) became subdued or restricted then growth suffered. This is a fact of the Now.

There has been a lot of news about the dot com bubble and the real estate bubble and the capital markets bubble. All sorts of bubbles. Bubbles occur near the end of every kind of bull market. Bull markets typically “blow-off” at the end before switching to bearish conditions. Likewise, bear markets tend to create a bloody mess and drive everyone out before they turn back to bullish conditions. This has traditionally been the story.

But we live in extraordinary times. Markets are not allowed to express themselves. Central bankers try to control growth via stimulus actions and direct capital (debt) injections that do not necessarily result in capital expansion through consumer-driven growth. This disrupts the post-1945 historical narrative, the norm.

You cannot generate wealth by increasing debt alone. The debt has to be tied to growth and if growth doesn’t come and you add more debt then you are rolling Keynesian dice. This has worked historically and Keynes represents the primary economic school of thought globally. But, what happens to growth when, as we are now, you are saddled with unprecedented debt? We know in Japan this led to stagnation. So far, in Europe it has led to repeated recession.

The US still has by far the most robust economy in the world. So maybe there is no comparing what happens to capital markets here with other capital markets globally. But that seems naive to me. It is difficult to imagine any economic formula where ever-increasing amounts of debt-fueled capital expansion generate sustainable wealth in absence of genuine job growth.  We are in the fog of growth and we look Japanese to me. 

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