The
BIG Picture Transcript
December 15,
2007
Part 1 Real
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Mp3
Part 2 Real
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Part
1
Ben's
On the Job Training
2008
Macro Themes
Part
2
Clearing
the Mechanism: Sitting Tight
The
Simple Things
Q-Calls
DAVID WESSEL: On Tuesday, the Federal Reserve disappointed markets by cutting interest rates only a ¼ percent. Then this morning, joining hands with central banks from Canada and Europe, the Federal Reserve showed that it really hadn't finished its work yesterday. It announced that it is attacking a particular symptom of the current financial crisis: special lending for loans to banks for about a month at a time. That's a part of the market where there has been particular stress and it's an important part of the market. Banks are unwilling to lend to each other at decent rates at that point and that's pushing up rates on adjustable rate mortgages among other things. The Fed also agreed to give some dollars to the central banks in Europe whose client banks, the commercial banks want dollars. They need them for their business and are having trouble getting them. It’s all basically a kind of another attempt by the Federal Reserve and its colleagues in other countries to deal with the particular aspects of this persistent financial crisis.
Will it work? That's an open question. The Fed got a lot of headlines on August 17th when it said it was willing to lend a lot of money to banks through what is called its discount window. Now they’re trying something else. It's a sign really of how seriously they think the current situation is. It's also a major show of force by the Fed and its other foreign central banks, a way of conveying to individual investors, institutions, politicians and the public at large that all of the central bankers of the world are concentrating their resources and thinking on trying to relieve this credit crunch before it plunges the world into a painful recession.
JOHN: That was the voice of David Wessel this week talking about the capital markets. We took that from the Wall Street Journal video site; that’s where it first appeared. You know, I always believed, Jim, when Greenspan was getting out, I thought he should have – I guess this sounds bad, but he should have worn a rat costume as he went over the side of the ship because I really believe he was sort of saying, “Well, I've had my great career, here is a big ball of trouble coming, I want to exit before that happens.”
And we've seen the markets here anticipating all of these rate cuts, but the markets don't seem to be really happy at what's going on at all right now. Not only that, there is all of this flip-flopping going on, so they are busy trying to read what Ben Bernanke is doing, who has now inherited this bailiwick from Alan Greenspan and that's creating a lot of confusion out there right now.
JIM: When the Fed cut interest rates a quarter of a point, a lot of people thought they would cut the federal funds rate a 1/4 of a point and perhaps cut the discount rate a half of a percentage point. And when they only went a quarter and on top of that they made no statement in terms of “hey, we’re neutral, things are balanced” or “we’re leaning more towards weakening economic growth or inflation” –there was no statements – so a lot of people were confused. And I was trying to think: What's going on here. Why did they only cut a quarter? And I think there are a number of reasons why, John. Number one is the dollar, because the dollar has been falling. Had they cut 50 basis points or more without the cooperation of other central banks, you know, we could have the dollar falling, so we could have a currency crisis.
The second –and that's related to the dollar – is up until this week they have not had much cooperation from other central banks. Now, last week, the bank of Canada and the Bank of England cut interest rates, but the ECB held firm and said they are still worried about inflation. They are still where our Federal Reserve was three or four months ago. So number two is no central bank cooperation.
Number three is take a look at on the day you and I talking, the headline inflation numbers, the consumer price index is taking off. On Thursday, the Producer Price is up. So if you take a look at the CPI, PPI, inflation is on the rise; and the thing about this is I think they were hoping that as the economy weakened that these inflation problems would go away. And looking at this from the Fed's point of view, if the economy weakens, that reduces demand for goods, so the price of those goods should go down. Two, if the economy weakens, more people lose their jobs. That takes pressure off in the labor markets. So, the third reason I think the Fed has got to be watching, and why they haven't been as aggressive as they could be, is inflation.
And four –and I think this is the scariest one – I think this is probably the least experienced Federal Reserve group that we've seen. Most of these guys have come out of academia, and if you listen to a lot of things that they say, I don't think these guys really understand how serious a problem they are confronting. [5:15]
JOHN: It's almost like on-the-job training at this point.
JIM: Yeah. I mean that's basically it. I mean if you take a look at all of the flip-flopping (and we'll get into that in just a moment) these guys are being educated as we go full steam ahead into this crisis; and they are sort of learning as they go along in terms of what needs to be done or “wow, this is more serious than we thought.” [5:40]
JOHN: You talked about four reasons here that you really believe why the Fed didn't get aggressive in the whole thing. Which one of the four do you really think carries the weight here?
JIM: I think that it's a combination of at least three. I think they have to be very cognizant of what's going on with the dollar. Secondly, I think they have not been getting much cooperation until recently from other central banks. In other words, if the Fed began to cut interest rates and other central banks cut interest rates as occurred in, let's say, 2001, when we were in a recession and a crisis after 9/11, then there would be less pressure on the dollar. That’s because as we cut our interest rates aggressively here and other central banks don't, then from an interest rate perspective, it's more attractive to be in another currency. That would be less so if other central banks were also slashing their interest rates. So the second is there hasn't been much cooperation.
And then the third is, I think, inflation. I mean if you look at the numbers that are coming out this week, both the PPI numbers and the CPI numbers –and remember these numbers are understated to begin with – but PPI inflation year over year is 6.8%. And even if you look at the CPI numbers year over year they are trending up. They are 4.3%. They've been trending. I mean if you go back six months, they were trending about 2.6%, so now the headline inflation numbers are trending up.
And even some of the core rate of inflation, if you believe in such nonsense, even the core rate of inflation was up 2.6% in the last three months and it's up over the 2% range. You know, you always hear the Fed wants to keep core inflation around 2. So from a Fed perspective, they are dealing with an inflation that’s unlike the 90s when they were mainly dealing with asset inflation and at the beginning of this decade. Now, you're dealing with inflation in the real economy. So you've got a falling dollar, you've got inflation rising and you're not getting the full cooperation of central banks. I think that's about to change. And you even see it in the Fed's statement accompanying the cut on Tuesday. They said they are worried about elevated energy and commodity prices in their statement. The thing about it, John, is what can the Fed do about energy and commodity prices? About the only thing they can do is kill the economy. So if the economy weakens, there is less demand. If the economy weakens, more people lose their jobs. It takes pressure off the labor market.
So anyway, I think those are probably the three that they're dealing with, and why they haven't been as aggressive as, let's say, Greenspan was in 2001. [8:29]
JOHN: This is sort of the end game though, isn't it, when the currency gets to this level, then you don't have the wide swath of options, say, that they had back in the days of Paul Volcker. And as a result of that, what it seems like they are doing now is they are tinkering. It’s sort of like, “I don't care, try anything,” at this stage of the game. And the markets, before which used to sort of worship at the altar of Fed rate increases and decreases, is losing faith in its God. I guess that's the best way to put it.
JOHN: I think that the Fed has a credibility and a confidence issue here. And the reason, if you take a look at Bernanke when he took over the Fed in February of 2006, the first thing that was the famous Maria Bartiromo flip-flop. In April, when he was before Congress, when he was talking about “I see things as easing and we're going to be able to cut,” and he gave the impression that the Fed was going to begin an easing cycle and the markets took off. And then he's at this dinner with Maria and he flip-flops and he says “I think the market misinterpreted what I meant.” And then we had the big selloff that came in May of last year, so we had the Bartiromo flip-flop.
Then you get into August of this year. The Fed meets and they meet in August, they leave rates unchanged and they say: “No. We're worried about inflation.” Two days later, they flop and they cut the discount rate by 50 basis points. Then you get to October and they cut interest rates a quarter of a point and then they go to a neutral stance saying that risks are equally balanced. And then immediately after they cut a quarter of a point, you had Fed governors going out and saying “wow, we're concerned about inflation, maybe we shouldn't have cut interest rates a quarter of a point, maybe we'll have to take that interest rate back.” And people are saying, “what are you guys doing?!” And then three weeks later they are almost panicky talking about, “uh-oh we're concerned about growth in the economy.” And all of a sudden the market has gone in almost a different direction.
And the problem that you have right now is this is probably the most serious financial crisis that we've faced going back to the Asian problem in 97, the S&L problem in 1991. In a time of crisis, markets do not like uncertainty. And so in a time of crisis, markets want to see confidence and I think one of the reasons markets are becoming more jittery is lenders don't trust each other. So at a time of uncertainty, markets want this confidence from government and the regulators. And Bernanke flip-flops...in my opinion, the Fed is losing a lot of credibility here and probably even more important, I don't think Bernanke has got the stature of his predecessor. Usually in the crisis, you look at Greenspan and whether it was the S&L crisis in 91, the Peso crisis in 94, Long Term Capital Management, Greenspan would come out, he would liquefy the market (which the Fed was able to do because there was less debt in the economy), but there was at least a consistency with Greenspan that you don't get that consistency with Bernanke. [11:53]
JOHN: The difference in perception between Greenspan and Bernanke is Greenspan was always able to reassure the markets and assure that he would liquefy as needed. Why was that working at one time and why is it different now? Is it just a matter of the philosophy between the two different Fed chairmans or is it just the situation had gotten so bad that it wouldn't have made a difference if Alan Greenspan were still sitting in the chair?
JIM: I think there would be a difference if Greenspan was still there because he had more of the confidence. You know, if you take a look at Greenspan's career, he spent two and a half decades in Washington, so he understood politics and he had his own consulting firm. I think he had a better understanding of markets. You know, if you take a look at the Federal Reserve as it's composed today, this is probably the least experienced Federal Reserve that we have seen. And that's the scary part at a time that we're in a serious global crisis. And you've only got one member, Donald Kohn who has ever been around to negotiate through a financial crisis. Most of these FOMC members, John, are academics. They have very little understanding or for that matter, very little sympathy for financial markets.
And I think another thing that is very important here between the two personality types, Bernanke is more of a consensus builder. He's more of a bureaucrat rather than a decisive decision-maker. That's what's scary right now. He's more apt to say, “okay, what do we all think? Let's try to build a consensus and come to an agreement here.” And he doesn't seem to have as much control over his fellow board members. I mean, I don't think you would have seen under Greenspan, if the Fed made a decision after the Fed made a decision, you know, six different Fed governors going out the next two weeks giving different speeches. One guy is saying “no, we shouldn't have cut.” Another guy is saying, “no, we have got to raise.” Greenspan had more control over his group. And I think this is what's really causing people to lose credibility when the Fed does one thing on a Tuesday and then immediately on Wednesday they are saying something different by one of the FOMC members or another Fed governor saying something different on Thursday. In terms of the crisis, what you need to do is you need to speak with one voice. And more importantly, you need to be consistent. And this good cop, bad cop routine when you're trying to cajole the markets may work in normal times, it really doesn't work when you're in the middle of a crisis as we are today. [14:35]
JOHN: Yeah. Also we've talked before about consensus. You know, consensus thinking is dominant in much of government today. And consensus doesn't really mean everybody agrees. It means sort of a forced agreement among everyone even if they don't agree. And unfortunately, in times of crisis where decisive thought is required, consensus doesn't work, but a lot of the political ideology and establishment rotates on this type of thinking.
But let's look organically at policy. Why is the policy not working –just from an analysis of the policy itself, regardless of who is at the helm?
JIM: The main problem that you have here is financial institutions don't trust each other. And the problem is transparency. On one hand, as some of the financial pundits have been talking about that, the good news, John, is the financial risk has been dispersed. There is no one large organization, financial institution that is sitting on all of the bad potatoes, much like Long Term Capital Management in 1998. But since this problem is dispersed, you know, here is the problem: Banks don't trust each other. We've seen close to $80 billion of write-downs so far and by the best estimates that we have is there is probably another 300 billion plus of bad loans, bad securities that are going to have to be written down. So everybody is saying, “okay, who is sitting on these other $300 billion? Who is holding the hot potatoes?” So banks are reluctant to lend money to each other for fear of further losses. Who is going to be the next guy that's going to come out and come clean and say, “we're going to write off 10 billion dollars.”
I mean the root problem is everybody knows there are more losses coming ahead of us and it's going to be in subprime, it's going to be in CDOs, the SIVs. And the real question people are asking is: Who is not telling the whole story? I mean just take a look at some of the news headlines we saw this week. We have Bank of America, Wachovia, PNC, all warned of big losses coming in the fourth quarter. And then on top of that, they said there are even bigger losses coming next year, because this is when we know the bulk of these subprime mortgages are going to reset. So already, all of those warnings and there is all kinds of caveats, so no one is sure how big these losses are going to be and everybody knows there is more to come next year. I mean when you've got Ken Lewis head of Bank of America making speeches less optimistic about the economy, and making a statement that he doesn't see this getting better or any improvement until maybe the year 2009.
So everybody knows the fourth quarter is going to be bad and everybody knows it gets worse next year. And so even when you have Bank of America writing off $3.3 billion and warning the markets that that's what's happening. As we get closer to the end of the quarter, a lot of people are saying, “well, we think we're going to write off this much, but we really can't tell you because we're not sure.” [17:52]
JOHN: Well, it seems like every day you're hearing about new writedowns and if there is one thing that's really becoming obvious, you and I were talking about this coming crisis at the beginning of the year, but I think it has really startled the markets out there as to how deep it really has run, which probably should be a lesson about the new emerging monetary crisis.
JIM: Yeah. And basically what we're doing is there was such a massive amount of reflation that took place between 2001 and 2006, the amount of leverage, lending standards going up. We could spend a whole show and analyze why all of this came about, which we'll do in our year end program. But every single week now, two or three weeks ago it was the major brokerage firms fessing up to their losses. And the problem is there is enough liquidity out there, John. There is plenty of liquidity out there to handle this. I mean just take a look at Citigroup getting a cash infusion from Dubai and the $7.5 billion infusion into Citigroup is a drop in the bucket because I think Dubai's sovereign fund is sitting on almost $900 billion. There is plenty of money in Asia and the Middle East. UBS went this week and got $10 billion from Singapore and a Middle Eastern group. You saw a couple of weeks ago other firms doing the same and then this week you had just in the last couple of weeks City Group, Washington Mutual, MBIA, all of them have gone begging for cash, whether it's going to a hedge fund group.
So the problem is you need to come clean and they need to get all of the losses out in the open, and until you do that and then liquidate the problem –just very much like we did with the S&L crisis, let the weak companies go under, let them fail, roll up the losses, liquidate, have a fire sale, cleanse the system. It may take three-to-five years as it did in the S&L crisis, which took place in 90 to 91 and real estate didn't start to come out of it until after 95. But the problem is the markets will correct and heal the problem. But unlike the past, John, and as we're seeing here from politicians and the financial markets, nobody wants to let the markets work their way out. You're talking about bail outs coming for homeowners and you're talking about bail outs for financial institutions. [20:19]
JOHN: You can't do that either politically because go out and talk on the streets. You know, that's where it's said if you really want to find out what's going on with the economy, don't look at government's job numbers. Go out and go to the bars, the nightclubs and the restaurants, talk to people out there, see what they are thinking. They are hurting at this point. So anymore pain is especially in an election year isn't going to fly.
But the other thing is, this really does seem like a different crisis. I'm not sure if the pundits have really grappled with this. This is not the same thing as the last time we went through the recession in 2001, which we off loaded responsibility to 9/11. You and I know that wasn't true. That was just simply an excuse to put it somewhere after 9/11 happened, to put the blame. But this one is different, Jim. It just feels different.
JIM: Yeah. Because if you take a look at the 2001 recession, John, it wasn't a consumer-led recession. Real estate didn't go down as it normally does in a recession. Real estate prices actually went up. And most of the asset bubble was in the stock market. So it affected more the financial economy to some extent than it did the real economy. This was a lot more serious and the reason being is real estate involves the banking system where the stock market bubble really didn't. So with a real estate crisis you moved further up the financial food chain.
You know if you look at where we are today, there is a lot more debt this time around, there is a lot more inflation in the system. So the Fed doesn't have probably the same flexibility as, let's say, Greenspan had in 2001 when we had less debt, less inflation and probably more cooperation from other central banks.
However, as all credit cycles, John, you go from this boom to a bust and then what happens, you come in and reinflate, and all you really do is you really just postpone the issue and that's what we seem to be doing. Unlike 1981 and 1991, in 1981 Volcker was raising interest rates, he was cutting the money supply, cutting the supply of money and credit. He brought inflation down. Debt levels didn't accelerate as much.
In 1991, we did the same thing. We liquidated and we let the markets do their magic. Yeah. It was painful. It probably cost Bush Sr. the election because you had a recession and a housing and S&L crisis, but, John, the system cleansed itself. [22:56]
JOHN: Yeah. But we were reading his lips, Jim, and I was really disappointed. You know that? Remember that way back when? So basically what we're doing here right now is in the best case scenario of this whole thing which there really is like the lesser of two evils, all they can do right now is postpone the problem or the day of reckoning. And it really comes down to the analogy we use here about musical chairs because if who is going to be sitting in the White House, who is going to be sitting in Congress, who is going to be sitting as Fed chairman the day the music dies?
JIM: Yeah. I really think as we go forward into 2008 and we're going to get into this as we – in our next section on issues for 2008, I think the issues leading up to the election are going to change from what they are debating today and especially as the final candidates are chosen and then whoever wins the White House, whoever takes control or maintains control of Congress, John, you might as well just issue them fireman hats because the best we're going to get out of this is we'll solve it but basically we're going to move the crisis or postpone it.
And this is something that the Austrians have always warned about that when you get into these credit cycles all you do is postpone. And one Austrian economist –one of my favorites – Murray Rothbard talked about this. And I'm reading this from one of his books and he's talking about the assessment or possibility of deferring the arrival of the depression and he described it in these terms. He said why do booms historically continue for several years? What delays the reversion process? The answer is that as the boom begins to peter out from the injection of the credit expansion, the banks inject a further dose. And let me just paraphrase here. What are you seeing the central bank do now? [24:47]
JOHN: Well, I guess if you follow that theory, they are injecting more credit just like Rothbard said.
JIM: Sure. In short the only way that you avert the onset of a depression or adjustment process is to continue inflating money and credit. Much as they are doing now. “For only continued doses of new money on the credit market will keep the boom going and the new stages profitable. Furthermore, only ever –and this is very important –only ever increasing doses can step up the boom, lower interest rates further and expand the production structure for as prices rise –just as we're seeing right now – more and more money will be needed to perform the same amount of work. [25:34]
JOHN: Okay eventually, every boom goes crash. Now, why is it that you can't just perpetuate a boom forever? Remember that's how the Federal Reserve actually came into existence was because the country starting in the 19th century had been through a series of regionalized or semi-regionalized bank panics and the promise was that by creating the Federal Reserve bank, those panics would be gone forever. (A panic was the same as a crash –we're talking about a boom-bust cycle.) Why is it you just can't keep the boom going forever?
JIM: Well, there are three basic reasons why the boom eventually comes to an end. One, and this is we're seeing some of this right now, the rate at which credit expansion accelerates, either slows down or stops due to the fear experienced by bankers and economic authorities. In other words, as banks begin to lose a lot of money, as many of these banks now that made promises –whether it was private equity loans or SIVs, they are taking these loans onto the book, so one of the problems, banks aren't lending to each other. And that's this process right now that the Fed is fearing which is the rate at which credit expands or accelerates starts to slow down. So there is your first reason.
A second is credit expansion is maintained at a rate of growth which nevertheless does not accelerate fast enough to prevent the effects of the reversion in each time period. So for example, a sharp rise in the price of consumer goods, simultaneous inflation and crisis, depression, all of this, high rates of unemployment, all of this stuff are the maladjustments that have resulted from the boom and that starts to take hold. Indeed at some point, it's reached [a point at] at which growth in the price of consumer goods will actually start to outstrip the increase in the monetary income. So there is another reason why this comes to an end.
And then I think the third, and this is the one that the Fed probably fears the most is the people and the economy, or what we would call economic agents, begin to realize that the rate of inflation is certain to continue growing. And then you get a widespread flight towards real values beginning to commence. And you're already seeing that in the commodity markets, the gold markets, along with an astronomical jump in the price of goods and services. You're seeing some of that now.
And finally, and this is where you lead towards the end game, the collapse of the monetary system, an event which will ensue when the hyperinflation process destroys the purchasing power of the monetary unit and the economic agents are, let's say, people in the economy begin to use another type of money. In other words, they start looking towards real goods and real assets to say, you know, it's kind of like Germany in the 20s and say, “I want something tangible that's not going to lose its value.” [28:33]
JOHN: You know, this is why we have been discussing this whole issue about what happens when money dies – and we've done this for the past few weeks on the show. And what people try to do to defend themselves from the ravages of it because obviously if it's dying out from under them, they have to do something, first of all, to keep ongoing on a day-to-day basis, but to protect themselves from the wild ravages. And you can think of Weimar Germany in the 1920s and you can think of the Bolivian peso being inflated beyond belief in the 1980s. It always runs the same course.
JIM: And this is something that every generation, every group of central bankers that come in, “you know what, we're smarter than the previous guys or only if we do a little bit more tinkering.” But it all gets down to this. The only thing they can do is postpone the problem, they can inject more money and credit as the Fed will begin doing and you can almost see it coming, John. The helicopter drops and the B-52 drops. [29:33]
JOHN: So ultimately does the fix work?
JIM: Here is the problem that you've got with the subprime resets that are going to hit the markets in the first six months of next year. The New York Fed recently released a paper, and 99% of the sub prime resets, John, are tied to six month LIBOR rates; 38% of Alt-A mortgages are tied to LIBOR; 1% of sub prime is tied to one year LIBOR; 22% of Alt-A tied to one year LIBOR rates. And the problem that they've had is that LIBOR has been stubbornly high; and LIBOR rates are still about 5% or more, almost 100 basis points above the European Central Banks benchmark rates. And you know, you compare that to let's say the beginning of the year where LIBOR was only 25 basis points.
So credit spreads keep widening, and so even the day after the announcement of the coordinated intervention contract rates rose in the LIBOR futures market by almost 6 basis points. So it's basically the market's way of saying they don't expect spreads to go down. And even though the latest actions don't solve the problem of the mistrust among banks, on the one hand, and the potential for more credit losses which we expect in the future, borrowing costs have soared. And a lot of institutions are just pumping money into T-bills rather than lending because we're getting back to what I said is the reason the boom ends, the three reasons, institutions are frightened right now. They don't trust, they are worried about further losses. So what the Fed and the central banks are seeing what is their probably worst nightmare unfold which is a credit crunch. And when credit begin to dry up, all economies go into a recession as the crisis widens. [31:30]
JOHN: This is getting a bit spooky at this stage, so what happens next after that?
Listen. Up in the air. It’s a bird. No. No. No. It's a plane. Well, some of them are planes. Yeah, B-52s. And mostly helicopters loaded with Ben Bernanke's cash for the next cash drop. So you think that's what's going to happen?
JIM: Yeah. I mean they already told you that. You know what's funny because they are going to inject $40 billion in this new fund and then they are going to give the European and Swiss central banks 24 billion dollars of money and they are saying, oh, but this is not new money. You're going to see more coordinated and widespread intervention in the financial markets because, John, they have two choices right now. Either, one, they let the markets work, let lenders and debtors fail and the markets will wash out, cleanse the system; or if that is intolerable to politicians and central bankers, the other option is print and tinker. What do you think they are going to do? [32:40]
JOHN: They are going to print money or digitally generate it. We don't print it anymore. We digitally generate it, you know, basically.
JIM: Yeah. That's exactly what I think. But I also believe they have a problem that's checking some of their coordination or money printing and that's the rise in the gold and oil markets. They've been very successful so far in keeping gold contained when it went up close to 850, but if you look at a chart of gold, it's looking more like a coiled spring. And watch silver. And watch for a break out of silver because it's looking like silver is ready to launch. And I also think oil is another matter that they keep trying to knock it down, talk it down, you know, whether the Saudis are going to increase production or we no longer have a problem with Iran's nuclear program. But, John, it keeps moving back up. Oil and gold may have become in this market what the bond vigilantes were in the 70s. [33:37]
JOHN: So do we dig our way out of this thing or is basically this going to be it? I mean are we basically – we need to talk a bit about what you see when you see the death of a currency, you know, a description of that too.
JIM: You know, I think if they began coordinating and working together, I think they can pull this off one more time. It probably helps to understand and take a look at, for example, the US economy today. We have two economies. We have the Main Street economy where companies manufacture widgets, make goods, provide services, that's Main Street. And then we have this financial economy that is involved with asset bubbles, derivatives etc. Most of the damage so far has been in the financial economy.
And here is the problem that they are facing. If they don't check this soon, then the damage that is occurring in the financial economy begins to spillover into the real economy, the one bit of strength that we have in the economy right now, the service sector is still doing well, it's holding firm. You’ve had exports which are growing in the manufacturing sector. You've had businesses which are sitting on lots of cash and still investing. If business confidence continues to decline, then what they don't want to see is now all of a sudden businesses begin to cut back, they begin to lay off people. Then you're in a recession. People lose their jobs. As more people lose their jobs, people that are making their mortgage payments on time, now they can't make their mortgage payments because they just lost a job. So the real estate and the mortgage crisis gets even worse. And that's the thing that I think they have to watch out for.
The problem if they are to postpone it or to contain it is going to be –and I've contended this – the coordinated intervention by all of the central banks. They are also moving to unlock, I think part of the credit crunch. One of the problems that they've had at this point is they've lowered the discount rate. But there is a stigma, John, when you borrow from the discount rate. The first thing is the stigma associated with it, “ah, they are in financial trouble.” Firms are reluctant to go there. That's why this new lending vehicle that they came up with is going to function much like the discount window, but nobody will know who is borrowing, so you can keep it sort of quiet. The other thing is the institutions that ran short of dollars in Europe are going to be provided with a $24 billion swap with the ECB and the Swiss National Bank. What they did this week goes back to a paper they did back in 2002 and 2001 when they were in a crisis and they basically said what happens if interest rates get down to zero. Nobody wants to borrow and we get into this credit crunch. It's basically: How do we get helicopter drops? That's how serious this issue is right now. [36:46]
JOHN: So obviously there is already anticipation out there of the probability that that could actually happen.
JIM: Yeah. And because when you get, once again, how a boom comes to an end is lenders get fearful, as they are now, and they say, “I'm not going to lend. I would rather basically take my money and put it into Treasuries or something that's less risky because number one, I don't know how bad my own looses are. I'm worried about maintaining my capital ratios and basically I'm frightened. I don't see anything out there that look as attractive to invest it.” [37:21]
JOHN: But I can hear the politicians now too. They go, “well, that's not fair and you greedy money people, you banks should be thinking about the poor person out there who is losing their home or can't refi because you won't lend to them.” You can hear that.
JIM: Yeah. And that's why and especially with an election year, what we're going to see is more tinkering.
You know, there are two things you can do. You can have less monetary policy, in other words, less money printing and do more fiscal spending. In other words, a tax cut and I expect next year that the idea of a tax cut as the economy weakens will begin to strengthen and will move to the forefront as one of the possible options to try to turn the economy around because obviously, if you're lowering and slashing interest rates but nobody sees a business opportunity because lenders are fearful and borrowers become fearful, slashing interest rates isn't going to cut it. [38:19]
JOHN: No. But I think there is going to be demand for it because despite all of the talk about hiking taxes and how well we do and we can soak the rich some more, etc, I think that the average guy out there, if you talk to the small business owner, they understand that taxes are their issue. I talked to several people who are trying to pay off delinquent taxes and everything. They understand they are being soaked. And so politically, there is a ground swell of what I would call voter anger over this whole thing right now.
JIM: Sure. Because even on the real estate front where some states do not have caps on property taxes, the states have been jacking up property taxes as the price of real estate has gone up. Now you're in the reverse situation where you've got declining real estate prices. And you know what governments do, they don't call you up and say: “Well, we raised your taxes because the value of your property went up 40%. But now that it's dropped 20% we're lowering your property taxes 20%.” They don't do that. [39:13]
JOHN: Yeah. That's why we even had talk here in Idaho of Prop 13, which is a California proposition, if you recall. People say, “wait a minute, I shouldn't be taxed on unrecognized gains on my property just because some artificial paper change happened. Wait at least until I sell it and get something for it before you start charging the new rate.”
JIM: And that's another thing that's hitting homeowners is not only have they been having to do with resets and higher mortgages, but their property taxes have been skyrocketing. So unless you have California Prop 13; and, even though we have Prop 13 here, the politicians have gotten around it by assessing all kinds of fees that go into the cost of land and construction that makes housing less affordable. [39:56]
JOHN: You know you always wonder why that is. You have a point where the voters actually say something and the politicians don't get they can't do that; or by the way if voters demand a cut back in taxes what they do is when the taxes are cut back, you see this a lot in education, when the taxes are cut back, the first thing that the politicians or the bureaucrats will do is go and make it painful for the voters. They won't cut the fat, they won't cut the overages and the bad budgets and the bloat. They go right for the services for which they were created in the first place to try to make it painful for the public. And that's why we never get this under control. [40:30]
JIM: Absolutely because bureaucracies do nothing but grow. They become almost like a cancer. They just keep multiplying and basically you'll see in any department over a long term if it's been in existence for a while, more of it goes to the bureaucracy than the services that they perform to the public. That's the nature of government. [40:55]
JOHN: Right. Yep. First purpose of a bureaucracy is to give lip service to its public function. The second purpose is to preserve its existence at all cost; and the third purpose, third function is when caught with the hand in the cookie jar to deny accountability. Those are Loeffler's three roles of every bureaucracy. I challenge anyone to prove me wrong on that one. I've been watching that one for too many years.
Okay, so if we had to frame the imminent scenario upon us, there would be more rate cuts, that means more liquidity injections of money. And then we will see more inflation, first of the money supply; then prices going up, we'll see that ultimately; and another asset bubble. And of course the question is which assets are going to be affected by the bubble?
JIM: That pretty much sums it up. The longer they wait, the worse it's going to get and the more they are going to end up cutting. So what they don't want to do is come across as being panicked. I think right now they are in the panic mode. When central banks cut interest rates more than a hundred basis points which the Fed has now done, you're not talking about just a temporary crisis. You're talking about trying to head off a recession. So that is what they are going to be dealing with next year. [42:06]
JOHN: A recession next year. I mean we're beginning to see Bernanke saying it's a possibility. So basically it's almost inevitable at this stage of the game, isn't it?
JIM: If they move in a concerted action, they may be able to stave it off, maybe what you end up getting is staginflation, economic growth 1% or less with higher inflation rates. That's probably the best outcome. If they don't move in a coordinated fashion, then I think you get a recession. [42:33]
JOHN: And question is how is this ultimately going to affect the political races too –the congressional and the presidential races –because this, as you say, is going to be factored in? It will become harder and harder and harder for politicians during debates, especially when we center in on who the two presidents are for presidents in both sides. It's going to be very hard for them to avoid this issue
All right. So if we are going to head toward this next asset bubble and we're talking about investment, I mean you can obviously make money during the bubbles, where you're going to put your money for the bubble.
JIM: I think you've already seen it, John, in commodities and hard assets because the best you're going to get with all of this reflation is stagflation. That's my optimistic scenario. So it's going to look a lot like the 70s and you're already starting to see it. I mean the day you and I talking, oil prices are still at $90 a barrel, you've got gold prices even though they are hammering it, it's still remaining persistently close to $800; silver is remaining persistently high near $14. The CRB Index and you're already starting to see it was sovereign funds. There is nearly $2 trillion, I think the latest figure of sovereign funds where the central banks themselves recognize that we've got global inflation.
It's amazing. Something that we've been following here and we're now pointing it in our new economic resource page, which we added to the website, is we're following global money supply growth and we're following global inflation rates, and the rise in the PPI and CPI as you're seeing here, you’re seeing it also in Europe. You're also seeing it in other countries. If you look at today's consumer prices up more than expected, the Euro zone reported their November price index went up to 3.1%. Germany's inflation rate is running at 3.4%. Spain's inflation rate is running at 4.1%. I don't care anywhere that we look, John, whether it's Latin America or whether it's Asia, whether it's Europe, whether it's the United States, inflation rates are rising globally and that's the message that's coming out with this expansion of money and credit. So I think the next asset bubble, we've already seen it, if you look at a chart of any of the commodities over the last five or six years is going to be commodities. [44:58]
JOHN: You know, Jim, the white house paraded out the first dogs this weekend. I don't know if you saw that. Barney and Mr. Beasley for the press; it even included former Prime Minister Tony Blair of the UK in a funny little piece they did. So not to be out done, Lodo would like to play some of her favorite Christmas Carols for our listeners. Do you want to play a carol or jingle bells.
[Lodo barks jingle bells]
JOHN: Well, now we get to the point where at the end of the year, by the way, not the point in the program, but we get to the point in the year when we begin to talk about the coming year. And as we started this year in 2007, we had all sorts of themes that we were talking about and we made some predictions. Now we're going to start moving in that direction again for the year 2008, which I really maintain is actually getting more interesting, at least from a news reporting standpoint than 2007 was.
JIM: Yeah. It's going to be interesting. There are a number of cross currents, John, and I think there is going to be a number of theories that are going to be challenged in the financial world next year. And the first of them is this so-called decoupling thesis. And one of the themes that you heard throughout this year is yes, the US economy was slowing down and as a result, you know, economic growth and profit growth would slow with that, but the rest of the world, it was going to be immune to a slow down in the US economy. Therefore, instead of the United States economy becoming the economic locomotive, Europe, Asia, the emerging markets would become the economic locomotive and we would be okay because there would be enough economic growth in the rest of the world that would create demand for exports from the United States and therefore we'll be okay.
And, you know, you saw this too. If you take a look at, for example, the third quarter profit numbers for the S&P 500 companies, the year-over-year growth in the financial sector was abysmal; it was only about 3 ½%; the non-financial sector year over year, was down about 6%. But those companies that derive the majority of their income and profits from overseas, year-over-year, John, it was up 35%. So you can see where that thesis would become prominent. They are saying, “hey, look, as long as US companies or S&P 500 companies are international and they get the bulk of their sales, the profit picture will be up.”
So two themes that I think are going to be challenged next year is the decoupling thesis because I do not believe you can see economic growth rates in the US slow down to 1% or less as they are expected in this fourth quarter; and even worse in the first and second quarter of next year and the rest of the world isn't going to be impacted. I think Europe's economy will begin to slow down. We are seeing it in Spain, Italy already. We're seeing it in the UK and I also think you'll even see it in some of the emerging economies slow from the hectic growth rates in China of let's say 11 and 12%. You might see Chinese economic growth slow down to 10% or less. So decoupling thesis is, I think, number one on the charts in terms of a macro theme. And I think it's going to be proven to be false.
Accompanying that if you take a look at the S&P estimates for profits, next year for the S&P 500, all of a sudden magically they begin to go up next year so the economists are expecting “hey, this is a temporary soft landing, the Fed will begin cutting interest rates. That's going to turn the economy around and when the economy turns around, you're going to see profit growth.” So I think the corporate profit estimates are, as they are at the beginning of the year or at the end of the year looking forward, a bit too high. [49:47]
JOHN: But let's swing over to this topic that we were just talking about, the credit crunch, because obviously this is going to bleed over, actually flood over into next year and we're going to see lenders being more and more reluctant to lend because of the risk in the whole, the way the whole system is running.
JIM: Yeah. I think that's a third theme which is the credit crunch because if we do get a credit crunch, then you're talking about the end of a credit cycle. Does it accelerate next year? And if it does keep going, remember, the Austrian business cycle theory, in order to postpone the day of reckoning, you have to have faster rates of credit growth. If you don't get that –if credit growth remains either stagnant, it doesn't increase or it declines – then you get a recession. So the credit crunch: Will the Fed with this new latest lending vehicle be able to unlock that credit crunch and get money moving through the system. And then that, I think, will lead to a fourth theme, which is a recession versus the soft landing. In other words, how will the Fed begin to in other words, can they cut aggressively, can they move in unison with coordinated attacks globally, to ward off a recession. Maybe we get on a best case and I've seen even some of the optimists are talking about economic growth rates 2% or less and maybe 1%. You know, in a 1% economic growth rate, John, you may call it a growing economy but it's going to feel more like a recession. [51:27]
JOHN: Jim, you know, that theme was discussed this week. The Wall Street Journal has a video section and this was discussed by Jim Awad who is a money manager. Let's pick up part of that conversation that was posted this week.
WSJ: A cash bail out from the Federal Reserve and other central banks, what does it mean for investors? I'm Paul Linn [phon.] in New York and here to answer that question, Jim Awad of WP Stewart Asset Management and $5 billion in assets under management and thanks for joining us.
AWAD: Always my pleasure.
WSJ: What does this do, this $40 billion injection? what does it do for the liquidity in the markets?
AWAD: Well, that's exactly what it does is liquidity. The risk in the market is that credit seizes up, that banks don't want to lend, that counterparties don't trust each other, that credit is denied to those who want it and therefore you slip from slow growth into a recession. And originally, when the Fed lowered the federal funds rate and the discount rate by 25 basis points, the market was fearful that that didn't provide enough liquidity in the system. So what the Fed did is they directly provided lots of liquidity theoretically that people auction for it, bid for it, by putting into place this facility in conjunction with other central banks. And the markets basically said that's a good thing. It will help us get through this bridge period. [52:38]
WSJ: As a money manager, what does this do for you? Do you feel concerned about the, you know, the coming year?
AWAD: Well, on the margin, it is helpful. It probably reduces the chance of a recession somewhat. But it is not in any way a cure all, just like the SIV fund is not a cure all. It's all part of the process of getting us through this difficult period of paying for the excesses in the housing area and the housing finance related area and in the leverage loan area and the leveraged area in general. And we are doing that.. we're correcting it. It's no different than correcting the technology bubble in the late 90s. There will be individual company casualties individual investor casualties, but basically the economy will get through it and what's helpful this time is you're having this fabulous growth overseas and combined with a low currency, a low dollar, it means export growth is growing dramatically, and that's offsetting some of the weakness in finance and housing and consumer discretionary. So what do I think for the next 12 months? I think we'll flirt with recession, we'll narrowly avoid it. That the financial stocks will remain in a recession, as they are, but that the large cap multinational growth companies will do just fine because of the stronger growth overseas. [53:57]
JOHN: We're going to talk about investment themes, by the way, coming up in the next hour of the Big Picture. A recession, obviously, is on the table and if we get into a recession, they'll be talking about a soft or a hard landing. But, you know, energy is one of these things that, yes, it's there from an investment standpoint that people are talking about that, but this cognizance of this emerging energy –do we call it a – crisis or something, is still not really on a lot of people's radar. It's not there yet.
JIM: Yeah. I think that once again as energy has dominated the headlines this year as it has through out this decade, John, I think it move to the front burner next year because I do expect oil prices to cross over $100 a barrel. I'm not going to make any prediction whether that happens in January, February, or it happens next summer.
You know, there was an interesting article that was done in the Wall Street Journal and this is a point that I think the markets don't recognize that we have talked about on a number of times on this program is that everyone just assumes the demand is going to grow by X% a year or X million barrels a day, and the supply will be there and it will come from OPEC. And a point that we've been trying to drive home is OPEC production has been somewhat stagnant and along those lines, not only has it been stagnant but also one of the fastest areas for oil consumption in the world today is within OPEC countries where the price of oil and energy is subsidized by the host government. And if OPEC is not able to increase its production at the same time it's consuming more of what it produces, that just means there is less oil to export to the rest of the world.
There was a great article in the Wall Street Journal this week about Saudi Arabia and what Saudi Arabia is trying to do is say “look, we've got high unemployment, we've got a lot more people living in this country today because of the population growth than a couple of decades ago. We need to create more jobs with this oil that we have.” So one of the largest aluminum smelters in the world is going to be built in Saudi Arabia. They are building refineries, they are moving to creating plastics. In other words, all of the byproducts of energy.
And even though Saudi Arabia is bringing on a new field next year that will be able to produce 250,000 barrels a day, Saudi consumption increase next year is rising over 200,000 barrels a day as these new industries. They are building four new industrial cities in Saudi Arabia with new ports. All of that means, John, they are going to consume more of the energy that they produce. So yes, they'll have a new field coming on next year, but their own internal consumption demand will absorb the majority of that. So I expect peak oil and the energy crisis – and for our listeners we've been talking about that, for example, the summer with the change with the IEA report, talking about an energy window crisis beginning in 2009 – and I would say, John, as we get closer to the November elections in 2008, I think energy is going to be on the front burner, especially as the trading range in energy starts trading more above the $100 level – just as we've seen here recently where oil has been persistently high and trading over $90 a barrel for almost the last two months. So energy, peak oil is probably the fifth topic or theme for next year. [57:48]
JOHN: Well, this sort of brings us to the other leg of where we're going, remembering that the politics of a country and its economics are irrevocably inextricable. That sounds neat. I had to write that one down.
JIM: Yeah. That sounds like a big word.
JOHN: Hey, I should be chairman of the Fed because I can do these big words I can do them. I can!
JIM: You can bamboozle them.
JOHN: I – add that one in there, bamboozle. Anyway, politics...
You know, one of the things that I do on my own weekly radio program which I've been doing for almost two decades before you and I met, that's at www.Steelonsteel.com, is we try to monitor the entire relationships of the three legs of society all of the time. One is what I call the religious world view leg, the other is the political and legal leg and the third leg is the economic leg. And contrary to what people are trying to do nowadays in academia, they are trying to separate these out and say that this stands over here, that stands over there. They don't ever get together, they don't interact, as you can tell from what's been doing on with the presidential debates, religion and politicians are back at it again. And those are not going to be separable because when people show up in Washington, or show up at a state or a provincial capital to be able to pass laws, they pass those laws based on their world views; and religion is inextricably linked to that. And so since these things are tied together like this, what we're hearing, especially from the Democrats –and this is the question we're going to ask now –is that we need bail outs for all of these problems because this affects people. And there really are people who are hurting through this whole thing.
Then I keep hearing more taxes, especially from Barack Obama. It's a little more clouded when you hear it from Senator Clinton, but basically more taxes. The funniest phrase I've heard lately is the rich have to pay more of their fair share. I say, “now, wait a minute, are they paying their fair share.” “Yes.” “Then how can you pay more of your fair share and still have it fair? Is it fair or not?” And as you and I both know, there is nothing fair about this Internal Revenue code at all. It is so distorted.
But basically we're hearing about more wealth transfer because if you were to have socialized medicine, if we were to deal with Social Security, if you notice by the way, for the most part except for a few glancing mentions, nobody is talking about Social Security as an emerging green dragon that's going to be really pronounced. It's like it's fallen off the radar again. So at the same time the debt is running out of control, the budgets are running out of control, real economic crises are moving over the horizon, not on the radar screen yet. At the same time we're being promised all of these social programs and somehow there is this delusion that we're going to have the money to pay for this. Are we really moving more to the left and what do you think is going too happen as this thing begin to blow apart, especially the death of the dollar. [1:00:00]
JIM: You know what is even striking, John, you're talking about Democrats talking about higher taxes and bail outs. But also the Republicans are doing the same thing. I mean if you listen to the Republican debates, I mean the President has his own bail out program, Paulson is working on. So even the Republican party itself, so I think that's the reason why a lot of people within the Republican party are saying, “waiting a minute, you guys are supposed to be conservatives, you're supposed to be fiscally sound, and yet when you guys controlled Congress, you were spendthrifts.” Just as right now, there is all kinds of pork barrel projects that the President has threatened to veto now that we're in a election year that the Democrats are doing. The Democrats are doing the same thing that the Republicans did. And that's the thing that is discouraging. It doesn't matter if the Democrats control Congress or the Republicans control Congress. They all spend, they load pork barrel projects for their constituents that help them get elected.
And you're right, John, nobody is talking about Social Security because it's bankrupt and it's going bankrupt and nobody wants to deal with the issue. That's kind of like “okay we'll put that one off into the future.” We won't want to deal with it now because now they are talking about a new entitlement which is health care. And you know, it's very difficult to talk about health care if you've got Social Security and Medicare going bankrupt. So I think that's one reason that you don't see that. But that's going to be the real question. When you get to November of next year, if the economy is in a recession, the President's party will be blamed for that and will the country shift to the left for more taxes, more government regulation and more government involvement and control of the economy. So that's going to be a big issue and that's going to affect the markets as well. [1:02:24]
JOHN: I think tied to that, though, if you look at a political area is the issue of what I call the Bill of Rights. And both parties from the perception of a Libertarian, both socialist party D and socialist party R have been happily bashing away on the Bill of Rights for about 20 years right now. The precedents go back even forward through the New Deal, back in the Federal Reserve act, and if you look, you can find places where both sides are trying to do end runs around provisions in the Constitution for their own political gain. And both sides, some of the Right and some of the Left are recognizing that that's happening, but they misperceive that as being strictly a problem of the other side. And in reality, I think the Libertarians are only some of the ones and the Constitutionalists and smaller parties, they are recognizing, “hey, wait a minute, we are blowing foundations out from under us.” And like Dr. Alan Keyes was saying during the Iowa debate this week, the one thing that we're facing is we're facing a constitutional crisis as well. You're only hearing a few voices. A lot of the candidates are ridiculing that, but people like Ron Paul and Alan Keyes –and I'm trying to think of who on the Democratic side – are drawing attention to the fact that wait a minute, we're destroying this whole thing for ourselves. And you can't have a free market without a stable society and that's guaranteed by a stable Constitution. [1:03:38]
JOHN: Well, we're going to watch the interaction of those three issues as the year come along, the world view with the political and the economic. We've gone through six items so far before we log out of this particular segment of the program. Is there anything else that's going to hit the radar next year?
JIM: Yeah. I really think so. It's going to be the debate whether inflation or deflation is on the memo. There has been a lot of people that have been – the deflationists are coming out of the woodwork again talking about everything from the Kondratieff Winter to serious deflation in this economy as this debt crisis begin to implode. But, John, I just don't see it. I see, you know, this debate between inflation and deflation and I think the inflation argument is going to win next year as I expect more of it. That’s because one of the things that we have today, there is no limitation in terms of what governments can do. In other words, no paper or currency around the globe is backed by anything. They are all fiat and that's what makes where we are today so much different than where we were, let's say, in the 30s in the US or Japan in the 90s. And that's why I think you're going to see the inflation argument win over and maybe we'll paper it over or, you know, we'll do things like the core rate. Maybe we'll come out with a – they are already talking about revising the CPI index, so they are going to jigger with that. And you just may hear, well, the core inflation is only two-tenths of a percent within the Fed range, and ignore the headlines – pretty much the way they did today. [1:05:28]
JOHN: Yeah. It's going to be interesting. What has always been funny, I talked to a professor at Berkeley a couple of years ago during an interview. “What’s always been funny,” he said, “whenever a worldview begins to die or some of its core tenets begin to crumble or shatter, there is a certain form of epistemological panic that sets in.” And I had never quite heard it expressed like that from a philosophical standpoint. And what it is, and you can see this by the way, in some of the discussions going on on the financial channels is that even when confronted with the evidence of immediacy (remember Peter Schiff, for example, on some of the talkies and everybody is downing what he was saying, but Peter says, “yeah, but I'm right. Look, it happened and you guys were saying I was full of hot air just weeks ago and it happened.”) and even in light of that, there is always this scramble to try to reinterpret what's happening in light of your cherished ideology. So that's where philosophy and world view interlinks with economics. And they both go together.
So to sum up everything, we'll put this in the hopper for examining, say, let's pick a day here, what, June, we're going to pick this up begin, by the time we get there we'll do a summary and say how far have we come from our summary at the end of the year. Number one, the decoupling thesis is globally going to collapse in front of our face, corporate profits, that will be an ongoing monitoring thing. That's number two. Credit crunch. This is not going to be the end of this credit debacle. It's going to continue into next year as borrowers get more and more nervous. That's item number three. Four, the discussion will turn more and more towards recession and whether or not we're going to have a soft landing or a severe crunch. Number five, peak oil – energy crisis, I guess what are we calling it – “choke oil” really because the energy is more choke oil instead of peak oil. And that is really going to come over the horizon, more and more radar will pick it up in the coming year. I don't think the full impact is going to be there, but I think we both agree, what, we're both 300 and – grab my notebook here, we are 325 days out from the next elections here in the United States. And I think by the time we get into mid next year, we're going to see this type of thing end along with inflation and possible recession really dominating the conversation.
Politically, the question is are we going to turn toward the left because now, Jim, we don't have the robust economy in the same way that we did before where the economy can support a lot more abuse. And in order to turn to all of these programs, you're going to have to abuse it some more. There are just not enough rich people to soak to make it work, especially the Social Security debacle. Remember 2008, the baby boomers start retiring. And finally the inflation versus deflation argument it's going to be really clear who wins in that one and who loses in that one. So those are our predictions of at least areas of concerns for the coming year. You're listening to the Financial Sense Newshour at www.financialsense.com.
Clearing
the Mechanism: Sitting Tight
JOHN: Well, former Fed chairman Alan Greenspan's book is The Age Of Turbulence, and maybe we should call it the age of anxiety –let's pick the German world angst – because everyone seems to be busy chasing whatever is going on in the markets out here. Here we have today oil is down one dollar to $91. It's still over 90, but all of a sudden, there is this big selloff in oil. We find out that the inflation rate is actually higher than expected, but people are still selling gold, and so things don't seem to be matching up. And perhaps what we've really lost here is long term perspective on anything. Everybody is just watching the data points from day-to-day to day.
JIM: One of the problems, I think that in the information age that we live in is news is instantaneous all around the globe. If something happens anywhere in the world, immediately it's going to show up in either the newswires, it's going to be on the internet or it's going to be on the cable channels. Somebody is going to be talking about it. You're right. There is all of this news.
And what amazes me is you watch the markets right now is the level of volatility; and that's because we're living at a time where there is a lot of uncertainty regarding this credit crisis; there is maybe less confidence in our leaders in terms of getting us through it. If you look at the VIX which measures volatility, that was trading around 10 and then we got our first little blip of the credit crisis in February of this year and the VIX went up all of the way up to 20 and then they told us, “okay, the crisis is over and it only hit a couple of financial intermediaries and then the VIX goes down in the 12 to 15 range and pretty much stays there until we get the first signs of another credit [crisis], a little bit of head wind coming our way in late June. The VIX goes down again and then it just goes from 15, shoots all of the way up to 31 in that July-August period when the credit crisis fully hit. Then the Fed begins cutting interest rates. Everybody becomes more sanguine about the outcome, the VIX drops down close to 15 again and then shoots right back up in October after the Fed meeting and when especially the Fed talked about, you know, basically flip-flopping saying they went to neutral, shoots right back up to 31 again and then it's been coming down. Now it's inching up. So you're right. There is a lot of volatility and so much is focused on the day-to-day trends rather than on what long term trends are unfolding in the economy and in the financial markets.
And that's where I think, when you talked about the Chinese warning about Americans are too short-term focused in what we do, there is a lot of noise in the market and one thing that Ben Graham used to talk about was Mr. Market, who is very irrational. In other words, if the stock market goes up 350 points one day and then the next day it drops 250 points, you have to ask yourself what changed in 24 hours in the economy? What changed in the markets, what changed with corporate profits? In other words, what's behind much of this behavior that we're seeing today where there is always this urge to trade. [3:28]
JOHN: Well, I mean assuming if you're a day trader you can make money off of just playing these ups and downs, especially if you have enough money to move around, but that even puts angst in your life because you can't take any time off. You've got to be there whenever the market is open, you know, as opposed to picking a longer term investment strategy and sticking with it.
JIM: It's absolutely true, and one of the great money managers Peter Lynch who had a stellar record running Magellan when he did, there is a quote that he said:
Thousands of experts study overbought indicators, oversold indicators, head-and-shoulder patterns, put-call ratios, the Fed's policy on money supply foreign investment, the movement of the constellations through the Heavens, the moss on oak trees and they can't predict markets with any useful consistency anymore than the gizzards wizards anymore could tell the Roman emperors when the Huns would attack.
So much is spent on where is the market going to be next week, where is it going to be a month from now. Rather than looking at the broader macro themes that are operating in the marketplace, the broader operating trends, everybody gets focused on all of this short term noise and I think that's why we're seeing these gyrations from day-to-day. [4:40]
JOHN: Is this the result of a transition we're making right now from a low inflationary stable environment, or relatively stable environment to a high inflationary, unstable environment? Is it a result of that, or would this go on anyway? And also the other factor in there is all of the money now due to the inflation practices of the various central banks, there is a lot of money sloshing around the globe looking to do something right now.
JIM: Well, yes. We're definitely in a transition, John, to what I think is going to become an inflationary type of environment, a more crisis-prone environment because you're absolutely right: There is a ton of money that is sloshing around the globe. It's nervous money because a lot of it happens to be leveraged, whether it's leveraged on margin or it's leveraged in the futures pit, or it's leveraged with the yen carry trade. And you've got all of this noise and everybody is reacting to this noise.
It brings up something – there was a movie that came out, oh, this was towards the end of the 90s. It was with Kevin Costner and it was called For The Love Of The Game and it was about this aging all star baseball pitcher and he used a term called clearing the mechanism. And at that time, I lived in a neighborhood with a couple of Padres and one of them was a Padre pitcher. And we used to have breakfasts on Thursday morning together every week and I asked him about the movie after I watched it. I said do you really do that? Do you clear the mechanism? And he said, “absolutely, because you're on the pitcher's mound and you may be playing, you're a Padre and you may be playing in the Yankee stadium or some other stadium. There is booing, there is the fans are jeering and what you've got to do is you need to remain focused. You've got to clear all of the noise out. You can't think about your last pitch. You've got to think about that batter directly in front of you. Okay, how am I going to strike that guy out.
So you have to keep yourself focused and I think that's sometimes what happens in financial markets is the financial markets love certainty. And I think that's one of the reasons why we always are looking for forecasts because somehow forecasts add a level of certainty on to a market that is uncertain. Why all of the emphasis on weather forecasts? Why all of the emphasis on financial forecasts? Why all of the emphasis on financial predictions. What's going to happen next week? Are stocks going to be up and down? [7:13]
JOHN: Well, you can see all of the yammering going on. I mean first of all there is sort of an adrenaline punch if you're chasing the stuff on a day-to-day basis and it gives you the feeling that something is happening worthwhile. But, you know, also, if you look at say if oil prices drop to, what, $50s a barrel or something, suddenly the discussion turns to is it going to go down to 30, is it going to go down to nothing? We’re going to have free oil! It is always this “tell me the future, give me the latest tip.” And for the majority of people they are always jumping in first of all in the wrong part of the cycle because by the time the latest tip becomes a tip that you want to hear, it's gone. The train has already passed.
JIM: It was amazing, Warren Buffett talked about his mentor Ben Graham and Ben Graham used to talk about Mr. Market as this irrational being; and he said I'm reading from – I've got a book of Buffet's quotes and some great stuff here. He goes:
Ben's Mr. Market allegory may seem out of date in today's investment world in which most professionals and academicians talk of efficient markets, dynamic hedging and betas. Their interest in such matters is understandable since techniques shrouded in mystery clearly have value to the purveyor of investment advice. After all, what witch doctor has ever achieved fame and fortune by simply advising “take two aspirins”?
And that's one of the problems that I think that we have today and Graham talked so much about this and that was looking at the bigger picture, taking a position, holding that position. We talked about in the last segment with politicians and central banks, there is always this feeling, well, we've got to tinker with something, and we tend to make things more complex. I mean if you take a look at the industry that I operate in today, the financial industry is so much more complex today in terms of derivative formulas, statistical formulas. You see it today at hedge funds were you hear about quants, people with PhDs. And we are making this world that we live in so complicated. And I was thinking of another Graham comment that he made towards the end of his life, and this was right after he revised his book The Intelligent Investor, and he said:
In 44 years of Wall Street experience in study, I have never seen dependable calculations made about common stock values that went beyond simple arithmetic or the most elementary algebra. Whenever calculus is brought in or higher algebra, you could take it as a warning signal that the operator was trying to substitute theory for experience, and usually also to give speculation the deceptive guise of investment. [9:56]
JOHN: But that's what everybody wants to hear. They want to know what the latest wiggle – why did the market go down 100 points today? What's going on out there? And a lot of this is really, in the long term of any kind of investing, meaningless.
JIM: Yeah. And if anything, when markets go down, the more basic philosophy to take is to use that to your own advantage. And once again I want to quote Graham here. He said basically price fluctuations have only one significant meaning for a true investor. They provide him with the opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.
Every once in a while, a friend of mine, Eric King, will talk about this and especially as it applies to the gold markets. There are days where gold stocks are going down, the price of bullion is going down. You can get all worried and fret, people jump out of windows, they sell their stocks. He said, “you know, you're probably better off to go kick a soccer ball.” Better off going to the beach. But I would say you're probably better off saying, you know what, I'd like to own oil because I believe in the oil story. And so what I'm going to do is I'm going to wait when the market gives me that perfect pitch as Warren Buffet likes to talk about: When things get sold off for no apparent reason, then the price of oil is going down two or three dollars a barrel. And you use those opportunities to add to your position.
And I think, John, the problem that we have today when you really boil it down is we are probably our own worse enemy. We react to these wiggles, these short term fluctuations, the noises that are out there rather than adopting a philosophy, understanding the fundamentals, understand why did I buy this stock? Why did I buy this company, what was the reason behind it?
One of the things that we do is when we buy a stock and it goes on our buy list, we have a two page summary. We have five fundamental reasons for purchasing a stock, we have comparisons to other companies, other industries and we put down the sheet. We take a look at where the stock is trading technically. In other words, is it sky rocketing? Do we really want to jump in now, or do we want to hold off, is it in a consolidation? In other words, is it at a level that makes business sense to go in and make a purchase? And by the same token, we also look at that sheet when it comes time to sell something. If something changes, if some of the assumptions that were behind the original purchase changed, then, yeah, you reevaluate and say is this a temporary problem, is it more of a permanent problem and then you examine whether you either hold onto it or sell it.
And once again, this will probably be one of the last Graham quotes, but this is something that Graham talked about doing your homework and understanding the fundamentals or the reasons why you buy a stock and he said:
If you formed a conclusion from the facts and if you know your judgment is sound, act on it. Even though others may hesitate or differ, you're neither right or wrong because the crowd disagrees with you. You were right because your data and reasoning are right.
And Graham always felt that if you did your homework and your reasoning was sound on your purchases, in the long run the market will prove you right. [13:28]
JOHN: But that requires a lot of intestinal fortitude, there is always comfort in the herd. Let's face it, and if you're going to stand out there, especially if it's your own money, there is an emotional risk in here, I guess is the way I'm putting it.
JIM: Well, sure. And one of the hardest things that you have to do as an investor and even if you're a technician and you're a trader, you know, probably one of the best books ever written about investors’ psychology was a book called Reminiscences of a Stock Operator, which was about Jessie Livermore and there was a quote that Livermore came to the conclusion as he was gaining experience and learning and becoming more successful in the market and I'm reading this from Reminiscences of a Stock Operator. This is a direct quote.
After spending many years on Wall Street and after making and losing millions of dollars, I want to tell you this: It was never my thinking that made the big money for me. It was always my sitting. Got that? My sitting tight. It is no trick at all to be right on the market. You always find lots of early bulls in bull markets and early bears in bear markets. Men who can be both be right and sit tight are uncommon. I found it one of the hardest things to learn because it is only after a stock operator has firmly grasped this that he can make big money. And the reason that a man may see straight and clearly and yet become impatient or doubtful when the market takes its time about doing as he figured it must do. That is why so many men on Wall Street who are not at all in the sucker class, not even in third grade, nevertheless lose money. The market does not beat them. They beat themselves because even though they have brains, they cannot sit tight and they don't have the courage of their own convictions that tells them intelligent patience to sit tight.
And then he goes on here, and I've just got a couple of more quotes, but I think it is so relevant today. He talks about disregarding the big swing:
And trying to jump in and out was fatal to me. Nobody can catch all fluctuations.
and this is what I want to tell gold investors, this is what I want to say to oil investors. This is what I want to say to commodity investors, and let me go back to Livermore.
In a bull market, your game is to buy and hold until you believe that that bull market is near its end. To do this, you must study general conditions, not tips or special factors affecting individual stocks. One of the most helpful things that anybody can learn is to give up trying to catch the last 1/8th or the first. These are the two most expensive eighths in the world. [16:41]
JOHN: Well, if this were a matter of, I don't know whether we call it faith or fate, in that people don't have their own convictions anymore. If they have convictions, they don't believe in them. If they don't believe in the concept of convictions, then they are sort of just chasing what's out there.
JIM: You know, I think it's sometimes either one they don't have a philosophy, a methodology that they use that keeps them consistent, that helps them control their emotions. And let's face it, John, with the internet, all of the different forms of media that we have today, we're bombarded with news, and so unless you have faith in your own convictions or believe in what it is that you're doing, it is very easy to get influenced by the latest news events and drop out of your positions yourself – jump out the window, like last week, we did that little thing on market cinema with the Two Johns. That's so true today. It's very tough and especially if you're in the markets that we're in today where they are much more volatile and especially if you're a gold investor.
But one of the thing that I have learned in what, my 30 year career in this business, the things that have worked out the best for me in the long run were things that I took a position in, did my research, held on, even through thick and thin. I mean there was one of the – probably one of the best things we've ever done, we financed about, oh, I would say, 15, 20 companies. And John, two of these companies that we have financed, initially after we financed them, one of them continued to fall every single year for almost a two-and-a-half year period, but I knew the person running that company, I knew the area they were mining in and I continued to have faith in the project as I saw it progress. And the stock – didn't matter what the company did, it had great discoveries, it had reserves or resource estimate it came out with, they announced a resource estimate, the stock sold off, and so there was no apparent reason fundamentally to see what was happening with the stock. But the fundamentals were there, so we held on. And as a result of that, John, that stock is up over 8000%.
There is another issue where there was another company we financed and it's down probably about 30, 40%. But they have just made a new discovery that almost looks Aurelian like in this discovery. And yet the stock has been hammered, people just aren't paying attention to it. There is another company we're involved in that's a turnaround situation that is sitting on a major large deposit. It gets hammered. There is a large naked short position reported on the AMEX in this company that's been in place here for the last two weeks. So there is all kinds of reasons why a stock can go down, but if you don't believe in what it is that you're doing, let's say you don't believe in the