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THE
WAY AHEAD "Old age brings this one vice to mankind, that we all
think too much of money." Note to FSO readers: This is a slight reworking of an article I wrote for an online tip sheet last US Thanksgiving Day. In the interim, nothing much has really changed in the financial universe, though there are signs the Credit Bubble is indeed cracking. I think this is also why I may have a short career as a market commentator here on FSO. "The Mills of the Gods grind slowly", and all that, and trying to come up with something original every week, let alone every day, is tough. Have to admire guys like Bill Fleckenstein and Jim Puplava. -DR Introduction It's US Thanksgiving season, November 2003, with 2004 not very far off, and Canadian markets are slow. This gives us a chance to peer into the future a little bit. So where do we stand in this post-modern world, and what is going to unfold in the months and years ahead? As a consequence, where should we allocate our financial resources to both protect capital, and hopefully tilt the odds in our favour to make more? I know many of you here follow the great recommendations and aren't worried about short term dips or large scale trends. On the other hand, trading the markets is very enjoyable for me, and it's always good to have alternate plans. We all have our histories, along with strengths, weaknesses and prejudices. I'm going to try and draw on my own knowledge and of that of others, to make some predictions, some bold, others no-brainers. Finding analogies to today's world and financial situation is tricky, and hence trying to produce a "road map" for the future may be difficult in my opinion. But, we do sense trends, and there are precedents to draw upon. Finding A General Theme I think we're entering a time of transition from increasingly larger geopolitical and financial entities to a world which will become increasingly dis-integrated. I put the hyphen in the word to emphasize this will be a continuous process rather than a sudden falling apart. I think this is just natural progression. It's happened before, only this time it may be on a truly global scale. Historically, there are many examples of this. Empires get successful, bigger, richer, stagnate, and break up. As Britain in the 1700's got larger when its financial clout increased, so did it contract on the way down. Other examples include the Persians, Ottomans, Borgias, and Russians. The Chinese are no strangers to dis-integration. Building the Great Wall kept the Mongols out, but cost so much to build it weakened the Ming dynasty to the point where the Manchurians took over (one of us!). Over time, China then further dis-integrated into a number of War Lord feudal regions. Ironically, a major effort to keep the state intact had led to its dissolution. There is often a signature event which announces that the old regime has had it, and the way ahead is to break up. For Britain, it was probably the First World War, when they were forced to abandon the gold standard. They never did recover, gradually losing their overseas assets and competitive edge to the new ascendant and growing power, the United States. The roaring twenties bypassed England for the most part, caught up in trying to pay down war debt and regain fiscal stability. One of the events that seems to point to dissolution ahead is when the currency used begins to be inflated by the government. The Romans clipping their coins is the most obvious example, and China experienced numerous paper money collapses. Where We Stand Now Whither
goest thou, America, in thy shiny car in the night" There are several great, vastly different, financial and political integration efforts underway today, most of which I think are ultimately doomed. In the blue corner, we have the Euro zone, desperately trying to create a common economic framework as a prelude to greater integration and never go to war against each other again. To do this, they're trying to create a stable currency (in fact, they call it the stability pact) and force financial discipline on its members. In the other blue corner, we have the US, trying to create a world of free flowing capital and democracy in far flung places, borrowing money like crazy for consumption at home. Their current behaviour is rooted in the old ideological battle with their arch-enemy, Russia, but the Soviets went broke and can't come out to play any more. The extant US apparatus (military, logistical, etcetera) created for the Cold War seeks a new outlet for its justification, and is in the process consuming vast resources. On the surface, everything looks fine with Europe and the US, but under the surface, we got trouble. First, the US is stuck between a fiscal rock and a hard place. It's so in debt to foreigners, and a collapse of its inflated asset prices would be so devastating to its badly weakened economy, that it must inflate or die. Their central bankers have quite clearly indicated that given a choice between inflation and deflation, they will choose the former. And act on it. Eventually, holders of its debt will start to demand higher risk premiums (i.e. interest rates) that a process of asset deflation, or inflation in some sector of the economy will begin. In fact, it is well under way in the housing and stock sectors. The essential flaw in the way the US is doing business is that more debt must be created to service old, they're not producing things people want so they can pay down debt. That means they must either find new sources to buy the offerings, or old sources must take on more. It can't go on forever despite the top US government financial official's musings of "A new era in risk and debt intermediation leading to a benign resolution of the capital account deficit situation." The Europeans are quite properly aghast at the drivel coming out of Alan Greenspan's mouth, but they're stuck, too. To wit, they're trying to achieve stability and unity in an increasingly unstable world. The Orient now has a series of major independent economic players, and their cheaper labour and flexible management styles is eating Euro-land lunch. The individual nations which make up the Euro zone are going through some tough times, and politicians need to get reelected everywhere. Recent national elections in France (9% unemployment!) saw a far-right candidate do extremely well. How long until a "Fredonia First" candidate gets the reins of government and thumbs his nose at Brussels? The US is talking about building a homeland wall. Dumb, and inevitably it must fail, as did The Great Wall. What will happen is that as the US loses its ability to carry on (default on a host of obligations or raise taxes precipitously), citizens will increasingly look to more local governments to represent their needs. Look for a major resurgence in "States' Rights" in the next few years in the US. Dissolution, if it comes, will come from within, and the entity called the United States will come under increasing strain from all sides. It's already happening to a certain extent as state and local governments face a variety of credit crunches as their industrial and personal income tax bases collapse. It's better business for Californian companies to sell the land under their factories and move. Don't be fooled by the sudden increase in US Gross Domestic Product. It's mostly more debt sustaining the unsustainable. Protectionism is also rearing its ugly (or pretty I guess, if you get your job back) head, but this is just a sign of what lies ahead. Again, it will be local interest groups pushing for protection. The farm lobbies of a host of developed countries are already receiving massive tariff protection in the form of subsidies, and the pressures will mount to "save jobs." Dis-integration will happen one way or the other. The signature event which provides the transition to dis-integration of the US or Euro regions may be the imposition of a huge round of tariffs and counter-tariffs, or it may be a large hedged currency or derivative (complex financial instruments 'derived' from asset prices) player defaulting on obligations. The precursor to this was the collapse of Long Term Capital Management in 1997. Or, the event might be a sudden bond sell off (with attendant rising mortgage rates). The response by the US financial establishment to economic shocks in the past was for them to inflate the number of dollars out there, essentially papering over the bad debts. This has been done principally through the "Government Sponsored Entities", who underwrite mortgages, and their "Books of Business" have gone exponential (see Prudent Bear for some dramatic charts of this). Increasing credit at this point may not work any more if another financial shock occurs. Who's Getting Bigger, and For How Long? Today's new kid on the block, China, is getting bigger and will one day probably assimilate Taiwan with hardly anybody noticing. All Asian economies are loaning money to the US which returns to those countries to pay for their exports, a consequence being that the US gets into more debt. It will be interesting to see if the large Asian countries can get along with each other when strains come out into the open, or whether old rivalries will reemerge. With the inevitable next recession, will increasingly confident regional Chinese business classes push for some kind of dis-integration? They're already experimenting with democracy at the local levels in China. Will these new governmental forms start pushing for real power? How will India respond to an economic shock, with its huge and highly educated population? I don't know, but I think localization movements are certainly on history's side right now. Japan is in a unique situation, with its island nature and insular attitude, but it will not be immune to dis-integration. In this case, it will probably finally become increasingly disconnected from the United States, when the latter is no longer able to provide direction and ready consumption of its exports. Look for Japan to gradually gravitate to its Asian neighbours, and a pan-Asian monetary union is a distinct possibility. Will continued deflation finally cause some splintering of thought in fortress Japan? In fact, it's probably a very good question to ask if Asia will become more integrated as it asserts its new found power, or splinters when times turn tough. It probably depends on the depth of the recession ahead, and if a new source of consumption emerges. Asia is awash in US dollar holdings, their price paid to export goods, and repidly increasing the amounts of their own currencies. If a round of tariffs come about, they will have no more incentives to buy, or even hold US debt instruments, and that's why I think the world of US-centric "structured finance" will one day come under extreme pressure. The time and subsequent pace of such an adjustment is unknown, but the US dollar has already begun its descent versus currencies which are not engaged in active management. After the initial financial adjustment period I see ahead (collapse of US consumer demand, deflationary waves throughout the rest of the world), I see the possibility of a sustainable pan-Asian economy emerging. But, it's going to take time, and the transition won't be easy. How will all these potential splits play out? Hopefully, the models will be peaceful like Czechoslovakia or even Russia, and not Yugoslavia. Canada First? I am of two minds thinking about how all of this will affect Canada. The "emerging" world's voracious appetite for raw materials may be balanced by deep cuts in cross border trade with the US. The "hot" investment money may one day come here in size leading to speculative frenzies of one sort or another. House prices are already up over 12% year-over year in my area. One thing is certain. Canada will rely less on the US after it goes through it's wrenching adjustment process ahead. Instead, we will probably trade more with the Pacific Rim. The other problem we've got is that very few of our own resources are owned by Canadians. This is an unfortunate consequence of never having had a revolution. We've just exchanged one set of of foreign owners for another. We may ship lots of things but derive very little benefit from it. Will Canada break up? Probably not, but the newly reelected Liberals under Martin will go back to doing what they always do, feeding their power bases in Ontario and Quebec. If there's a major depression up here, increasingly disenchanted Western regions may look West across the Pacific. Western Separatism? Who knows. What to Do? How about gold? In this world of rapidly increasing paper claims, there is an alternative. I think "real things"; wheat, oil, gas, nickel, soybeans, and so forth are the investments of choice. There are only two times to own precious metals, when inflation is high, or when other asset classes are defaulting (like, soon). "Real things" are not an asset which is ultimately somebody else's liability (e.g., a loan), an investment approach predicated on safety as much as hope for capital gain. It's not that the assets are going up in price, it's the currencies they are measured in are going down. Gold just sits there, earning no interest, ultimately costing its owners money to store. Intrinsically, it has only the value we assign to it, the available world store of it increasing about 2% per year. Yet, for thousands of years, people have desired it, fought over it, and more importantly, particularly in times of stress, used it for money. Gold is money, a store of value, and a medium of exchange. When the US went off the gold standard in 1972, it wasn't gold that was demonetized, it was the dollars. We are approaching such a time of stress. Gold will be a good investment for the foreseeable future. The world's governments go on inflating their fiat (backed by nothing) paper currencies together much faster than the store of gold is increasing. Gold is undervalued relative to the amount of currency out there. It's that simple. The Euro zone has so far resisted flooding their currency (note gold versus the Euro is practically unchanged over the past 3 years), but the price of stability has been stagnation. Some recent Euro currency intervention has occurred, suggesting they may be more willing to enter the worlds of deficits and competitive devaluation. One day, there will begin a paper revulsion, a financial dis-integration, and it behooves us to be ahead of the curve. It isn't a matter of profit, it's a matter of survival. Banks may fail, "secure" deposits evaporate, and the little guy will get screwed. It's happened depressingly often before, and a crisis of confidence in the financial establishment looms ahead. In times of stress, governments confiscate financial assets. In the great depression, the US confiscated citizens' gold, but since few people own gold in quantity these days, the confiscation will probably take the form of inflation. Savers are, and will be, punished with less purchasing power. Historically, this process has usually led to social dis-integration (Germany of the 1920s being the greatest example). Look for some breakdown in societal norms. It won't be a linear process, however. Many bizarre things will happen on the path to dis-integration, and planning for them is somewhat futile. The one sure thing is that gold will progressively become more highly valued as the process continues. Be prepared for some bad days ahead. But be prepared. This is not a time to buy, hold, and walk away. Financial plans may be made and adhered to, but be prepared to alter course if circumstances dictate. A flexible approach is called for. Diversify your investments. Keep some cash, have a Euro account handy, maybe have some physical gold. Be prepared to get in and out quickly, but at other be times be prepared to "Stay the course." Situations have to be met individually. Conclusion Let's see what the three deans of US investing the past 40 years have to say about investing today. I'm speaking of course, of Warren Buffett, George Soros, and Richard Russell. Many of their views overlap, so I'll only provide little snippets of their views. 1. George Soros. "The last few financial crises were at the periphery. I fear the next one will be at the center." Sounds about right to me. I've moved all my assets out of the US, diversified my holdings into "real things", and have a few exit doors picked out. 2. Warren Buffett. "I don't like the stock market right now." Neither do I. Strictly defensive sectors. We never did have a real Bear market after the Nasdaq bubble, despite what the analysts say. But we will. Stocks are overvalued, earnings bogus, and consumption in the US is being held up with massive deficits, both trade and budget. 3. Richard Russell. "This is a unique historical opportunity to buy gold dirt cheap. Silver, too." No comment
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