Thursday, January 21, 2010

Issue VI - Gold/Silver Ratio 1/21/10

Dear Readers,

As you know, many investors and central banks the world over have been turning to precious metals in the past year to protect against inflation. While gold is enjoying the best bull run it has seen in a generation, its little brother silver is currently underpriced when one considers the historic gold/silver ratio. Additionally, given its additional uses as an industrial metal, along with a potential shortage lurking in the wings, silver potentially offers more robust returns for the duration of the bull market in commodities. Knowing the history of this monetary ratio in the United States is necessary to understand its relevance today.

Silver is about 17.5 times more abundant than gold in the earth’s crust (.07 parts per million to .004 ppm, respectively, according to the US Geological Survey). This ratio was recognized by civilizations as they developed currency systems over time. Thus, in 1792 the newly formed US Congress passed the First Coinage Act. The Act officially established the Dollar as our currency, defining one Dollar as a weight of pure silver, 371.35 grains to be exact. A Quarter Eagle ($2.50), was defined as 61.875 grains of gold. The Act legally set the gold/silver ratio at 15.

In 1834, Congress passed the Second Coinage Act, slightly tweaking the gold/silver Ratio from 15 to 16. This better reflected market values at the time and drew it closer to the natural ratio. In 1858, silver was discovered at Comstock Lode, Nevada, and the resulting influx of ex-49er’s and subsequent discoveries (Eureka, Pioche, etc.) led to the proliferation of silver mining as an industry in the 1860’s. Needless to say, this threatened to collapse the price of the metal. In response, the 1873 Fourth Coinage Act discontinued the minting of silver Dollars, and decreed that silver coins above $5 were no longer legal tender. Thus, the gold/silver ratio was allowed to rise. Silver advocates and miners for the next generation would refer to this statute as the “Crime of ’73.” The closest the US came to reintroducing silver as a monetary metal was when William Jennings Bryan advocated bimetallism during his ultimately unsuccessful 1896 presidential campaign, arguing that it would induce inflation and help indebted farmers and the rest of working-class America, who had lived in a deflationary economy from 1873-96. The debate over this at the time was made indelible by the metaphor of the Yellow Brick Road in L. Frank Baum’s The Wonderful Wizard of Oz, originally published in 1900. Indeed, the name “Oz,” as in ounce, implied that bimetallism was the “golden road” to prosperity. (Refer to Chart 1.)

Chart 1: The Gold/Silver Ratio from 1900 – 2008

In the early years of the 20th century, the ratio rose to the low 40’s but fell back into the teens during the Roaring Twenties. After Roosevelt confiscated gold from the American people in 1933 and devalued the US Dollar by revaluing an ounce of gold from $20.67 to $35, the ratio nearly cracked 100 in 1939. (I referred to this devaluation in my January 1st commentary on Chairman Bernanke.) After Bretton Woods and against the backdrop of economic prosperity of the Post-War era, the ratio fell to around 20 until Nixon abandoned the Gold Standard in 1971. As the price of the yellow metal floated, gold outperformed silver until the fallout from the 1973 oil crisis, and then for the remainder of the decade silver outperformed gold as the ratio fell.

This culminated with a mega-spike in the price of silver in late 1979 and early 1980 when the Hunt Brothers tried to corner the market. The gold/silver ratio hit a bottom of about 16 at this time. As traders exited their positions en masse and the Hunts were wiped out, silver fell even faster than gold, which itself crashed from $850 to $600 in just three months (refer to Charts 2 and 3 and my subsequent comments). By May 1980 the ratio was back at 40.

Charts 2 and 3: The Gold/Silver Ratios 1970 – 2009

Chart 2 is Gold, Chart 3 Silver. Overlaid on both is the Gold/Silver Ratio. Note the extreme activity in 1979-80 on both. In percentage terms Silver rose, and eventually fell more, hence the crashing and then rocketing ratio.

For the duration of the decade and into the early 1990’s, the ratio continued to rise because gold outperformed silver, but only because it did not lose as much of its value. While the ratio reverted back to its 20th century average by 2000, gold and silver did not bottom until 2001 and 2003, respectively. At that time, silver once again turned up and the ratio began to fall. This trend continued until the onset of the 2008 Financial Crisis. The 2007-2008 spike in the ratio provided a very attractive entry point for those with the means to take advantage of it.

This brings us to today (refer to Chart 4). The ratio spiked to over 80 in 2008, and was at 70 as recently as last July, currently standing at 62.17 as of yesterday’s close. The trajectory is downward, which creates a potential advantage for investors in 2010. In short, silver is still undervalued. Of course, it’s not going to fall to its pre-1873 ratio of 15 or 16 anytime soon. Despite the historical ratio and the natural ratio, the fact is that after the Industrial Revolution and through the 20th Century, the ratio’s average was roughly in the range of 47-50. However, a lower ratio is not out of the question if the current bull market in commodities sustains for long enough. During inflationary times such as the 1970’s, the ratio averaged between 20 and 40, falling below 20 during the final spike in early 1980. Given the current trend, in 2010 I expect it to fall below 60, and possibly even break 50.

Chart 4: The gold/silver ratio January 2007 - Present

If inflation begins to pick up in the next few years, there is no reason that the ratio will not fall back into the 20-40 range or even below. Even then, if the gold/silver ratio fell to just 50, and prices held at their current levels, gold would be worth about $1,110 but silver would rise to $22.20, representing a 24% increase from the January 20 closing price of $17.90. Thus, if gold merely surpasses its early December 2009 high of $1,225 and the ratio continues to revert to its 20th century average, $24-25 silver would not be out of the question by the end of 2010. For that reason, silver potentially offers more lucrative returns than gold.

As I write this, a pullback is occurring in precious metals. Current events, including continued worries about Greece’s financial woes, China’s curbing of bank lending, and Scott Brown’s Senatorial victory in Massachusetts, led to silver selling off by 3% today, with gold down slightly less. In my opinion, this is because for silver, China’s continued expansion is particularly important because of the metal’s plethora of industrial uses. I have no doubt that will continue, and today’s movement merely reflects the short-term focus that permeates today’s markets. Additionally, the Dollar Index, after falling for the past week, shot back up over 78 solely due to the weakening of the Euro. The USD has actually continued to fall so far in 2010 against the pound and other currencies in the six-currency-basket Dollar Index (refer to Charts 5 and 6). In fact, gold and silver priced in Euros were only down slightly today. For 2010, I am confident that the long-term trends that favor precious metals will reassert themselves, including that of the gold/silver ratio.

Respectfully Yours,

Matthew R. Green

Chart 5: US Dollar vs. British Pound July 2009 - Present

Chart 6: US Dollar vs. Euro July 2009 – Present

Note the jump that began with the Dubai debt scare in late November/early December, and the spike this week due to the Greek finance debacle.

Sunday, January 10, 2010

Issue V - M&A - 1/8/2010

Dear Readers,

The Mergers and Acquisitions market in 2009 ranged from the doldrums of the “winter of discontent” to showing real signs of life by the end of the year. M&A activity toward the end of the year (Warren Buffett purchasing Burlington Northern railroad and Exxon Mobil buying XTO Energy, etc.) was certainly indicative that strategic acquisitions are making a comeback. However, it is too early to say that we have hit bottom for several reasons.

I am suspicious that the number of announced deals in 2009 is indicative of a very large pickup in activity. I have seen several prominent M&A group heads quoted on TV and in the Wall Street Journal noting that since 1990, M&A activity has been about a 2-year cycle from peak to trough. By such criteria, 2009 should be the bottom. It is a cyclical business by nature, which goes in tandem with the US economy. Several headwinds exist against the argument that the activity in late 2009 is the advent of a new M&A boom. First, many companies spent 2009 repairing their balance sheets, and many, particularly manufacturing companies, are still in that process. Second, the equity markets were very volatile in 2009. Volatility in the equity markets is usually not conducive to M&A because companies want a fairly stable equity environment before they act, whether their intentions involve making an offer or issuing stock, etc. Finally, even with the comeback of strategic acquisitions over the second half of the year, such deals were often greeted with lukewarm reception from the market.

If this recession proves to be a double-dip recession, we could see another downturn in M&A activity as well. In early 2009, during the depths of the recession, the majority of M&A assignments involved strengthening clients’ balance sheets. We saw this across the entire spectrum from mid-sized companies to components of the Dow and S&P 500 such as Alcoa and US Steel. In Alcoa’s case, Morgan Stanley and Credit Suisse helped raise $1.3 billion via an offering of both stock and convertible debt. This “Rescue M&A” was the focus until about April/May, and acquisitions were about the last thing on the CEOs’ minds.

In December, Paul Parker, global head of M&A at Barclays Capital, said, "If you look deeper into 2009 and you back out rescue financings, which were counted as M&A transactions, we're closer to $1.6 trillion in traditional M&A. So much of this year has been nontraditional M&A and a few mega healthcare deals.” Indeed, the few deals that were executed early in the year involved clearly defined companies, were very conservative in nature, and did not go outside the companies’ core businesses. Perhaps the two best examples of this were Pfizer’s acquisition of Wyeth in January and Merck’s reverse merger with Schering-Plough in March.

In September and October, things began to get interesting. Xerox announced the acquisition of ACS, and Michael Dell announced he was buying Perot Systems. Later, on December 14, Exxon made headway into the Natural Gas business by buying XTO Energy. Suddenly, transformative deals were back in the news - deals where a company was going outside the realm of its core business. The market did not initially digest these deals as well as one would have hoped. The reaction was lukewarm at best (see Charts 1, 2, and 3). However, it should also be noted that by the end of the year, this trend began to show signs of abating. Warren Buffett’s acquisition of Burlington Northern and Comcast’s purchase of NBC Universal (announced on November 3rd and December 4th, respectively) were well-received and both stocks have reacted favorably since. Nevertheless, the trend over most of the year was not favorable toward strategic acquisitions, as was reflected in the respective stock prices against the backdrop of a great rally in the equity markets.

This presents a problem that many chief executives are now experiencing; they are finding themselves trapped between a rock and a hard place. A CEO will get punished if he or she presides over a low-growth business. However, in an economic environment like that of 2008-09, if he or she attempted a strategic acquisition, they often got punished because the market interpreted the move as one that was going outside their realm of expertise. What carries the most significance never changes - it is the return on invested capital, which in the long-term is best for the shareholders.

Too many CEO’s, especially in times like these, are being forced by their boards and shareholders to look for growth regardless of the economic setting. This is a phenomenon that is seen close to the peak of any bull market. This is especially relevant as we near the 10th anniversary of the ill-fated AOL-Time Warner merger, announced January 10, 2000. That deal marked the peak of the Technology Bubble (Time Warner’s stock shot up almost 40% the day that the deal was announced), and today serves as perhaps the most egregious example of what can happen when CEO’s focus on growth simply for the sake of growth. Again, what CEO’s have to look at is not market values, but at the big picture with respect to their company’s position.

In 2009, there is one deal that stands out in my mind that best followed these guidelines. On August 4, PepsiCo announced its intention to re-takeover its distributors Pepsi Bottling Group and PepsiAmericas (it had previously spun them off in 1999). PepsiCo CEO Indra Nooyi and her board wanted to retake control of a core part of their business that they thoroughly knew, and the market rewarded the move (see Chart 4). CEO’s should never forget that bold moves where a company stays within their realm of expertise will be rewarded in almost any environment.

Besides seeing decreased activity in the “corporates” sector, the other major reason 2009 was such a lean year for M&A activity was that its other engine, private equity, has largely been on the sidelines since 2007. Ever since banks became reluctant to lend money for classic leveraged buyouts, their lifeblood of credit has become scarce. Of course, PE bigwigs such as Henry Kravis, Stephen Feinberg, and Ted Forstmann are known for being very smart and innovative. Deals are what they thrive on, and they will find a way to make money in most environments. Therefore, while they are likely be absent from the $5 billion-plus acquisitions, they are initiating highly structured deals to put their investors’ money to work. Many assets were on the market in 2009, and they often pounced if they found a deal to be attractive.

A great example was the Sept. 17 Kohlberg Kravis Roberts deal for Kodak. KKR came in, assisted with Kodak’s balance sheet, and will buy $400 million in senior secured notes due in 2017, at an interest rate of 10% to 10.5%. As part of the deal, KKR could control about 20% of Kodak's shares via warrants. In typical Kravis fashion, he also received two board seats. At the end of the day, it was a vote of confidence in Kodak’s film-to-digital transformation and long-term health. Of course, that does not change the fact that the M&A market is looking forward to banks becoming more willing to lend money for deals with higher leverage, so that private equity firms and corporations can begin to compete on deals once again.

To close, the M&A market appears to be showing some signs of an uptick, but in the grand scheme of the economy it appears to not have gotten ahead of itself. Jeffrey Kaplan, global head of M&A and financial sponsors at BofA-Merrill Lynch, told ThomsonReuters in December, "You need a sustainable economic recovery. You cannot expect the M&A market to flourish without favorable economic conditions. The best deals often are done at the beginning of a recovery. Post-bubbles create opportunities to get great values but are not always the best times for sustained M&A activity." Indeed, the numbers tell the story. M&A totaled about $2 trillion in 2009, down 32 percent from 2008 and down 53 percent from the record high in 2007, according to data from the Wall Street Journal. It all adds to the reasons to hope for a continued economic recovery in 2010.

Respectfully Yours,

Matthew R. Green


Chart 1 – Xerox (XRX) August 2009-Present

Xerox announced its acquisition of ACS on Monday, September 28, 2009. As you can see, the market did not react favorably. Subsequently, the stock fell off the late 2009 rally until mid-December.

Chart 2 – Dell (DELL) August 2009-Present

This deal was announced on September 22, 2009. The market’s reaction was not favorable, and the stock is still 15% below its 2009 high, despite a December rally.

Chart 3 – Exxon (XOM) August 2009 – Present

Exxon announced its acquisition of XTO Energy on December 14, 2009, perhaps the most strategic deal of the year. The market has not reacted favorably in the three weeks since.

Chart 4 – PepsiCo (PEP) August 2009 – Present

PepsiCo announced its acquisition of Pepsi Bottling and PepsiAmericas on August 4, 2009. This was perhaps the best-received acquisition of the year, and the company’s stock has been rewarded with a nearly 10% increase since.

Issue IV - Deflation - 1/1/10

Dear Readers,

“The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”

– Ben Bernanke, Speech to the National Economist’s Club, November 21, 2002 (emphasis added).

A schism is developing among economists as to what will happen to the US Dollar as a result of the 2008 financial crisis and subsequent actions taken by the Federal Reserve. In my last letter, I focused on monetary inflation and why I think it could become a problem in the coming years, although the US will not likely face a situation of hyperinflation. This week’s letter explores the opposite: deflation. Notably, Nouriel Roubini and Marc Chandler (author of the popular “Gloom, Doom & Boom” report) feel that deflation is the current problem that the Federal Reserve must confront. Regardless of which group is correct, the fact of the matter is that the Fed’s actions of the past year are geared toward preventing deflation by all means possible. The background of Fed Chairman Ben Bernanke further illustrates this point. Finally, technical analysis of the US Dollar suggests that further declines in the currency are on the docket for the first few years of this decade.

Monetary deflation is often associated with extended economic contractions, which can lead to a vicious cycle of falling asset prices. Japan has experienced deflation since the early 1990’s (refer to Chart 1 and my subsequent comments), and indeed deflation was a major factor in causing the Great Depression in the 1930’s. After an economy enters a cycle of deflation, it often takes decades to break out of it. In calling for near-term deflation, Roubini and other economists point to the large gluts in housing, industrial capacity, etc. That being said, the response of the US Federal Reserve to the 2008 financial crisis has been the polar opposite to the response during 1930-32, which was lassiez-faire. The difference in response can be attributed in great proportion to one man: Federal Reserve Chairman Ben Bernanke. As perhaps the most respected scholar on the Great Depression, even before the 2008 crisis Bernanke made clear that aggressive central banking actions were necessary to prevent deflation. His responses to the crisis have made it clear that he intends to use every policy tool at his disposal to prevent deflation. Depending on one’s view of his actions, the fact that he is the Fed Chairman who faced the crisis is either a blessing or an unfortunate circumstance. I believe the American people are fortunate to have had his mindset and actions in charge during and in the immediate aftermath of the crisis. However, in the long run the forecast is not as rosy.

It is extraordinary that Ben Shalom Bernanke was appointed Chairman of the Federal Reserve two years before the broadest, most severe financial crisis since the Great Depression began. If Bernanke was not in the Federal Reserve, in my opinion he would have been at the top of the list of individuals to be consulted for advice on understanding the crisis and, more importantly, how to construct policy in response. Bernanke served on the Federal Reserve’s Board of Governors from 2002 to 2005, and briefly as the Chairman of the President’s Council of Economic Advisors before his appointment as Chairman of the Federal Reserve. As soon as he arrived from Princeton, his first speech as a member of the Board of Governors (on the occasion of the great Milton Friedman’s 90th Birthday), outlined his theories for fighting inflation. The ideas put forth in the speech have come to be known as the “Bernanke Doctrine.” The speech as a whole has become eerily prophetic in the aftermath of the 2008 crisis.

By late 2002, in the wake of the deflating technology bubble, Alan Greenspan had slashed short-term interest rates to 1%. Yet, uncertainty lingered in the aftermath of the 9/11 attacks and the Enron and WorldCom scandals. The Dow and NASDAQ did not bottom until October 9 of that year. Thus, over the course of 2002 deflation had been mentioned as a potential problem by several economists and economic policy groups. As mentioned, Bernanke took the opportunity of his first speech as a member of the Fed to address the potential problem and how to deal with it.

In his speech, Bernanke outlined seven steps to prevent deflation. First, increase the money supply (M1 and M2). This point was backed up by the quote that introduced this letter. Obviously, in 2002 the strength of the US Dollar was not a pressing concern, as is the case today. Bernanke went on to mention the prospect of the Fed purchasing US Treasuries (this was initiated in March 2009 by Bernanke in cooperation with Geithner’s Treasury), and also the implied purchase of stakes in companies using newly printed money (sound familiar to TARP and the GM Bailout?). Finally, Bernanke condoned a more direct method of devaluing of the dollar, to augment the printing of money. In extolling the Fed’s actions under Roosevelt in 1933, he said:

"It's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly."

Fast forward seven years. When Bernanke speaks about the US Dollar today, his words are carefully crafted to finesse the point and to avoid creating volatility in the currency markets. After all, the mandate of the Federal Reserve involves, among other things, maintaining the strength of the US Dollar. Thus, he would likely not be so blunt today. Regardless, Bernanke’s philosophy toward fighting deflation was well-formed long before he assumed the office of Chairman of the Federal Reserve. Given his knowledge of the Great Depression, Bernanke appreciates more than anyone else what could happen if the United States were to fall into a deflationary spiral. Hence, it can be argued that he helped save the United States from what could have become a “Second Great Depression.” Yet, the actions of his Fed have greatly undermined the long-term health of the Dollar. These actions could lead to a weaker dollar and inflation during the new decade.

The argument against deflation is further enhanced via technical analysis of the US Dollar. The dollar is in the midst of a secular, multi-decade decline (refer to Chart 2). In my opinion, this decline was inevitable due to US output as a percentage of the global GDP gradually declining and the emergence of the Euro and other reserve currencies, among other factors. From a technical standpoint, this decline is not likely to stop. Of course there will be short-term corrections, this past month being a perfect example (refer to Chart 3 and my subsequent comments). Trading at the upper range of both the Bollinger Bands and Stochastic (50-Day over 200-Day Moving Average), the majority of this short-term correction has likely run its course. Keep in mind that the flight to safety that began in mid-2008 resulted in the Dollar Index jumping from 72 in July 2008 to about 90 in March 2009. This occurred while the Fed more than doubled its balance sheet and commenced quantitative easing. The decline that began last March was inevitable and will likely continue.

In my November 27 letter, I predicted that there would be volatility in the wake of the Dubai debt scare. At the time, I predicted the dollar would resume its decline “anywhere from two weeks to a month from now.” Beginning last month with Dubai and Europe’s exposure to their debt, and more recently with debt concerns in Greece and Spain, the Euro has been hammered against the US Dollar, falling from 1.50 USD to 1.43 on December 31. Due to the heavy weighting of the Euro within the Dollar Index, some currency specialists are predicting the bounce in the Dollar to continue into the early part of this year.

Regardless, I remain unconvinced that the recent dollar rebound is anything other than a temporary head fake. The Dollar Index has been treading water between 77.50 and 78.45 for the past two weeks. If several important technical barriers are broken early in the new year, we could see continued dollar strength for the next few months. However, with another $871 billion balance sheet expansion on the docket (the health care bill), barring a few countries in the Eurozone defaulting or another unforeseen geopolitical event (Iran, Israel, etc.), the dollar will likely continue to decline in 2010. A sustained climb in the Dollar Index would be a sign of deflation, but with a deflation watchdog like Bernanke running the Fed, it is not likely to happen.

Respectfully Yours,

Matthew R. Green

The full text of Chairman Bernanke’s speech can be found on the Fed’s Website:

Chart 1: Nikkei 225 Index 1965 – Present

This chart illustrates what a deflationary spiral can do to a country’s capital markets. The Nikkei peaked on December 31, 1989 and is today more than 70% below that. Granted, the US economy will likely never see a bubble on the scale of what the Japanese economy experienced from 1985-89. To illustrate my point, in late 1989 the Financial Times reported that the land in central Tokyo beneath the Imperial Palace and its grounds was more valuable than the entire state of California.

Chart 2: US Dollar Index 1986-Present

The USD’s fall in the mid-1980’s was a direct result of the 1985 Plaza Accords. This agreement was a planned devaluation of the USD vs. the German Mark and Japanese Yen (indeed, it contributed to the Japanese Asset Price Bubble). For Americans, the best part of the 1990’s was that the market was rising along with the value of our dollars. By contrast, in the 2000’s the market was volatile, ending the decade with little to no gain, while the dollar lost more than 20% of its value.

Chart 3: US Dollar Index - January 2005 to December 2009

The Dollar’s move in 2008 should be viewed as an aberration. Without it, the short (blue), mid (red), and long (green) term moving averages would all be lower. Notice that combined with the Dollar’s correction this year, the Long-term moving average is virtually unchanged since September, 2008. The rise in the dollar the past few weeks (the Dollar Index closed on 12/31 at 77.95), has allowed it to approach its mid- and long-term moving averages. This is an interesting circumstance. Normally, a security’s mid-term average crossing through the long term average on a downward trajectory is a bearish signal. However, dollar strength in early 2010 could result in the Dollar Index crossing both levels of resistance. This would be a bullish signal and likely pave the way to further dollar strength in 2010. At the same time, the short-term Stochastic and MACD indicate that the Dollar is overbought in the short term. Bottom line: the market will be keeping a close eye on the Dollar Index in the next few weeks for direction in 2010.

Issue III - Inflation - 12/10/2009

Dear Readers,

As we all know, the past two years have borne witness to the sharpest, most severe economic contraction since the Great Depression. Recent sets of economic data have suggested that the recession is abating, if not having ended already. Simultaneously, many economists have suggested that the extraordinary measures initiated by the Federal Reserve and other entities point toward another looming crisis: Inflation and the debasement of our currency. In my last letter, I argued this with respect to the current Dollar Carry Trade, and how that trade, while there may be corrections from time to time, will remain the trend as long as the practice of systematic devaluation remains in place. I believe the devaluation of the US Dollar will continue as long as Bernanke and Co. is running the show. At the same time, we need to pause before we immediately begin to convert our US Dollars into Australian Dollars or Norwegian Kroner (these countries are both already in the process of raising rates, refer to Charts 1 and 2 at the end). Indeed, inflation has its cons, but it has pros as well. The fact is that it has more pros than its evil stepsister, deflation. Additionally, the experience of Argentina from 1976-1991 reveals that inflation does not necessarily undo a society. It is necessary to consider the position of the United States within the world economy compared to other countries that have experienced high levels of inflation.

The last three generations of Americans have come to regard inflation as a fact of life. Retro advertisements that tout a bottle of Coca-Cola for 5 cents are now used as d├ęcor in countless households. Those over 60 recall purchasing candy and ice cream for pennies. Controlled inflation over time is an acceptable economic scenario. Rising asset prices make their way through the system, from stocks to real estate. For example, as prices gradually rise, it is easier for companies to report rising earnings year-over year. Good earnings result in higher stock prices. Such is the opposite in a deflationary scenario. Prices are forced lower, which forces companies to cut costs and lay off workers. This can become a vicious cycle (examples: US Great Depression and Japan Post-1990). Since Paul Volcker’s Fed was able to get inflation under control in 1981-83, it has been low and manageable for the longest stretch in history. In fact, in the five years leading up to the Credit Crisis, many economists, including Alan Greenspan, suggested that late 20th century banking practices had led to a new age dubbed “The Great Moderation,” in which volatility in inflation, GDP, unemployment and many other economic variables would be permanently low. The Credit Crisis and its implications have tossed this paradigm out the window.

The monetary base of the United States has been expanded more than ever before due to the Federal Reserve’s response to the Credit Crisis and subsequent recession. The end result of this will be higher inflation. In a letter to his (no doubt extremely happy) investors, hedge fund manager John Paulson argues, “the monetary base has expanded to an absolutely exponential degree. Typical year-over-year changes in monetary base were under 20%. When the crisis occurred, that year-over-year change skyrocketed to 128%. Additionally, the correlation between the monetary base and money supply is very close, almost 1:1 as the monetary base finds its way to the money supply.” What he means is that while the monetary base has swelled, the money supply has not, at least not yet. This is due to the velocity of money plunging, accelerating after the other Paulson (Hammerin’ Hank) allowed Lehman Brothers to go bankrupt. The heart of John Paulson’s argument is that inflation has lagged money supply growth by 2-3 years. Thus, now is the time to be preparing for it. In his case, he is currently raising outside money for, and placing $250 million of his net worth into a new Gold-centered hedge fund.

Examples in modern history show that even decades of inflation will not lead to the undoing of a nation, as many pundits may inevitably suggest in order to sell books, get face time on TV, etc. The Weimar Republic is not a good historical example, as the main trigger of the 1922 hyperinflation was the forced debts on the Republic via the Treaty of Versailles to pay for the rebuilding of Europe after World War I. Argentina is a better comparison in that it is not only more modern, but brought about by untamed government spending (sound familiar?) Additionally, the example of Argentina fits well in that it is still a proud, First World nation today after nearly twenty years of crushing inflation. Finally, the icing on the cake is that the US enjoys several economic advantages that Argentina did not. It is these advantages by which hyperinflation will likely never happen.

The South American nation of Argentina experienced steady inflation, including short bouts of hyperinflation, from 1976 to the early 1990’s (for perspective, refer to Figure 1). The Argentine Finance Ministry would initiate currency reforms in 1983, 1985, and finally in 1992. In the midst, the 1985 currency reform introduced a new currency, the Austral. After another round of hyperinflation in 1990-91, the 1992 currency reform introduced the “New” Peso. One New Peso equaled 100 billion pre-1983 pesos. The hyperinflation during this period was largely due to populist spending sprees, such were the legacy of Juan Peron and years of dictatorship. Other factors included building stadiums and improving infrastructure for the 1978 World Cup, and even waging a bold war they had no real chance of winning, the 1982 Falklands War. The money for these expenditures was essentially printed, contributing to the final inflationary spike that led to the 1983 currency reform. Seeing their savings and peso-denominated assets deteriorate, Argentines began to park large portions of their money in US Dollars. Wealthier Argentines sent their money to US Banks, while working class Argentines often kept $100 bills in safes. The country did have its problems. Poverty increased to around 40% in that time period, although it is markedly lower today. There were periods of rioting, although from an historical perspective they were roughly comparable to the US at some points in the 1960’s. No coup d’etat ever occurred. The first part of my point is that despite this decade and a half of difficulty, in addition to a more recent crisis in 2001, Argentina was and remains a First World country and G-20 member today. They have managed to short up their finances such that their Debt/GDP ratio is now lower than the US and many other industrialized countries.

Moreover, the United States, due to its position in the world and the accompanying economic interdependence of so many other nations, will likely never face the type of hyperinflation that defined life in Argentina for nearly twenty years. First and foremost, Argentina never had the advantage of their currency as a global reserve currency. The role of the US Dollar has gradually built up to the current economic interdependence between the US, Europe, Japan, and China, with particular emphasis on China. If the US Dollar enters a period of swift decline, these countries’ massive holdings of US debt will be reduced in value as well. This will be in addition to everything that is priced in USD (oil, food, other commodities) rising as the dollar is falling. This will not just be a US problem; this will be a global problem. We saw bits and pieces of this in early 2008 with the food riots that occurred in Latin America and the poorer regions of East Asia. In the off chance that we do have a currency crisis in the next five years, I personally think that we will see unprecedented efforts by governments worldwide to prop up the US Dollar. Central Banks will take measures to let their own currencies decline against the Dollar to keep it propped up until a new, global reserve currency can be introduced (this concept, highly interesting to me, is a possible topic for a future newsletter).

I believe we are looking at a decade or more of high deficits and higher inflation with neither likely to ever truly get out of hand (although the range of what constitutes “getting out of hand” is vast, especially among talking heads). Despite the massive 2009 budget deficit, the Public Debt/GDP ratio of the United States does not exceed that of the European Union or Japan (Japan is closing in on 200%!), and about a dozen other smaller countries. Don’t misinterpret, this trend needs to be reversed. The point is that we have a long way to go before we will really be in trouble relative to the current state of other world economies. Although not as dominant as before the introduction of the Euro, the health of the US Dollar is still vital to the global economy more than any other currency. Other countries are aware of this. The recent, colorful debate between Hu Jintao and President Obama over the former’s refusal to let his nation’s currency appreciate is more about the immediate situation than the future. If China immediately lets its currency appreciate, one of the immediate effects will be that some (not many, but some) manufacturing jobs could make their way back to the United States. Reversing this trend of the last twenty years could jeopardize the continued rise of the Chinese middle class. For this reason, while the yuan’s appreciation could help the US economy in the short-term, Jintao has no interest.

In the meantime, relax. Allocate 5-10% of your portfolio to precious metals and/or other commodities, and allocate more than that if you fear a currency crisis. Inflation and the debasement of our currency have resulted in 95% of the dollar’s purchasing power being erased since 1913. However, during that time the Dow has risen 12,000%. You only lose if you put your money under the mattress or in a simple checking account. Personally, I am a fan of Silver more than Gold as an inflation hedge, but this will also be the topic of a future newsletter. As long as Ben Bernanke has his way, we will not be doomed to a Japanese-style deflationary cycle. At the same time, we as a nation need to get our deficits under control in order to completely avoid an Argentina-style experience. Low inflation on a year-in year-out basis is acceptable. High inflation which could destroy the savings of middle-class citizens is not.

Respectfully Yours,

Matthew R. Green


Charts 1 & 2

Chart 1 is Gold when priced in Australian Dollars; Chart 2 is Gold in USD. As you can see, Gold (or any other commodity) is actually down over the course 2009 when priced in AUD. This illustrates the AUD’s strength.

Figure 1 - Illustration of Inflation in Argentina 1975-1991

January 1975: Highest denomination is 1,000 Pesos.
Late 1976: 5,000 Peso note introduced.
1978: 10,000 Peso note introduced
Late 1981: 1,000,000 Peso note introduced
1983: First Currency Reform: 1 Peso Argentino = 10,000 Pesos
1985: Second Currency Reform: 1 Austral = 1,000 Pesos Argentinos
1992: Third Currency Reform: 1 “New” Peso = 10,000 Australes

Bottom Line: 1 1992 Peso = 100,000,000,000 Pre-1983 Pesos (100 Billion)

Source: International Monetary Fund

Issue II - On the Dollar Carry Trade - 11/27/09

Dear Readers,

“Americans are apt to be unduly interested in discovering what average opinion believes average opinion to be; and this national weakness finds its nemesis in the market.”

- John Maynard Keynes, 1935

The 20th century British economist John Maynard Keynes was a veritable trove of quotable quotes. The above may be the most famous, yet many others are appropriate to economic circumstances time and time again. Today is no exception. The above quote is taken from his 1935 book The General Theory of Employment Interest and Money. To paraphrase, we Americans are very good at following the pack. Whether this applies to the stock market or the housing market, this trait comes back to bite us. It has, time and again.

The propensity to gravitate toward the trend also helps explain why those whose viewpoints eschew the trend make easy headlines. In recent years, they are often not taken seriously until after a particular economic bubble has popped. Some of these individuals buck the trend, only to be wiped out for calling the top too early. In 1998, the great hedge fund manager Julian Robertson became convinced that the Nasdaq had run its course. He began to actively short the tech sector. The resulting short position losses, along with several bad long positions (notably US Airways), and bad currency bets, ended with Robertson shutting Tiger Management in February 2000. The Nasdaq peaked on March 10, 2000, a mere three weeks later. Such an example illustrates another notable Keynes quote; “The market can stay irrational longer than you can stay solvent.” Others, like John Paulson in 2007, had more fortuitous timing and made a killing when their target (in his case, subprime mortgages) deflated.

Currently, one of the top trades in the news is the Dollar Carry Trade. A quick explanation; A carry trade occurs when a trader borrows money denominated in a certain currency order to buy assets in that currency. He does this with the expectation that the real value of the debt will erode over the time period he will own it, because the underlying currency will decline. With respect to the Dollar Carry Trade, many eyes in the investment world are paying very close attention to this trade due to its close relationship to other markets, especially the Gold trade (no uncrowded space at the moment) and the global equity markets. In the past month, several prominent economists have publicly predicted a swift, destabilizing unwind to this trade. Of these, Nouriel Roubini has been the most prominent.

On Wall Street, Roubini has earned the name “Dr. Doom” since 2006 for not only predicting the real estate collapse, but the rapid domino-effects it would have on the banking system and consequently the financial markets. In a recent Financial Times editorial, and also in trading verbal punches at a conference with commodities investor Jim Rogers, Roubini has made his view clear: the Dollar is due for a swift appreciation that will reak havoc on the markets. However, one needs to interpret the most extreme viewpoints with a degree of moderation. While a currency trade, especially one that is crowded, can turn on a dime, an investor needs to take a long look at the current position of the US Federal Reserve, and also the history of carry trades, in formulating a comprehensive thesis. In the opinion of this writer, Roubini is now playing the part of the epithet he most definitely earned, and little else.

In the past year, the Federal Reserve Bank of the United States has unleashed an unprecedented amount of liquidity into the world economy. As a noted scholar of the Great Depression, Chairman Ben Bernanke surely knows more than the average central banker of the potential destruction caused by deflation. High inflation is bad, but deflation is much worse (the logic behind this will be the topic of a future commentary). After six months of dollar appreciation, the Fed responded to the looming possibility of a depression-like vicious cycle of deflation. In his March, 2009 testimony to the House Financial Services Committee, Bernanke announced that the Fed would commence a program of Quantitative Easing. (This took the form of the Fed purchasing its own Treasuries, in order to keep rates artificially low). It was at this point (Refer to Chart A) that the US Dollar resumed its downward trend. Among other tools in their arsenals, other Western governments have been doing much of the same thing. The end result is the devaluation of the US Dollar and other fiat currencies. Thus, the trend remains in place for traders to borrow the USD to fund asset purchases, with the expectation that the real value of the debt will erode, because the underlying currency will decline.

Chart A

US Treasury Secretary Timothy Geithner announced that the Fed ended its QE program after the latest Treasury Auction earlier this month. Nevertheless, the Federal Reserve remains determined, by all means possible, to prevent what happened in 2008 from happening again. One method they continue to utilize is the devaluation the US Dollar via low interest rates, and therefore inflation. Inflation year in and year out is nothing new. In fact, since the Federal Reserve was created in 1913, the US Dollar has lost 95% of its purchasing power. The bulk of this decline has been since President Nixon took the US off the Gold Standard in 1971. Since then, it has lost 80% of its purchasing power. Prices going up overtime, and the dollar being gradually devalued are part of a continual trend.

Additionally, the Federal Reserve has very little room to maneuver with respect to interest rates and indeed the US Dollar. If rates are raised, the Fed threatens to derail the fragile economic recovery. For recent news conferences, Bernanke and Geithner have concocted very carefully worded statements regarding their stance on the dollar. They continue to claim that they support a strong dollar. Yet their actions of the past year suggest otherwise, including the fact that they have not expressed any intention to begin raising rates for “quite some time,” which many on Wall Street have translated into around late 2010. According to the transcript of the most recent Federal Reserve Board of Governors meeting, several members, including the Governors of the St. Louis and Dallas branches, are beginning to express concern that such low rates could lead to high inflation in the next five years. Given the state of the current economic recovery (or lack thereof, some might argue), combined with Bernanke’s track record and his philosophy of inflation over deflation, I fully expect these concerns to be ignored for the time being. The Fed will likely condone a steady decline in the dollar now and in the near future. This paves the way for the Dollar Carry Trade to continue for years.

Using a certain currency for Carry trades is encouraged via the systematic devaluation of a country’s currency, whether it is Argentina in the 1980’s, Japan in the 1990’s, or the US today. With systematic devaluation, there is not a great danger of any particular carry trade blowing up in the midst of such policies. Since the mid-1990’s, many currency traders have used the Japanese Yen as a funding currency. This began when, in the wake of the deflationary fallout from the Japanese Real Estate Bubble, the Japanese government began lowering interest rates in earnest. A 0% rate was ultimately instituted in 1997. Since then, and indeed for the greater part of this decade, the Yen was the carry trade of choice throughout the financial world. It took until 2007 for the Yen’s real effective exchange rate (simply put, the exchange rate when adjusted for inflation) to reach its low. As the credit crisis began in 2008, the Yen rapidly shot upward against other currencies, notably against the Australian Dollar (Refer to Chart B). In mid-2008, the US Dollar was hitting its lowest levels in decades against numerous other world currencies. With the onset of the credit crisis, this trade quickly unwound beginning in August 2008, until March 2009 (Refer to Chart A). This “flight to quality” lasted until March, when the Federal Reserve announced its Quantitative Easing program. As mentioned earlier, this is (not coincidentally) when the US Dollar resumed its decline. Therefore, the US Dollar is gradually replacing the Yen as the carry trade of choice, in addition to the October-March uptick being unwound. Both are contributing factors to the growth of the Dollar Carry Trade in the past six months. As with the Japanese example, carry trades have the potential to last for years, if not decades.

Chart B

Once again, I will repeat that Dr. Roubini is correct in that a currency trade can snap in either direction quickly and relentlessly. This is particularly true in any trade which is crowded. A swift reversal can result in a selloff, or a swift tick upward can result in a “short squeeze” if the crowded trade is on the short side. As one can see in the charts, Roubini is indeed right that a currency reversal can be swift and disruptive. This is particularly true for the US Dollar, by which commodities and many other financial instruments are traded.

As I am writing this, it has been announced that the Emirate of Dubai is asking its creditors for a delay in the repayment of over $50 Billion in debt. This was the debt taken on this decade to transform Dubai into the metropolis it has become (and less than 33% occupied, with the world’s tallest building at that!). The US Dollar is rising more today than it has at any other time in the past eight months. The reversal is quick, and the short-term outlook is volatile. Roubini will inevitably get additional facetime on CNBC and Bloomberg if the dollar has a brief uptick for the next two weeks to a month. Ultimately, I think this will prove to be a head-fake. Compared to European Banks (Standard Chartered and HSBC in particular) and indeed Governments, the US has relatively little exposure to Dubai, although I am by no means an expert on the matter. What I do know is that the Federal Reserve’s policies are in place for a gradual devaluation of the US Dollar. Therefore, Dubai should not prove to be a very disruptive event, and I forecast the dollar to resume its secular decline anywhere from two weeks to a month from now. In any long-term pattern, there will be corrections. This will prove to be no different than countless others throughout history.

I hope everyone had a Happy Thanksgiving. Have a great week.

Respectfully Yours,

Matthew R. Green

November 27, 2009

Welcome to Pastures Online

Dear Readers,

Welcome to Pastures online. Here you will find all of my previous and future posts. I hope you enjoy them and please share with any interested colleagues or friends.

Respectfully yours,

Matthew R. Green