Monday, May 24, 2010

My Prediction on the Economy & Market (continued)

Based on my previous articles, right about now, you may be asking yourself, "If our country's finances are in such peril, why will the dollar strengthen?  Why wouldn't gold or commodities, which traditionally have a negative correlation with the dollar, be the place to invest?"

As I discussed in my previous articles, nearly all goods, currencies and investments, including precious metals, fell in price during the market crash of 2008.  This was due to people panicking, hoarding their currency and attempting to pay down their bills and/or save their cash on hand in preparation for more hard times to come.  The government provided the banking industry with TARP and TALF, in hopes that rescuing them would give the banks the security needed to push them to lend again.  As we now know, lending standards have increased dramatically since the mortgage bubble popped and, in turn, rather than lending out the government’s money, the banking industry has been using it and the Federal Reserve’s cheap lending rates to pad their own pockets and continue on their merry ways with the same risk taking that got them into their predicament in the first place.

Rather than selling securitized mortgages, these cheap loans to the banking industry are being swapped for Fed-subsidized derivatives, stocks and bonds and other investment vehicles, using the Fed's zero percent rate in order to make money off the backs of the government's artificial inflation and, thus, creating much of the rise in the stock market.  In return, bank profits have soared, allowing them to quickly pay back the government’s (forced) loans and they are now, once again, back to their high times… on the coattails of investors who took their hype... and bait, hook, line and sinker.

In my opinion, the crash that happened just a few, short years will most certainly repeat itself.  The financial industry will, once again, get caught with their pants down and be forced to sell securities all at the same time, just like occurred in 2008.  Already nervous investors, who bought into the market hype, will once again find themselves grasping for anyone who willing to take their securities off their hands.  Only this time, investors will be less willing to take on the risk, as major world currencies, led by the Western industrialized nations, lose investor confidence.  We see this already happening with Greece and the Euro.  Even after the IMF and Europe’s nearly $1 billion rescue, investors the next day sold the Euro in favor of precious metals and the U.S. dollar.  The Euro has lost 20% to the dollar in the weeks since.

The U.S. dollar, in my opinion, will be the last Western currency to lose its value, even though it should probably be one of the first, due to our previously discussed perilous fiscal position.  This will again be the case, just as it was in 2008, because investors view the U.S. dollar to be the safest currency on the planet, due to it being the world's reserve currency.  Our treasuries are largely considered to be the single safest investment in the world, as is commonly referred to in the investment world as the “risk-free rate.”

This perception is not to be underestimated and, therefore, will, once again, be the single-most popular investment in the world.  As witnessed already, this perception is the only reason why our bond yields have remained lower than most anywhere in the world, even though our supply of debt on the world market has increased dramatically, to stupefying levels.  This is due to sovereign wealth funds still craving our treasuries.  As such, even though a massive quantity of dollars is on the market and will be even more so in the future, demand, in my opinion, will outweigh supply, at least temporarily, and again push the U.S. dollar back to 2008 levels and higher.

Perception is not the only reason why the dollar will soar.  Practicality is also at play.  Investors, as well as much of the world’s industrialized population, are heavily in debt and since the U.S. dollar is still the most heavily used currency in the world for global transactions, the dollar will retain its value even more so than other currencies.  Investors, corporations, and the world’s citizens still have bills to pay… and they will pay in dollars.

Mortgages will also play a part in strength of the dollar, but in a way that seems non-commonsensical to most.  Personal, corporate and public bankruptcies will play a huge role in the strength of the dollar, as will the vaunted system called the fractional reserve banking system.  As previously discussed, loose bank reserve requirements and loan underwriting allow banks to create credit out of thin air under the fractional reserve system, creating something called the money multiplier effect.  However, in times of trouble, that credit can just as easily disappear.

When someone, for instance, defaults on a mortgage that credit is vaporized from the money supply just as quickly as it was created.  As we saw just a few years ago, this creates a massive deflationary effect on the economy, since dollars are less plentiful.  When the cause is a systemic dilemma, such as with the mortgage crisis, credit evaporates quickly, creating deflated prices almost instantaneously.  This is partly the reason why nearly all good prices collapsed during the latest crisis, in conjunction with the U.S. dollar playing the role as the world's reserve currency.

The U.S. mortgage crisis still lingers beneath the surface more than most news people care to admit, and it will again play a large role in the coming period.  As of February, nearly 25% of all mortgages were underwater, or the value of the mortgage was worth more than the underlying asset (home).  When you factor in the number of adjustable rate and Alt-A mortgages that are due to reset this year, as shown here by Credit Suisse, it appears imminent that many more mortgages will be underwater, as the supply of homes onto the market dramatically overwhelms the number of buyers.  Repossessions are expected to reach 1 million this year, according to RealityTrac.  During the quarter ending in March alone, the number of repossessions was 16% higher than the year prior.  The number of banks on the FDIC watch list now stands at 775, as of the end of March, versus 702 at the end of 2009.

Just like in 2008, I predict the FDIC will attempt to calm the populous as the number of banks on their continues to rise, however, as discussed in my last article, we already know that the FDIC is broke.  There will be no way for the FDIC to continue to guarantee consumer certainty without intervention by the government.

Traditionally banks have offset defaults by creating additional loans, increased banking fees, decreased interest rates in checking accounts, etc.  However, in times of mass uncertainty, such as during the recent mortgage crisis, banks become fearful of making another bad mortgage or loan, and resort to government for assistance or through calling its other mortgages or loans, as was done during the Great Depression.

The latter choice is one that, I believe, the banks will eventually have to take as, the public sentiment against rescuing the banking industry this time around will make it much more difficult to pass a TARP-like bill.  Citizens have seen little return on their taxpayer investment and now realize that we cannot afford to further burden our already fragile economy and financial situation.  More importantly, the world and the Federal Reserve understand that point as well, which will make a bailout option one that could literally break the back of our economy.  It is during this time that I believe citizens will eventually realize that the FDIC is broke and as banks fail, they will understand the fragility of the fractional reserve banking system personally through loss of their once-believed safe FDIC-backed deposits.

The U.S. will face an interest rate dilemma and the turning point will most likely be when the U.S. government faces the option of either bailing out the banking industry again or biting the bullet and cutting entitlements and government spending, allowing the banks to fail.  Based on the sentiment in the U.S. at the moment, it is my hope that the latter might occur before the former, but that could also be determined on when exactly the next crisis happens.  It is much tougher for a politician to stand on principals, not spending, especially in an election year, but the nation is now aware that it is the right move, just as FDR's Secretary of Treasury, Henry Morgenthau, Jr. realized, eight years after he helped to create the New Deal.  Whether the government will make the right decision may be too much to ask, although it is my hope that the people's voice will prevail.

There has been a lot of talk during the past couple of years about the dollar being replaced with a basket of currencies.  During the impending economic environment, there will be more such talk; however, the world is not yet ready to make such a change.  Everyone realizes that the emerging markets, the BRIC nations (Brazil, Russia, India, China), in particular, will be the world’s growth engine for decades to come, but none of these nations is ready to take on that responsibility or is able to absorb the dramatic transfer of wealth without creating a huge economic debacle for their own country.

China, for instance, is still a very poor nation with a population that traditionally saves approximately 40% of their income.  China must transform its citizens from savers into spenders in order to grow its industry and, in turn, its economic wealth.  China also has a significant problem with its disparity of wealth, as the nation’s wealth is in the hands of relatively few people.  Most people don't realize that the per capita income of China is just $3,600.  China must grow economically from within in order to expand its citizens’ purse pockets.  Changing a culture takes time and China is no exception to that rule.

I could continue further as to why I believe the dollar will remain strong for the foreseeable future, at least temporarily, however, the above are my principal reasons.  Yes, they are many of the same that contributed to the dollar’s strength in 2008 and will also, in my opinion, be the same explanations for why this pattern will repeat itself.   

The caveat to my reasoning, however, is that the dollar will continue to gain in strength in the time period ahead and climax, just like it did in March 2009, but this time the it will collapse and there will be no other place to invest, save for one, precious metals.

It is my belief that we are on the prefaces of a total economic collapse.  The world, for the most part, as a whole, has inflated their respective currencies in hopes of staving off imminent economic disaster.  Rather than take the sound economic action in allowing businesses to fail and recessions to occur, world governments have chosen, instead, to take the political response by inflated their currencies and, in turn, created the beginning of a meltdown the likes of which the modern world has not seen.  The Fall of Rome is imminent, and, in the end, gold and precious metals will prevail, just like it has for millenniums.

Of course, I am not a fortune teller, but this is my best hypothesis, using history as my guide, as to what will transpire in the coming period ahead.  It will be a frightening time, but using patience, history, foresight and common sense, this will probably be the biggest transfer of wealth in U.S. history, surpassing even the formation of the Federal Reserve.

It is my belief that that transformation has already started, with the collapse of the Euro, subsequent fall of the world stock exchanges and rush to safety by investors to bonds, treasuries and cash.

Barring any significant changes to my investment thesis, below is the plan that I will be adhering to and the one that I am advocating to my friends and family.  In my opinion, it is not only the most safe, but it is one that just about anyone can follow.

Basic 2-Step Plan:

1. As stated above and in previous articles, I believe that staying liquid is the easiest way that a person can protect themselves, for the time being, from the already begun collapse in the market.  The best way to do this is two-fold: open a bank or trading account that holds short-term U.S. treasuries or keep cash in a non-safety deposit safe.

The reasoning is quite simple.  U.S. short-term treasuries are the most safe, least interest rate sensitive securities in the world.  They are able to be withdrawn in the event of a bank holiday and, since they have the full backing of the U.S. government, they are not subjected to FDIC protection limits.  Holding short-term treasuries through one's bank or in a trading account/mutual fund is the best way to achieve safety.

Most people do not realize that holding cash in a bank's safety deposit boxes is not immune to bank seizure.  It is for that reason, that I would suggest holding cash in a safe, secure location in an equally safe and secure apparatus.  Quite obviously, keeping cash on hand is a strategy that one might like to keep to themselves, as it is one not immune to theft; however, it is a strategy that keeps your cash where it belongs-- in your possession.

(Gold will fall just like other goods during this time period, and I will explain why in my next article.)

2. The dollar will continue to strengthen for a given amount of time before it, too, collapses under the weight of our nation's massive debt.  When it reaches its pinnacle, that is precisely when I will be putting a majority of my investments into gold and silver.  How will I know when the pinnacle is reached?  Obviously, I won't know the exact date, but this is where history offers me some clues.

When news about the strength of the dollar or the weakness of commodities, such as gold and oil, are in bold print on the front page of the Wall Street Journal that is just one pronounced buy signal to look for.  Other signs will be those similar to the headlines at the end of 2008 and beginning of 2009.

Late-December of 2008 was the high-point for the U.S. dollar but the low-point of the U.S. stock market was in early March.  Here are a few of the headlines as well as the Federal Reserve yields from that time period.  Both of these are facts that I plan on using to my benefit in the coming period ahead.

Dollar High (12/28/08):
Federal Reserve Interest Rates- 12/28/09 (4-week & 3-month U.S. treasuries were both at 0.01%, the weeks prior, the 4-week was at 0.00% and the 3-month at 0.03%.)

"Gold, Not So Golden in 2008, Loses Chance to Be Market Star: 'Get-Me-Out Effect' Offsets Metal's Appeal as a Haven" - 12/29/08- WSJ
 
Dow Low (3/9/09):
Federal Reserve Interest Rates- 3/2/09 (4-week & 3-month treasuries rose to 0.18 & 0.30%, respectively.)

Korea's Crisis of Confidence - 3/4/09- WSJ

Mexico Steps Up Dollar Sales Central Bank's Move Seen as Effort to Stem Peso's Free Fall - 3/6/09- WSJ

Foreigners Sweat as Chinese Firms Teeter No Road Map Exists in Bankruptcy Cases; Like a Rubik's Cube- 3/5/09- WSJ

Will Value Investors Win the Day?: Wait Five Years and See.  In today's market, people may lose a lot of money before they make more. Yet even times like these could prove profitable in the long run for value investors.  - 3/4/09- WSJ

New Fears as Credit Markets Tighten Up - 3/9/09- WSJ

By this time, oil had risen to about $50/barrel from near $30/barrel at the end of December.  Gold had risen from close to $700/oz to over $900/oz.

I expect a steeper curve the next time the dollar reaches its high-point, as I believe it will quickly thereafter lose its appeal, but above are similar headlines that I expect going-forward, although I feel there is a high likelihood that the headlines might be more striking going-forward, now that world governments have tried to spend their way out of a recession.

For the more advanced investor or risk taker, I would consider adding an additional step by including short selling and derivatives into your investment approach until the time to switch to gold arrives.  I, personally, started to take this step last week by purchasing put options.  I will detail my purchases in coming articles and in a timely manner.

However, while one can dramatically increase their wealth using these investment vehicles, it is important to note that one can also lose a lot of money too.  Therefore, I would advise one to take small steps and to learn as much as one can about these approaches prior to using them.  For most, the best approach will probably be to stick with the 2-step program, as conserving one's wealth is the most important part of investing.

In coming articles, I will further explain why I believe that gold is at a temporary high and why I believe it will fall, along with the other goods.  I will also share my personal trades, both good and bad, so that you can learn with me through this tremulous period.

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