Peter J. Cooper’s Weblog

‘We have just been in Bahrain and everybody is cashed up!’ one banker told me today. My reply was that if everybody is now in cash then it just has to be the wrong place to be! Thinking about it there are some very good reasons to worry about a large cash position.

Quite apart from the contrarian argument that the crowd is always wrong, you have to consider what is happening to the supply of cash. We know that with the sell-offs in global capital markets there is plenty of demand for cash, what about the supply?

Money supply out of control

Another banker today showed me a chart of US money supply growth over the past few months, and highlighted a 111 per cent increase. This compared with something like 15 per cent money supply growth in the early 1930s as the US authorities grappled with the Great Depression!

There is an absolute tsunami of money coming into the system. What happens when the supply of something exceeds the demand: the price drops. And that is exactly what is going to happen to the US dollar - the authorities are about to inflate away their debt problem.

It is so simple: the debt stays at the same nominal amount, you print more money and the real value of the debt falls. Of course in the real world that also means a bond market collapse as inflation will make both the coupon and real value fall.

I wonder how long it will be until cash is deposed as king of the investment world? My guess is that it will not be long after the sell-off ends. How long will that take? It could be at the end of the year as the hedge funds attempt to square their positions, or it might be next spring after another lurch downwards in stock prices.

The bottom for stocks will be the top for cash and treasury bonds. Then inflation will start to emerge and depose cash from its temporary throne. Who will be the new king?

Gold and silver

Step forward precious metals to take a bow. Everybody knows that gold is inversely correlated to the US dollar and that silver is leveraged against the gold price. But why have precious metals taken so long to claim their crown in this financial meltdown?

The straight answer is that hedge funds have been selling assets across the board and turning gold into dollars, or at least the paper gold of futures contracts into greenbacks. The physical demand for gold and silver has been growing strongly all the time, hence the silver coin shortage and the $3.5 billion Saudi gold purchase.

Once the hedge funds stop selling, and you always do eventually run out of assets to sell, then gold and silver prices will rally, and the rush out of cash and into precious metals will do something pretty spectacular to the price. Gold and silver stocks, languishing at a 40-year low, should jump and deliver phenomenal performance for new investors and repay the patience of long-term holders.
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After the brutal corrections of August and now October holders of precious metal assets are in need of some good news. Is the election of a US President committed to higher public spending and larger US deficits the answer to their prayers?

President Barack Obama will have the majorities in the new congress necessary to carry out his plans for increased spending on national infrastructure and a massive fiscal stimulus package. This will complement the multi-trillion dollar bank bailout program now in progress.

But this is all far too late to prevent the US recession deepening and the whole world falling into a recession in 2009. It is going to be a horrible start to a new presidency. Unemployment is rising, bankruptcies will soar and home prices continue to fall. The best hope is that rock bottom is touched some time later next year.

Another crash

Indian astrologers predict a stock market crash in the final days of 2008. I am skeptical about reading too much into the stars. But it makes sense to predict a short-term, post-election rally in stocks after the horror of this October.

The problem is that once you get to the end of the year and think about 2009 everybody will press the ‘sell’ button. That would further weaken the global economy even before President Obama steps into the Oval Office.

In October the strength of the US dollar was a surprise, and in another sell-off the dollar could rally further, if only because investors decide that this is the asset class that they wish to hold in a financial crisis.

But with massive budget deficits looming for 2009 the dollar rally is going to be another trap for investors. The federal budget deficit is going to balloon next year and require funding. The trade deficit is also going to balloon – ironically because the strong dollar means weak exports.

Will foreign countries be keen to buy low-earning US treasury bonds to finance these deficits? Will they not be concerned that the dollar is going to collapse with the money supply being expanded? Will they not switch to assets likely to earn higher returns?

Gold and silver

But which asset class could you possibly buy for safe returns in a collapsing global economy? Which asset class will protect you as the deflation of the recession turns into the higher inflation of the government printing press and the slow recovery?

This just has to be precious metals, just like in the late 1970s. Cash and precious metals beat bonds, equities and real estate in that troubled time. It is happening all over again – the 2008 crash is very much like 1974 and sadly so will be the outcome in terms of stagflation.

For President Obama the classic dilemma of an elected politician is presented: he had to raise enormous hopes for change to get elected; and now he will find it hugely difficult to deliver on his promises. That could mean he faces a short presidency like Jimmy Carter in the late 70s rather than becoming another FDR from the 30s but he might surprise us all.
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After the market crashes of October I confess to being in sober mood but still thinking! The dollar surge during the month is something I had expected in a crash and wrote about long ago on AME Info. But I wonder how long this strength will last.

Peter Schiff remains unrepentantly bullish on gold, and offers these thoughts:

“When inexplicable events perplexed our early forbears, village wise men concocted elaborate and colorful explanations to soothe the populace. Earthquakes, hailstorms, and solar eclipses were all ascribed to root causes that made sense to the villagers and increased the esteem of the story tellers. The recent, unexpected surge of the U.S. dollar has led many Wall Street witch doctors to conjure a series of logic-defying tales to give reason to what is surely the random scramble of a confused herd. Wall Street spun similar yarns during the dot.com and real estate bubbles as investors groped for reasons to justify sky high prices.

The recent surge, which has pushed the dollar up more than 30% against some currencies in recent months, is purely a short-term technical phenomenon. The move is caused by global investment deleveraging, in which major financial players are reversing (unwinding) risky trades and piling into what is erroneously perceived as the safest haven they can find. Increasingly, foreign assets, many of which had appreciated more than American assets, have been sold, and the proceeds stashed into U.S. Treasury bonds, which these investors believe to be the Fort Knox of finance. The cascade has caused momentum trades, margin calls, redemptions, and other factors having nothing to do with the underlying fundamentals of the dollar or the U.S. economy. In fact, all that has happened to the U.S. economy, and all that the government has done, and is likely to do, in their misguided attempts to contain the damage, is extremely bearish for the U.S. dollar.

Mesmerized by technical moves and oblivious as always to the fundamentals, the Wall Street brain trust has offered flimsy explanations. One popular rationale is that as bad as things are in the United States, they are even worse every place else. Still another is that since the U.S. was the first country into the crisis that we will be the first nation to come out. Still another is that since our government is acting more boldly than most to tackle the problems, our economy will not suffer as badly as others where governments have been slower to react and more timid in their responses. In addition, many still perceive the United States as the citadel of stability in a world of second-rate economies.

However, if we look beyond these “explanations,” the fundamentals loom simple and irrefutable: American borrowers of all stripes cannot afford to repay the trillions of dollars we owe. Over the past decade, the vast majority of lending has come from abroad, and as Americans don’t pay, the losses show up on foreign balance sheets. Since we blew most of the money we borrowed on consumption, we simply lack the industrial capacity to repay our debts without resorting to a printing press.

In bankruptcy, both the debtor and creditors are affected. However, while creditors take a financial hit, ramifications for debtors are typically more severe. Creditors are generally better prepared to absorb their losses. However, for bankrupt debtors usually much more substantial changes ensue.

Since America is the world’s biggest debtor, with our IOU’s broadly held by every creditor nation, the effects of our bankruptcy are being felt worldwide. However, while our creditors are suffering now, their pain will be temporary and relatively mild compared to what awaits Americans.

So while it may appear to some that things are worse abroad, that is only because the full extent of our problems has yet to be reckoned with. The main lesson our creditors will learn from this crisis is not to lend American consumers any more money. Once the lending stops, our “cart before the horse” borrow to spend economy will crumble. While the rest of the world absorbs their losses and moves on, we will be digging our way out of the rubble for years to come.

Earthquakes are caused by the fundamental shifts of tectonic plates beneath the Earth’s surface. A similar move is underway in the global economy. Describing either event without a basic understanding of either geology or economics will simply result in a tale being told by an idiot.”

For a more detail analysis Peter Schiff’s new book “The Little Book of Bull Moves in Bear Markets” looks a must read.
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A year ago I wrote about how a stock market crash would likely be accompanied by a US dollar rally, and several eminent commentators gave me a good deal of stick, and one sent me a series of charts showing that it was highly unlikely.

This criticism rather put me off the subject, though I stayed long in US dollar assets personally which has been a nice counter to the less than heroic performance of my precious metals portfolio recently (albeit I remain confident of a rally for reasons which will become obvious below). However, the US dollar has indeed shown immense strength during the October crash and I have been glad that I kept my money were my mouth had been.

Perhaps a little emboldened - though far from hubristic I hope - by this correct prediction, it is time to look at when the dollar rally might end. Nothing lasts forever, especially in markets where the VIX volatility indicator is at an all time high - indeed that means we should expect the unexpected.

Marc Faber

My friend Dr Marc Faber has delivered a remarkable reassessment of the German Weimar Republic in the latest edition of ‘The Gloom, Boom & Doom Report’ (subscribe today, it is the best financial newsletter in publication). He explains how in the early 1920s the German middle classes were ruined by currency devaluation which caught them totally unaware after a period of asset price deflation.

Let us not forget that the modern US economy is very much like the Weimar Republic - some might add a Banana Republic - with its huge internal and external debts, now compounded by a strong currency. It is the current equity sell-off - dramatic and sudden as it continues to be - that is causing this flight to the dollar.

Actually it is automatic - if you sell a dollar-denominated asset you get dollars in return, therefore increasing the demand for dollars and raising its value against other currencies.

What then might precipitate a sudden move in the reverse direction? I think the most obvious candidate has to be a rally in equities. This is not as stupid as it sounds. All big sell-offs are followed by a relief rally - which is just some people who sold out of stocks deciding to buy them back at the new, lower prices.

Equity rally

Now when they do this there will be a reverse move: out of the dollar and into equities, or more particularly out of bonds and into equities. This could well crash an already very fragile bond market and set off a chain reaction of financial collapses that would hit the US dollar very badly.

Of course, this is a pessimistic scenario. But is it more likely than an optimistic scenario: a new president confidently takes the reigns of office, bails out here, stimulates there, avoids a serious recession, rescues the housing market and keeps the dollar and financial markets steady?

President Obama will have a new team, and they do not take office for a vital couple of months while the financial crisis festers further. Any economist will tell you this is dangerous. Markets hate uncertainty and tend to vote with a move to the exit. Perhaps the next exit door has the words ‘bonds’ and ‘US dollar’ written on it.

Nonetheless, the sell-off in global equities still seems to have some way to run and the US dollar should hold firm until it ends. But when the selling stops then it might be wise to switch into any currency less exposed to a recession than the US dollar, and of course into precious metals as an alternative currency with a fixed supply and no third-party risk.

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The last two junior gold and silver explorer bulls capitulated last week. But at that very moment we saw the best rally in the spot gold price in decades, and the US banned shorting of financial stocks while deciding on a massively inflationary bail-out of its financial sector which also leaves the dollar open to a sharp devaluation this week.

I hope the excellent analysts from Zeal Research and Gold Drivers will take my comments in good part. But both research houses chose to publish gloomy articles on the juniors at the very moment that the market actually turned positive for these beleaguered stocks because the gold price suddenly caught up with economic reality.

Jim Sinclair, the doyenne of gold analysts, was first to spot how the change in sentiment against shorting stocks also might be the turning point for juniors, quite apart from the sensational change in direction for gold itself. As it now emerges the summer fall in gold was a perfect 38.3 per cent Fibonacci retracement from the March high, and prices have now bounced off this level.

This week the US Treasury and Federal Reserve will unveil their $800 billion rescue plan, arguably the most inflationary development in US economic history and certainly comparable to Nixon abandoning the gold peg in the early 70s.

The currency markets are going to see a storm, just like the equity markets did last week. But the direction of the dollar will be downwards. More currency in circulation means devaluation, pure and simple, and markets love a simple one way bet.

Gold has a negative correlation to the US dollar and should bounce decisively back over $1,000 this week, and may never cross that line again. In this context any share linked to gold and silver – and silver may well show its usual precocious volatility and outperform gold on the upside as it has recently done on the downside – will do very well.

That brings us back to the bombed out junior gold explorers, driven to these depths by shorting by hedge funds, much of it illegal naked shorting as Mr. Sinclair has pointed out and campaigned against. Now the shorts are going to start to run for cover.

Hedge funds probably will not wait around for shorting to be made illegal, and if they are sensible the time to exit is indeed now before the losses become too catastrophic. Nothing is going to undermine the hedge fund industry more quickly than an attack on shorting, as if current markets are not challenging enough.

In this environment you will see juniors that are bombed out at 10 cents double, triple or quadruple in a few weeks. That will be a great relief to the many who bought at the higher prices but for anybody seeking an instant profit then the thing to do is obvious.