Today's WrapUp by Mike Hartman 08.08.2003
Keep It Simple
The highlight for the week was the Treasury’s refunding of three, five and ten-year notes for a total debt sale of $60 billion. For the most part, prices in the markets didn’t change much since everything took a back burner to the Treasury auctions. The Dow Industrials added 38 points and the S&P 500 barely finished in the green with a three point gain. The NASDAQ took the biggest losses this week with a decline of 4.1% to close at 1644. With the volatility of U.S. Treasury debt this week, more money flowed into the blue-chip stocks as investors ran for cover.
Overall bonds firmed-up this week with the yield on the 30-year bond dropping to 5.25% from 5.33% last Friday and the 10-year yield fell from 4.42% to 4.29%. Next week I expect more money to gradually slide back into Treasury debt in search of safety. The dollar fell slightly this week, but I’m looking for the decline to pick up some speed now that the Treasury auction is out of the way. As I have said before, bond prices and the dollar have been moving in opposite directions, with stocks typically moving in line with the dollar and opposite bond prices. My best guess says that stocks and the dollar head lower next week while bonds firm-up some more.
On the commodity front, oil has remained over the $32 mark with a close today of $32.22 per barrel versus $32.31 last week. Natural gas has moved higher and popped back over the $5.00 mark to close at $5.04 per BTU, a gain of 3.4%. Silver lost nine cents per ounce, but the silver mining companies closed the week with some great gains. Gold remained flat through the auctions, but now we’re ready to rock! Gold added $10.00 for the week to close at $356.20 per ounce and looks like it’s building pressure for the next blast-off! The gold stocks finished the week nicely, with the HUI Index closing at 177.12 versus 162.63 last Friday.
Spin of the Week
“Less wealth generated from refinancing may restrain economic growth as early as the fourth quarter unless job growth and business investment kicks in soon, some economists said.”
I threw this quote out on Wednesday for everyone to see the subtle messages that we receive through the popular media that influence our perceptions to believe that debt is a good thing. Our financial system is dependent on ever increasing debt loads. The sentence automatically assumes that wealth is generated from refinancing. What could be further from the truth? The only thing generated from refinancing is debt, or possibly some “cash-out” on top of the existing loan balance with a corresponding increase in the total debt. Debt is not wealth. An individual that borrows more money today will enjoy the immediate gratification that spending the money brings, whether it’s on a vacation, a new car, a boat, home improvements, or whatever. The problem comes way after the money is spent, when all that the borrower is left with is debt service payments and a depreciating asset that was purchased with the borrowed money.
I was pleased to see the email responses from the regular readers of Financial Sense Online. As far as debt creating wealth, everybody got it. A couple of my favorite emails said, “That would be like a perpetual motion machine! When’s the IPO?” and “This is not a lie….it is merely ‘strategic deception.’”
My gut feel is that investors that are reading this site are working harder at their due diligence in trying to figure out what is going on in the financial markets. In contrast, there is a great multitude of investors that read the newspaper, selected financial magazines, rely on CNBC for the real scoop, and check-in with Louis Rukeyser once a week for the reassurance they need to hold on for the long term.
Most of the popular media is directed in their message discipline by Wall Street. Some writers refer to them as our “lap dog” press. Wall Street clearly has every motive to keep all players fully invested in the stock and bond markets and to continue expanding our monetary base by going further into debt. This is a grave injustice. There is a time to own stocks and there is a time when it is better to stay away. Have you ever heard one of the big brokerage houses issue an all-out sell order on a stock? If you have, it’s rare. When stocks are going up Wall Street would tell you to be fully allocated into equities and when stocks are going down, we are instructed to buy on the dips and hold on for the long term.
Debt and Cycles
In the early stages of an economic expansion when money is borrowed, it is spent directly into the economy thereby creating economic stimulus. At the same time, the monthly payments are a relatively small portion of disposable income. As the process of borrowing and spending gains momentum, more and more money is borrowed and pumped into the economy. As the process matures the borrowed money has been spent long ago, so the economic stimulus of the spending begins to fade, while the borrower now finds that the accumulated debt service payments are a much larger percentage of disposable income. The debt payments are now working as a hindrance to economic growth. The excess disposable income is no longer available to be spent into the economy since it is now committed to servicing debt. That is where we now stand in the long-term expansionary cycle.
The last economic expansion began back in 1982 (some would say 1974) and ended with the peak in stock prices at the beginning of 2000. Stocks have been in a bear market for three and a half years now, with five bear market rallies in the 15-25% range. From a “big picture” perspective, it is going to take longer for our system to purge the excess debt and absorb all of the excess capacity that was built-up over the last twenty years during the earlier stages of the debt expansion and spending cycle. You might argue that our economy is still expanding, but without the excessive government borrowing and spending our economy would be in severe contraction.
If you have not had any exposure to long-term economic cycles and waves, I highly recommend that you listen to (or read the transcript) of the archived interview that Jim Puplava had with Ian Gordon, author of the investment advisory newsletter called the Long Wave Analyst. It is imperative that you know where we are in the big picture cycle so you will know what asset groups are undervalued and overvalued, and generally how to manage your overall asset allocation. By the time you have covered the material you will walk away with a better understanding of why the past three years and the next three to five years will bring tremendous strains on financial assets (debt paper and equity paper), while tangible goods (commodities) that work well as a store of value will grow in demand and prosper.
Our Thinking Changed
There was a time when borrowers looked at the total amount of debt that they were willing to carry, while today more people are focused on whether or not they can afford the monthly payments. The paradigm shift came somewhere back in sixties and seventies and probably had its biggest turning point when President Nixon removed the U.S. dollar from all ties to gold as an asset based currency back in 1971. Our dollar is now purely a debt based currency where money is literally borrowed into creation. I think American citizens got the idea that debts could go on ad infinitum and never have to be paid back as long as we are able to make the monthly payments. After all, we’re only human. Why would we want to work for something if we can satisfy our wants and needs with credit? We take the lead from our federal government that debts never have to be paid back, just refinanced with cheaper dollars down the road.
This last week the government borrowed $60 billion to keep the boat afloat for another month or two. Of the $60 billion, it is my understanding that roughly $44 billion was used to refinance old government debt that came due and the balance of $16 billion was new money created into the system for the Feds to spend. They will be forced to borrow more next month, and the next month, and on and on. The deficits are getting out of hand and the rest of the world is taking notice. Foreigners are just about plugged to the gills with U.S. dollars. Our deficits are consuming most of the available capital inside the U.S. and the savings from abroad.
Since the strong dollar policy of President Clinton went into high gear back in 1995, we have literally flooded the world with U.S. dollars. This was a smart ploy because they could see the troubles coming for the dollar, but if all nations around the globe are holding more dollars they won’t want to see the value of their holdings decline. Even the Europeans that want to see the euro elevated to equal status with the dollar don’t want to see the dollar come unglued all at once. This is a macro transition that will take years to complete. We are watching it unfold right in front of our faces. There are no more Italian Lira, no more French Francs, and no more German Marks. Do you think that is a significant development in the last few years? It ain’t over yet. The power struggle between the dollar and euro is firmly entrenched and will continue.
Pretend YOU Are the Loan Officer
A potential customer comes to you and applies for a loan. The loan application shows that the applicants’ income has recently been reduced by three and a half percent while his spending obligations have increased by 7%. He explains that expenditures will exceed revenues by about 20%, but this is only for a few years until his income improves and he can get his household budget under control. As the loan officer, you make the call. Will you loan him your money?
The numbers I gave for our applicant are the same as the U.S. government for the first three quarters of fiscal 2003 versus the same period in fiscal 2002. Individual income tax receipts were down by 6% and corporate tax payments were down by 16%. At the same time revenues are in decline there is a greater need for more borrowing and spending to support homeland security, advance the war effort, and give tax revenues back to consumers so they can spend it, thereby supporting an artificially inflated GDP number.
Loan Officer for the Treasury Auction
The loan officer for the Treasury auction is the bond market. On Tuesday the government borrowed $24 billion in three-year notes with a bid-to-cover ratio of 1.32, which was the worst coverage for the sale of Treasury debt since 1983. The loan officer did protest loudly, but still made the loan. Word is that some serious phone calls went out Tuesday night to drum up some better support for the five-year auction the following morning. After calling in some markers, the five-year auction of $18 billion went off much better with a bid-to-cover ratio of 2.48 followed by the ten-year auction of another $18 billion with a bid-to-cover of 2.0. We made it through the treasury refunding this week, but the loan officer certainly voiced his disapproval on Tuesday. If we get to the point where a future Treasury auction reveals a bid-to-cover ratio of 0.9, all hell is gonna’ break loose in the bond market and in the forex (currency) market. These are the reasons that the dollar has been in decline for over a year now.
So What’s the Big Deal?
I think what got me fired up more than anything about the “refinancing generates wealth” is that we are encouraged and tempted from every possible angle to borrow more and more money. No payments until 2005, zero percent financing (all of which is built into the price of the goods), cash out re-fi’s, pre-approved credit cards show up in the mail, home loans with no proof of income necessary, buy a house with no money down, and so on. Maybe the financial entities just discovered mass marketing in the last ten years. Whatever the case, it’s terribly irresponsible. When does it come time to pay the fiddler?
I was most disturbed by the “debt is wealth” statement because we were right in the middle of a record week of U.S. Treasury debt issuance. We are mortgaging our future as a nation to keep going further into debt; not only that, but the current policies of the Federal Reserve and the Federal Government have actually penalized the frugal savers of our nation. Why should it be so difficult right now just to preserve what wealth you have accumulated? Do you feel safe in stocks? Do you feel safe in bonds? Investors are scared. People don’t know what to do.
We are standing at a crossroad for the second-half recovery. If the massive stimulus via artificially low interest rates and tax reductions don’t take hold in the economy, investors will have to come to the conclusion that this is more than a cyclical downturn. If job creation doesn’t begin to happen we will not break the downward spiral that feeds on itself as contraction begets more contraction. If the rest of the world doesn’t continue to loan us the money we need, investors will be forced to the conclusion that we are facing systemic risk. Our debt pyramid is approaching unsustainable levels at the same time our income as a nation declines.
I say investors are confused and scared right now and don’t know what to do. The reason people are in a state of paralysis to make financial decisions is because there is an overall lack of understanding of what money really is. As a nation we have been dumbed down to knowing what money really is and how it all works. Most investors don’t know how money is created out of thin air today, how fractional reserve banking works, the benefits that the U.S. dollar has enjoyed since we won WWII when we imposed the Bretton Woods Agreement on the global financial system. The fixed exchange rate system of the Bretton Woods Agreement subsequently failed because of U.S. dollar devaluation and massive selling of dollars by foreign exchange dealers. In 1973 the fixed exchange rate system finally collapsed as the world was unable to absorb massive selling of the U.S. dollar.
I did a quick Google search and found a fifteen page article that gives a nice overview of the Bretton Woods Agreement and what transpired from WWII through the Seventies. With the profound impact that those events had on the world financial system, it all leaves us where we stand today. The paper should open your eyes as to what is going on today. The very last sentence of the paper reads, “In summary, it was the economic condition of the U.S. that built the Bretton Woods system, and the deteriorating economic condition of the U.S. brought the system to an end. It can happen again.
What to do Now?
I am not here to fix the world or belly-ache and moan about the problems. The situation simply is what it is! Given the crazy monetary times we live in, how can we use these developments to protect our wealth and even make some money along the way? To take advantage of the situation you must take some time to study the history of money, and especially the history of the U.S. monetary system since the Federal Reserve was born 90 years ago. It’s not that long from a historical perspective, but much has changed just in our lifetime.
The overwhelming thing that hit me this week is that debt is not a good thing, but we are bombarded with temptations and encouragement to go deeper and deeper into debt. The Book of Truth keeps it VERY SIMPLE and tells us that, “The debtor is servant (slave) to the lender.” I do not care to be a slave to the financial system and never ending interest payments. In America we coined the phrase, “I owe, I owe, so off to work I go!” I would prefer to do with less today in order to have my financial freedom in the future.
Back in the Seventies I had an excellent economics professor that said, “Let me give you the secret to get ahead financially for the rest of your life.” He said, “During times of economic expansion when the money is flowing freely, do not be tempted to spend all of the money keeping up with the Jones.’ During the boom times is when you should accumulate your savings rather than spend, then when the economy is in contraction and prices are falling you can purchase what you desire for a fraction of the cost.” In hindsight I can now see that his advice was my first exposure to contrarian thinking in the financial markets. He has proved to be correct, and I’m glad I paid attention to his words.
Unconventional thinking is now required to survive the transitions that are upon us. The core issue at hand is money itself. What is the best money? What money will maintain its purchasing power as a store of value with the world monetary system in transition? Here in the U.S. most stocks, bonds and the U.S. dollar are overvalued based on our weak economic fundamentals; too much debt, falling incomes, rising unemployment and households across the country that are just barely hanging on from month to month.
The people that will come out of this whole mess on the top of the heap will be the ones holding the least amount of debt. The investors that come out on top will be the ones that understand what is going on in the context of global monetary developments. As issues heat up with the euro, dollar, yen, yuan, ruble, rand, dinar, and other currencies, your new-found knowledge of monetary history will help you in knowing the most prudent asset allocation. It is very much worth the time and effort to study the history of money because it will explain what is happening today.
I didn’t intend to get so philosophical, it just happened because I got to thinking why the debt thing bothered me so much. For the regular readers of FSO, please note that Jim Puplava is on a working sabbatical for the next three weeks, so Scott and I will be writing all of the WrapUps. Jim will be reviewing portfolio holdings, working on Storm Update, conducting radio interviews, writing “Ten Sigma” part 2, and beginning the work with his publisher to write his first book. It’s exciting times for all of us at Financial Sense Online / Puplava Securities! I’m not Jim, but will do my best to give you quality work in his absence. We miss him here in the office; he’s a “colorful” kind of guy!
I believe this is the first piece that I have written without a single chart. I am in the middle of my work to dissect the Dow/Gold Ratio, as I believe we are at a critical turning point. I have harvested that ratio for some great profits over the last three years, and I want to share my strategy with the investment community. I hope to have it published as an editorial early next week, so I’ll have lots of charts and numbers that you are not getting today.
Busy times, but glad it’s Friday! Have a great weekend!