Saturday, October 11, 2008

A Three Prong Attack

I'm sure by now you've heard that we have a problem in our financial system. I could go on in detail about every headline discussing how bad things are, but you can read those on your own. Instead I'd like to talk about why things are so bad, which you won't hear on the news, and where we go from here.

There are three powerful forces right now causing the market chaos. Let's discuss each one in some detail.

1. LIBOR

The LIBOR rate is the London Inter-bank Offered Rate, the rate at which large global banks are willing to lend to each other on a short term basis. In place since the 1980's, it's calculated every business day in 10 currencies and 15 maturities (time periods), ranging from overnight to one-year.

Usually central banks can control the LIBOR rate by adjusting their lending rates. (For example, when the Fed cuts interest rates it will usually have the effect of bringing the LIBOR rate down with it.) Unfortunately, over the past 5 weeks the central banks have lost control over the LIBOR rate. They are now rising on their own because banks will not lend to each other. (Why they will not lend is discussed below.)

Why is this a problem? 40% of adjustable rate mortgages are tied directly to LIBOR. This means if the LIBOR rate rises, American's monthly housing payments rise with it. With a tsunami of rates to adjust over the next 36 months, this will cause a new onslaught of foreclosures. This will trigger additional losses to all the bonds now floating around the world. This will trigger additional write downs, which will trigger additional bankruptcies, which will trigger an explosion in the Credit Default Swaps market.

2. The CDS monster has been revealed

Looking back now, I would bet the government would like to have a redo on Lehman brothers. This small company in the large scheme of banking has revealed the true horrific power of Credit Default Swaps.

All through the month of October, entities that insured the debt of Lehman brothers are now having to pay up on the losses from the bankruptcy. The problem with this, as we discussed before, is that they do not have the capital to do this because none of them factored in the risk of this type of market atmosphere.

Where are they getting the capital? They are selling everything they can. Stocks, bonds, commodities, everything. This is causing everything to go into free fall and everyone to sell at the same time. They have to do this because if they don't then they will then be out of business, and another company will have to cover the insurance on those losses.

Remember, this is only from Lehman brothers. If AIG was allowed to fail, well, I couldn't even imagine what would be happening right now. This selling pressure is creating additional selling pressure from over leveraged hedge funds who are now having to sell irrationally to keep their margin requirements. (Enough capital in relation to their assets) The fear of additional explosions from Credit Default Swaps has frozen the global credit because banks do not know what other banks have on their balance sheets. This is causing LIBOR to rise and has also awoken another sleeping giant that no one saw coming.

3. The yen carry trade

I could write three full pages on the implications of this, but I'm going to try and keep it simple as always. Japan has had very low borrowing rates for many years. This has allowed speculators to borrow Yen at a very low interest rate (let's say 1%) and then take that money and invest it in another country returning a higher yield. (let's say 5%) They can then pocket the difference, and it's like printing money. The only risk with this is that if the Yen starts to appreciate in value against the currency you're investing in, you're going to take losses.

The yen has exploded upward in value over the past few weeks creating a rush to the exits from investors utilizing this carry trade. In order to unwind their positions they are having to sell the foreign assets they are investing in; stocks, bonds, ect. This is creating massive additional selling pressure which again is causing additional selling.

So where do we go from here? Well, in my mind it can go two ways.

1. The government will do the correct thing and allow all the credit excess to purge itself from the system. This will cause a massive global sell off, and create a tremendous amount of pain in the short term. As the financial markets crumble, they will find a bottom as REAL capital will enter the markets to purchase the assets at a discount. (Warren Buffet, Wilbur Ross, ect.) This is the equivalent of sending a loved one to rehab to take care of their heroin addiction. The withdrawals will be horrible and painful but they will have been cleansed.

2. The Federal Reserve and central banks around the world will print money to try and keep the credit bubble expanded forever. This will cause a tremendous loss in the purchasing power for every paper currency around the world and bring the dollar to its ultimate death. This is the equivalent of pumping your loved one with more and more heroin every day so they do not feel any pain. You continuously up the dosage until they finally overdose and end up dead.

Thursday, October 9, 2008

4 Phases of the Bull

There are four phases to any bull market. They are:

1. Pessimissim
2. Skeptisim
3. Optimism
4. Euphoria

Markets usually move in 20 year cycles. Stocks had their most recent run from 1982-2000. Before 1982 only 17% of the country owned stock. It was just coming off its previous bear market that ran from 1966-1982 and people thought that owning stock was a losing bet. People were also bearish on real estate at the time with interest rates running at close to 20%. What were people investing in back then? Something called gold. People were standing outside gold dealers waiting in line to get their hands on the precious metal. When you turned on the evening news, the broadcaster did not start the news with how well the DOW finished, he started with the price of gold and speculation on how high the price could go.

In 1980, we were just finishing up the bull market in precious metals which started with the price of gold at $35 in 1970 and ended with it finishing at $850 in 1980. We had reached the euphoria stage for gold and people investing in stocks at the time, which was just entering the pessimism stage of its new bull market, were considered crazy.

I bring this up because no one remembers this. Investors are now told that stocks go up by an average of 10% per year and that investing in diversified stocks for the long run is their best chance of enjoying the American dream of retirement. The creation of the 401K and Wall Street's appetite for the generous fees involved with this new "retirement mantra" fed this new notion of investing.

No one tells investors that markets move in 20 year cycles and if you plan on retiring during a 20 year bear cycle you're probably going to be in serious trouble. No one tells investors that throughout history we get a depression about every 75 years. The last one came in 1930.

Why would no one tell the public this? Wall Street does not make money if you invest in gold. Wall Street does not make money if you invest in real estate. That's why during the recent real estate bull market in every "financial" magazine they compared the "long term" advantages of owning stocks over real estate.

The secular bull market for gold and silver began in the year 2000. The first five years marked the pessimism stage, and we have been in the skepticism stage since the year 2005. It is obviously the most difficult to invest in these stages because your friends and family tell you that you're crazy. Just like people investing in the stock market in 1980 were considered crazy. We will probably start the optimism stage of the gold and silver bull market sometime next year. This is when we'll start to see the first part of the American public enter the market.

You'll probably start to hear about friends and family putting a small portion of their money into the metals, and it'll probably start when gold crosses back over $1,000. Its run to $2,000 will be much, much faster than its run from $250 (2000) to $1,000 (2008). How high will it ultimately go during it's euphoria stage? Well that's looking better by the hour based on the current government policies.

Gold started the decade at a 50 to 1 ratio to the DOW.
Last year it ended at a 15 to 1 ratio.
It is currently hovering at around a 10 to 1 ratio. (9000 DOW - $900 Gold)

It will go to at least a 1 to 1 ratio during its euphoria stage. The actual dollar amount does not matter because we're moving toward hyperinflation. The early entrants will then be selling their gold to the American public which is rushing back into the market just as they were in 1980. When you turn on the news at night you'll hear the broadcaster start with the new record price of gold and why it will go up forever. The bottom will then fall out, and the masses will get slaughtered. It happens the same exact way during every bull market in history, and it's happening again right now.