Friday, January 2, 2009

2009 = 19 - - ?

As we begin a new year in a far different world than the last year began, many people make prognostications on how this year will compare to other years in the past.

Will it be similar to the late 1970's?

Will it be similar to the early 1930's?

The best example in my mind goes back even further, to the year 1900. As we entered the new century we saw a similar story.

There was a world power that controlled over 25% of the world's GDP. They had the largest military force, and they were the center of the financial universe. The country was Great Britain.

Across the pond there was another country that told different story. They were in the process of building an industrial powerhouse. They worked hard, saved their money, and woke up in the morning hungry for a share of Britain's dominance. The country was the United States.

From 1900 to 1960, America built themselves from nothing to the world's economic power. We were the Saudi Arabia of oil drilling and exports. We produced goods at a strong price, with strong wages, and exported those goods to the world.

Now in 2008, we control about 25% of the world's GDP. We have the largest military force, the world's reserve currency, and we are the center of the financial universe.

Across the pond there is another country with different story. They are in the process of building an industrial powerhouse. They work hard, save their money, and wake up every morning hungry for a share of America's dominance. That country is China.

In the year 1900, people who talked about Great Britain's fall and America's great future were considered crazy at the time. Why? Because people think the past will be the same as the future.

I do not believe that America will become 0% of the world's GDP, but what if they fell from 25% to just 15%? How would that effect the global economy and the way the world invests? I guess a better question is, do you think the next 50 years will be the same as the last?

Tuesday, December 30, 2008

The Ratio

One of the most important ratios that I use to track real market values is the DOW/GOLD ratio. Markets throughout history have moved in long term secular cycles. (Usually about 20 years) From 1980 to 2000 we had a long term secular bull market in stocks, and from 2000 to the present we have been in a long term secular bull market for Gold.

The DOW/GOLD ratio shows how many ounces of Gold it takes to buy the DOW. For example, in the year 2000 the DOW started at 11,550 and Gold was priced at $288. The ratio was:

11,550 divided by $288 = 40 to 1 ratio

It took 40 ounces of Gold to buy the DOW. The following shows the ratio to start every year since 2000:

January 1, 2000: DOW: 11,550 GOLD: $288

40 to 1

January 1, 2001: DOW: 10,628 GOLD: $268

39 to 1

January 1, 2002: DOW: 10,282 GOLD: $278

39 to 1

January 1, 2003: DOW: 8,636 GOLD: $354

24 to 1

January 1, 2004: DOW: 10,469 GOLD: $415

25 to 1

January 1, 2005: DOW: 10,584 GOLD: $435

24 to 1

January 1, 2006: DOW: 10,952 GOLD: $514

21 to 1

January 1, 2007: DOW: 12,374 GOLD: $636

19 to 1

January 1, 2008: DOW: 12,817 GOLD: $835

15 to 1

Today: DOW: 8,513 GOLD: $868

9.7 to 1

I expect the DOW/GOLD ratio to cross 7 to 1 in 2009, and ultimately I expect it to become 1 to 1. That will market the end of the bull market for Gold and give a clear signal to buy stocks. The last time the markets received this signal was 1980 when the DOW was at 850 and Gold was at $850. A 1 to 1 ratio. This signaled the end of the previous bull market for Gold and the start of the new bull market for stocks.

The daily, monthly, or even yearly prices for the two asset classes do not matter if you are a long term investor. A stock market rise is a great selling opportunity, and a Gold pullback is a great buying opportunity. Here is the return for both markets since the year 2000:

DOW: January 1, 2000 through Today: -27%
GOLD: January 1, 2000 through Today: +301%

Monday, December 29, 2008

Uncorking The Fire Hydrant

There is an interesting development happening right now in the banking system around the world. As discussed in length here, the Fed has spent the last twelve months removing as much of the toxic debt on the bank's balance sheets as possible and replacing that debt with cash. (Up until about mid October they were also mixing in treasury bonds, which I will get to in a minute.)

When banks receive cash from the Federal Reserve it then gives them money to lend out into the open market. This is how banks make money, on the interest on the money they lend out. However, due to the recent collapse of the American economy the banks have been too frightened to lend to anyone. They are just sitting on the cash.

A fractional reserve banking system means that when banks take in a dollar of cash, either given to them by the Federal Reserve or deposited by a citizen or company, they can then lend ten dollars out in new loans. This means they only need to keep 10% of the money they lend out on reserves at the bank. (Thus the term fractional reserve banking) This is the system currently used around the world.

This system, as you can see, allows the money supply to grow exponentially. The Fed's goal in replacing the toxic debt with cash was to have the banks then lend this out money out to help increase the money supply to offset the deflationary impact of the loans currently going bad around the world. (Money disappearing)

This failure to lend is what has now led to the Fed bypassing the banking system altogether to inject money directly into the economy. They will do this through purchases of mortgage securities from Fannie and Freddie, corporate debt, credit card debt, and even treasuries.

At some point during this process the banks will come out from under their shell and begin to lend. This means at the same time the Fed is injecting money directly into the system and continuing to remove the bad debt from the banks, the banks will start to lend out the money given to them by the Fed at the 10 to 1 ratio. This means every dollar swapped with the banks for the bad debt will become 10 dollars. (As mentioned above, the Fed until about mid October was mixing in treasury bonds with the cash to try and slow the money supply growth, but when they realized that no one would lend the money it became all cash exchanges)

When the banks begin lending again, it will be like uncorking a fire hydrant. So what happens next? Hypothetically, the Fed is then planning on trying to give the banks back all the toxic debt they took off their balance sheets. They are hoping to call them up and ask them if they mind taking all the losses back into their portfolio. Their goal at this point will be to try and slow down the money now entering the system.

Will they be able to do this? Of course not. The economy is going to be so much worse 12 months from now that they will not be able to raise interest rates or slow down the banking system which will still be in recovery.

A better question is, do they want to do this? Does the American government want a cheaper dollar? Of course they do. We owe about $57 Trillion right now. If that debt is worth less, it is much easier to pay it off. The trick is to convince the rest of the world (and the American public) that they want a strong dollar as it continues to depreciate. They are only trying to prevent a run to the exits.

The rest of the world right now is not sending us a loan, they are sending us a gift. The money will never be paid back, it will just be inflated away.