Friday, January 6, 2012

Obama Proposes Federal Worker Pay Increase

No additional commentary provided.  I'm afraid I'll say things I would later regret.  You can read the full article here.

Thursday, January 5, 2012

What Is Re-Hypothecation?

After the recent collapse of MF Global the financial world gained insight into a disturbing process known as re-hypothecation.  The following video explains in simple terms what it is and the dangers involved when a counter-party goes under.


Re-hypothecation from Marketplace on Vimeo.

Tuesday, January 3, 2012

2012 Outlook: Introduction

2012 Outlook Part 1: Introduction
2012 Outlook Part 2: How We Got Here
2012 Outlook Part 3: Sovereign Debt Review
2012 Outlook Part 4: Global Butterfly Effect
2012 Outlook Part 5: Japan's Debt Crisis
2012 Outlook Part 6: United States Stock Market
2012 Outlook Part 7: United States Bond Market
2012 Outlook Part 8: Gold And Silver
2012 Outlook Part 9: How To Invest
2012 Outlook Bonus: Real Estate

For the new readers to this site, especially the large number of new readers from outside the United States, welcome to The Future Tense.

My name is Tuna, and I am a market junkie.

I spend hours and hours every day reading articles and books, listening to radio shows and books, and devouring as much information as my time allows to learn about the financial and economic systems that connect the world around us.

For regular "work," I am involved in the property management industry, I am the broker-in-charge for a real estate company in Charlotte that also does consulting for larger banks and their real estate projects, and I have recently created a new company - a project I am excited to discuss on this site in the coming months.

I also spend a good amount of time studying sales, marketing, and business growth, topics I have not spent time covering on this site but plan to involve more in the future.

Anyone who has read the site for a short period of time knows that in general I am very pessimistic on the short term outlook for the global economy - specifically the American economy.  However, I look at the coming downturn as an opportunity for both business owners and investors, as long as you can both protect your capital before it hits and have the courage to use that capital when it arrives.

Over this decade there will be once in a lifetime opportunities to purchase stocks and real estate in our great country.  I look forward to the day when I can turn in my gold and silver and invest in a country that I can believe in.  Unfortunately, based on our current political structure, to reach that bottom we must first experience a collapse.

Again, thank you to continued readers and the new viewers from around the world.  I will continue to do my best to keep you informed and ahead of the coming trends that will impact everyone's life in the new world we are moving toward.

Next: 2012 Outlook: How We Got Here

2012 Outlook: How We Got Here

2012 Outlook Part 1: Introduction
2012 Outlook Part 2: How We Got Here
2012 Outlook Part 3: Sovereign Debt Review
2012 Outlook Part 4: Global Butterfly Effect
2012 Outlook Part 5: Japan's Debt Crisis
2012 Outlook Part 6: United States Stock Market
2012 Outlook Part 7: United States Bond Market
2012 Outlook Part 8: Gold And Silver
2012 Outlook Part 9: How To Invest
2012 Outlook Bonus: Real Estate

We begin quickly with how we got here. The financial system collapsed in the fall of 2008 when real estate loans were held on bank balance sheets with no capital reserves to buffer against the possibility that home prices would fall or home owners would be unable to make the payments. Both happened, causing the banking system to become insolvent (their liabilities were greater than their assets), and the entire system froze after the collapse of Lehman Brothers.

It was a historical moment in history. Governments decided that instead of letting the system cleanse itself of the toxic debt and try and back the good debt, they would nationalize everything and the toxic debt became one with the government debt. Central Banks around the world flooded with system with liquidity purchasing and backstopping trillions in toxic debt with printed money.

Then governments around the world unleashed massive stimulus programs creating new mountains of government debt to pile on top of the original government debt and new private toxic debt. Central banks continued to ease the burden by purchasing additional trillions in government debt and mortgage securities.

In March of 2009, a major accounting rule (FASB 107) for US banks was changed, allowing banks to mark their assets at full price (mark to myth), instead of having to write their assets down when they fell in value. This was a landmark rule change that put a floor under bank shares and the stock market as a whole, and they took off to the upside with QE1 providing rocket fuel behind them.

This also ensured that these banks would live on as “zombie banks,” a program used by Japan when their market crashed in 1990. With banks assets underwater, they were not able to lend to the market. How would we now finance mortgages, student loans, auto loans, and the necessary credit to keep our country growing? The US government through deficit spending.

After these actions took place, all appeared to be well again. The stock market was roaring, economic indicators were soaring, consumer and business sentiment rose, and there was an overall calm back in the financial world.

Then in the fall of 2009 a small city name Dubai announced that they were going to have to delay payment on their government debt. Essentially they were announcing default.

While this was seen as a blip on the radar, to the astute market observer it rang the opening bell for the next round of the global financial crisis.

Next: 2012 Outlook: Sovereign Debt Review

2012 Outlook: Sovereign Debt Review

2012 Outlook Part 1: Introduction
2012 Outlook Part 2: How We Got Here
2012 Outlook Part 3: Sovereign Debt Review
2012 Outlook Part 4: Global Butterfly Effect
2012 Outlook Part 5: Japan's Debt Crisis
2012 Outlook Part 6: United States Stock Market
2012 Outlook Part 7: United States Bond Market
2012 Outlook Part 8: Gold And Silver
2012 Outlook Part 9: How To Invest
2012 Outlook Bonus: Real Estate

Months passed after Dubai, markets forgot the event, and everything went back to the new normal. Then in March of 2010 another small country appeared in the spot light because they were having some minor “problems” with their government debt financing. Interest rates began to rise off their ultra low AAA status levels. Most investors brushed it off as a temporary problem easily fixed. The country was Greece.


The European Union came together with the IMF to announce a bailout package for Greece. This temporarily cured the panic. The Greece situation caused investors to take a look at the other government balance sheets in Europe and they found that both Ireland and Portugal were in serious trouble as well. Interest rates began to rise rapidly and a new bailout was announced for these two countries with additional funding for Greece.

The panic was temporarily cured. Interest rates continued to rise on “PIGS” debt into 2010 and the problem was seen as contained as long it stayed within the smaller European countries. A major problem would exist if it moved toward a larger economy like Spain or Italy.

Through the first half of 2011 Italy was never mentioned in the European debt discussion. Then in the summer their interest rates began to separate from Germany and move higher. Through the summer and into the fall interest rates continued to rise in tandem with the other “PIIGS.” (Portugal, Ireland, Italy, Greece, Spain)


A new bailout program was announced called the EFSF program. This program would take money from all European countries to form one large bailout program. The program was destined to fail before it began as common sense will tell you that an insolvent country cannot contribute funds to bail itself out. This left only France and Germany as the major contributors to the program and they did not have near the resources save the entire European Union.

Rating agencies began downgrading and putting downgrade reviews on countries across the EU (including France), which compounded the problem by making it more difficult for these nations to borrow.

After understanding what was evolving in Europe, investors then began to ask the next logical question: If these European bonds were losing value and may possibly face default, who is holding these bonds? Who was the lender holding the toxic debt on their balance sheet? After some research they discovered it was the European banks. Not only that but these banks purchased debt on leverage, sometimes 30 to 1, which was the leverage seen by US banks purchasing mortgage securities back in 2008.

Purchasing with 30 to 1 leverage means that you hold $3 in capital as a buffer against $100 in bonds purchased. Or to put it another way, if the value of the bonds fell by more than 3% you were underwater. Investors began to realize this as Greek bonds were falling in value by 20%...30%...50%, after being risk free only months earlier.

Dexia, a major Belgian-French bank, was nationalized soon after the market realized the losses on their balance sheet were enormous. MF Global, another major financial institution failed a few weeks later, after investors learned that they also had purchased toxic government bonds with tremendous leverage.

During the crisis of 2008 many countries, including the United States, spent (or printed) the money to recapitalize their banks. Europe did not. This means that their banking system is extremely fragile and many of the banks will have to be nationalized. The toxic debt will move from the banks balance sheets onto the government balance sheets compounding the current debt problem.

As the banking system began to freeze up in the last weeks of 2011, The Federal Reserve announced they were cutting interest rates on their global swap lines down to .5%. This means that foreign central banks can borrow an unlimited amount of US dollars in exchange for their own currency and pump that liquidity into the banking system.

The European Central bank doubled down on the this easing by announcing a program called LTRO in which European banks can give the ECB “collateral” (toxic bonds) in exchange for cash with the promise to pay back the money in 3 years at 1% interest per year.

We enter 2011 with everyone focused on how Europe will continue to manage the debt crisis moving forward, and will now look at where are headed in the year ahead, which promises to be one of the most turbulent in years.

We will find that just as Europe was not even on the radar in 2009, today there are even bigger sovereign debt crisis approaching outside the Eurozone that will be rocking the financial system as Europe is still reeling from their internal shockwaves.

In order to understand how events will transpire moving forward you have to understand that our entire financial global economy is interconnected. Those that feel that certain countries will not be impacted by another part of the world growing (positively) or contracting (negatively) will be hurt both in business and investing.

I believe we have now entered the stage where the 40 years of global debt binging is now coming to a climax. The toxic loans have now moved from the private balance sheets to the government balance sheets. With government loans now going toxic, we have reached the Endgame.

This is not the end of the world, it is not some sort of Armageddon, but it is the end of the current paradigm, financial period, or however you refer to our current monetary structure. Throughout history there has been a entirely new monetary system every 40 years. We began the current system on August 15, 1971 when President Nixon removed the current gold based system and we entered a global exchange rate system. Currencies are now valued against each other, backed and restrained by nothing, and governments now have the ability to run unlimited and unchecked deficits that were formally balanced through the gold system.

We have an off balance sheet derivatives market that grows annually and is closing in on 1 quadrillion in size. That is 1,000 trillions. The entire global stock market is valued at less than $50 trillion to put that number into perspective.

Our global financial system is an enormous bed of nitroglycerin waiting for a match. Before we move on to individual countries and markets let's review the bigger picture to see why a butterfly flapping its wings in Greece can create an earthquake in Japan.

Next: 2012 Outlook: Global Butterfly Effect

2012 Outlook: Global Butterly Effect

2012 Outlook Part 1: Introduction
2012 Outlook Part 2: How We Got Here
2012 Outlook Part 3: Sovereign Debt Review
2012 Outlook Part 4: Global Butterfly Effect
2012 Outlook Part 5: Japan's Debt Crisis
2012 Outlook Part 6: United States Stock Market
2012 Outlook Part 7: United States Bond Market
2012 Outlook Part 8: Gold And Silver
2012 Outlook Part 9: How To Invest
2012 Outlook Bonus: Real Estate

The question is no longer if the European Union will face a debt crisis. This was still a debatable topic as we entered 2011. We now can see that investors have turned on the debt, which marks an important psychological moment for the markets.

A piece of snow falls from the sky and lands on a mountainside. It triggers a few more pieces of snow to fall down the mountainside, they begin to gain speed, pick up other pieces of snow, and gain more speed. It reaches a tipping point when it has clearly become an avalanche and at that point it is far more difficult to contain or slow down than the point when it first began. The same theory applies to the collective psychology in our modern bond markets. The entire financial system is based on trust and confidence. What looks like a calm snow bank can soon turn into an avalanche in just a few moments if trust is lost. This can been seen repeatedly throughout market history (Latin debt crisis in 1980’s, Asian debt crisis in 1990’s, Long Term Capital Management in 1998, US subprime debt in 2007) but has most recently been applied to Greece, Portugal, and now Italy.


Now that the avalanche is here and visible the question is: how does this now impact the important financial markets around the world. The butterfly has flapped its wings in Europe, so what will be the effect in a small town in China, or a small business in America?

A recent book called This Time Is Different looked back at centuries of debt crisis and what took place after. Some simple key points:

-When a country reached a total debt to GDP ratio of 90% or higher it became a prime target for a debt avalanche to occur.

-After a major credit crisis (2008) a country becomes likely to soon after experience a sovereign debt crisis if they began on an unstable footing in terms of their sovereign balance sheet

- A sovereign debt crisis leads to austerity (spending cuts) and higher inflation due to bond purchases and bailouts from central banks and other governments

This last point is key because it is where we are today in Europe. When a country is forced to cut government spending their economy is going to slow down in the short term, especially if a large part of its GDP (economy) is currently funded through direct or related government spending.

To help understand why, imagine that you currently spend $20,000 per year using after tax revenue from your job. For the last 10 years you also have spent $20,000 per year using credit card debt that you only make the monthly payment on. You now have $200,000 in credit card debt and the company has told you that you can no longer borrow money. What impact would this have on your personal living standards and lifestyle? Your economic “growth” would take a major hit. It would also impact the economy around you. If you spent $400 a week at a prestigious restaurant and could no longer go, their business would suffer. If you purchased $500 a month in expensive new clothes and now had to shop at Wal-Mart, the high end store would suffer.

This exact scenario, although a very simple example, is what is taking place in Greece, Portugal, Spain, and Italy as their governments look for ways to cut spending where they did not need to look before. The country as a whole will slow down without the artificial boost it was receiving with enormous deficit spending. This slow down will reduce tax receipts, which will require even more spending cuts, creating a downward spiral effect.

The three major pillars of the global economy are currently the United States, Europe, and China. Many smaller and developing areas are tied in directly to these economies based on the interconnected nature of global trade and finance. While people pay very close attention to China’s exports to the United States, they only recently have taken notice of how dependent China is on exports into Europe.

Many view China’s economy as a potential snow bank just waiting on the first trigger to ignite an avalanche. The reason is not a problem with their government balance sheet (they have run a large trade and balance sheet surplus for many years), it is due to their real estate market.

China has pegged its currency to the United States to keep it artificially low which has provided a boost to their export market (specifically to the United States and Europe). However, when a government intervenes in the free market there are perverse side effects. Imagine a boat pulls up to China’s shores to collect goods that will be shipped back to the United States for consumption. The man on the American boat hands the Chinese exporter American dollars in exchange for the goods. The Chinese exporter then takes those dollars bank to his bank to deposit them.

The Chinese bank then provides the Chinese exporter an equal dollar amount of money in yuan, their local currency. But where does the (large) supply of yuan come from to satisfy the demand of the large number of exporters that show up to the bank to collect the money?

It is created (printed) by the Central Bank of China. The Central Bank stores the dollars as reserves and provides newly printed yuan in exchange. This has flooded the market with currency and has created high inflation in China. This is only one way dollars have entered the country; money can flow freely across borders in our global economy and investors and businesses have poured money into China buying real estate, stocks, businesses and bonds.

In a normal environment this would cause the currency in that country to soar in value (high demand and limited supply), but the central bank has matched this demand with new supply to keep the currency peg in place. So what effect does this have on China? This flood of yuan needs to find a home for Chinese citizens to protect themselves from higher prices. A lion's share of the money has moved into the real estate sector.

This caused prices to rise to astronomical levels creating an unimaginable price vs. income level. This, as we have seen first hand in America, has now created a housing bubble. In addition to the investment money pouring into the market, the government itself has doubled down on the bet and poured government funds into real estate development. Multiple “ghost cities” have even been constructed where hundreds of empty buildings now sit.

Developers are now beginning to miss payments on borrowed money from the banks and many will soon walk away from these debt obligations. This will bring strain on their banking system.

Estimates from fund managers who study the Chinese economy believe that somewhere between 20 – 75% of the entire economy is directly or indirectly related to real estate development. Only 6 – 10% is directly related to exports; the hot button that most analysts like to focus on.

The Chinese real estate market has reached the point where prices are beginning to fall in many major cities. Falling prices will cause new investors to back away from the market and recent investors to become underwater on their loans (sound familiar?). Falling prices in the real estate market is the psychological trigger, the snowflake landing on the slope, that triggers the downward spiral that is extremely difficult to reverse.

A Chinese slowdown of any kind has dramatic repercussions everywhere in the world. Commodity prices are impacted greatly by China’s insatiable appetite for growth (real estate growth). The Australian economy for example is heavily dependent on resource exports to China.

If Europe slows significantly, slowing a major portion of China’s exports to that region, it will only magnify the pain on China’s real estate market, significantly slowing their overall economy. The butterfly has flapped its wings in Italy, and a snowflake may fall on the Chinese economy.

How else will this butterfly effect impact markets around the world? Let’s take a look at a very important mountain slope just waiting for that triggering snowflake.

Next: 2012 Outlook: Japan's Debt Crisis

2012 Outlook: Japan's Debt Crisis

2012 Outlook Part 1: Introduction
2012 Outlook Part 2: How We Got Here
2012 Outlook Part 3: Sovereign Debt Review
2012 Outlook Part 4: Global Butterfly Effect
2012 Outlook Part 5: Japan's Debt Crisis
2012 Outlook Part 6: United States Stock Market
2012 Outlook Part 7: United States Bond Market
2012 Outlook Part 8: Gold And Silver
2012 Outlook Part 9: How To Invest
2012 Outlook Bonus: Real Estate

Many people assume that Japan’s largest trading partner is the United States. They focus heavily on the United States economy when making decisions about Japan’s economic growth. However, China accounts for 19.4% of Japanese exports (vs. 15.7% with the United States) making them far more dependent on their neighboring country. Japan’s third largest export market? Europe.

A topic not discussed today (just as no one talked about Greece in 2009 and Italy in 2010) is that Japan currently has the worst government bond balance sheet in the entire world – by far. Their current debt to GDP, the broadest measure of a government’s ability to pay back their debt now stands at 220%.


In comparison, Italy currently has a 120% debt to GDP and they pay 7% on their 10 year bonds. Japan now pays less than 1% on their ten year bonds. How is this possible?

Japanese citizens have an extremely high savings rate. They have put an enormous portion of their savings into Japanese government bonds, which has allowed the government to run enormous deficits while only have to pay out rock bottom interest rates. Things are changing now in Japan, creating a worrisome storm cloud ahead. The following shows Japan’s expenditures vs. tax revenue, a worrisome widening gap.


Japan's population is aging rapidly and entering the retirement stage of their life in mass. In order to finance their monthly living costs these retired Japanese citizens will call their investment broker and ask them to sell some of their investments and send them the cash to buy groceries and pay their mortgage. What does selling securities mean? Selling government bonds.

This is going to create a cascade of selling at a time when the Japanese government needs funding more than ever. The tsunami in March of last year only compounded the problem as government funds were needed to support the crisis.

The world's worst government balance sheets:

In 2012 Japan announced plans to spend a total of $1.16 trillion. $566 billion will need to be financed with new debt. This means close to 50% of their entire budget must be paid for with new bonds, an unprecedented statistic. Social security expenses will account for 52% of the spending in the coming year. However, looking under the surface you find that the numbers are actually even worse. $137 billion in spending was pushed down to the state and local government level in order to keep it off the national balance sheet radar.
A slowdown in China will cause a higher unemployment rate in Japan and lower the savings rate and internal bond funding further. Japan is also now running consistent trade deficits, instead of a consistent surplus which always helped their economy in the past.


The continued rush away from European assets as well as a coming panic in the Japanese bond market will provide a temporary period of strength in the US dollar. However, the same exact scenario that is taking place today in Italy and will soon be hitting Japan is waiting for the United States.

Next: 2012 Outlook: United States Stock Market

2012 Outlook: United States Stock Market

2012 Outlook Part 1: Introduction
2012 Outlook Part 2: How We Got Here
2012 Outlook Part 3: Sovereign Debt Review
2012 Outlook Part 4: Global Butterfly Effect
2012 Outlook Part 5: Japan's Debt Crisis
2012 Outlook Part 6: United States Stock Market
2012 Outlook Part 7: United States Bond Market
2012 Outlook Part 8: Gold And Silver
2012 Outlook Part 9: How To Invest
2012 Outlook Bonus: Real Estate

While stock markets around the world finished in the red, the DOW Jones (American stock index) finished the year positive. Investors believe that the US has and will continue to decouple from the problems facing the global economy.


There are two main measures to look at when deciding on when to purchase stocks. The first is the fundamentals of a company such as earnings, profit, and future growth. The second is the sentiment toward the particular stock or the price that investors are willing to pay to gain access to future company earnings.

The fundamentals of the US corporate world have been strong since the market bottomed in 2009. Companies have the ability to move fast when the macro-economic world changes around them. Companies began to slash their biggest expense when the financial crisis hit, employees, and they have not brought them back up to this point in the cyclical recovery. Employees are usually the first to go and the last to return during a market cycle.

US Corporate profit margins are at one of the highest points in history as can be seen by the following graph.


So far all appears to be well and the water looks warm, but this is only one half of the discussion.

The graph below shows the long term P/E ratio for the S&P 500.  The P/E ratio measures the Price and investor is willing to pay for a company's Earnings.  A higher P/E means they will pay a higher price for earnings.


At the beginning of a bull market sentiment is very low toward stocks. The P/E ratio is under 10, and investors don’t want to own stocks at any price because they "know" they are just going to go lower. Buying opportunities such as this come about at historic market bottoms, and it was last seen in the early 1980’s.

When all the sellers have been flushed out of the market, everyone is now on one side of the boat. All it takes is just a few passengers to move toward the buyer's side and prices begin to move up. There are no more sellers on the selling side to continue to push prices down because they have already sold out of the market out of fear for lower prices. This is why sentiment is so important to understand.

As you can see in the graph above, from 1982 – 2000, P/E ratio’s began to climb year after year as investors slowly moved from the selling side of the market to the buying side. As they saw prices go up, their confidence rose, and they were willing to pay more for future company earnings because they were confident that the underlying price of the stock would move higher.

This viewed from a strictly rational sense is easily seen as the exact opposite approach an investor should take. However, it is the way market participants are psychologically wired to invest.

For example, imagine a household begins 2012 by reviewing which funds they want to contribute in the coming year. During 2011 Fund 1 is up 20%, Fund 2 is up 5%, and Fund 3 is down 10%. The average investor looks at these three funds and believes Fund 1 is a better option because of its recent performance.

Of course, this has nothing to do with how it will or should perform in the coming year. All things being equal, the fact that it is up 20% means that it is far more expensive and thus dangerous than it was to start last year.

This simple psychological component of the markets is what creates tremendous boom bust cycles and it is why the masses always get hurt the most during major market turns. They move in herds. It will always be this way.

Of course, after providing you with all this psychological mumbo jumbo and earnings data, I'm sure you want to know where I believe the markets are going this week, this month, and where they will finish 2012. I understand, we’re almost there.

Historically, a P/E ratio under 10 was considered a strong buying opportunity and a P/E ratio over 20 was considered a bubble or an extremely dangerous point to enter the market (see graph above). However, aside from a few months in 2009, the market has been above 20 (or extremely overvalued) since 1996, when Alan Greenspan gave his Irrational Exuberance speech.

Markets have a way of working back to their historical mean. Investor sentiment has been slowly falling since the peak of the mania back in 2000. This can be seen most clearly by looking at what the average American investor does in terms of mutual fund allocation. Since the financial crisis hit in 2008, Americans have been pulling their money out of US Stock Mutual funds at an almost uninterrupted rate. During the entire run up from the market bottom in 2009, investors have essentially “lost faith” in the stock market and have pulled hundreds of billions of dollars out of the market and parked it into bonds.


They have pulled from stock funds in 34 of the last 35 weeks. While looking at just the blue portion of the graph above, the money pouring out of the market, you would think that the market would be sitting at all time lows. However, there has been another force in the market place, an invisible hand.

That force has been quantitative easing. The Federal Reserve has been dumping trillions of fresh cash into the banking system, much of which has made its way into the stock market. This has not only matched the mutual fund outflow, it has over powered it, sending the market up close to 100% higher from its lows in March of 2009.

Investor sentiment today is still considered to be above the “bubble” level with P/E ratios at 22 to start 2012.

US Corporate profit margins are sitting at close to record highs. This means as an investor in order to believe that the market is going to move higher, you have to believe that corporate profit margins are going to push continuously higher from their already sky high levels. You also must believe that P/E ratios simultaneously are going to move from bubble territory, back up to ultra bubble territory seen back in the early 2000’s. Could this happen?

Absolutely. The Federal Reserve has made it clear they want stock prices artificially high. They are fighting the forces of gravity with every tool they can use.

Next: 2012 Outlook: United States Bond Market

If you wish to bet that the stock market will move from over priced to very over priced that this is the time to enter. I do not like that bet. So, to answer the question you have been waiting ever so patiently for, where do I think the US stock market is going during 2012?

Lower.

Next: 2012 Outlook: United States Bond Market

2012 Outlook: United States Bond Market

2012 Outlook Part 1: Introduction
2012 Outlook Part 2: How We Got Here
2012 Outlook Part 3: Sovereign Debt Review
2012 Outlook Part 4: Global Butterfly Effect
2012 Outlook Part 5: Japan's Debt Crisis
2012 Outlook Part 6: United States Stock Market
2012 Outlook Part 7: United States Bond Market
2012 Outlook Part 8: Gold And Silver
2012 Outlook Part 9: How To Invest
2012 Outlook Bonus: Real Estate

Based on the previous discussion on the stock market outlook for 2012, you may be thinking that based on the massive outflows from US stock mutual funds into US bond funds that for the first time ever the average investor has it right. After hundreds of years of being on the wrong side of the trade the story is going to finally end well for the general public.

Wrong.

Once again, and it staggers my mind to watch it take place, middle class America has taken their life savings and placed it in the absolute most dangerous location possible.

After the 2000 stock bubble burst, Americans took their money from stocks and placed it in the one place they knew it would be safe: real estate. Home prices had risen for essentially 55 years straight and most living Americans could not even remember reading about a time when prices fell. This meant that prices could not fall, and they bought homes and second homes to protect their retirement.

Then we all know what happened in 2006. Real estate prices began to collapse.

Investors, learning their lesson from the 2000 and 2008 stock market crashes knew that their money is not safe there. They also now knew that they could not trust real estate. They then now put their money in the last location they knew was safe: the bond market.

Bonds have been rising in price continuously, year after year, for over 30 years. The average living American cannot remember a time when bond prices fell. Almost any financial advisor, who the average American pays to protect their future, cannot remember a time when bond prices fell.

We have reached the final stage of the current bull market in bonds: the mania. People will look back at the prices paid today for a 5, 10, and 30 year government bond with complete amazement, just as they now look back at internet stocks in 2000 and real estate in 2006. The following shows the current interest rates on these bonds:

2 Year US Government Bond (.23%)
5 Year US Government Bond (.83%)
10 Year US Government Bond (1.88%)
30 Year US Government Bond (2.89%)

These numbers are staggering. With money flooding out of Europe in fear, it has found a home with the United States government. When interest rates on bonds rise the underlying price of the bond falls and vice-versa. It is like a see-saw

If an investor were to purchase a 10 year government bond today at 1.88% and the interest rates next year were to rise to just 4% (still way below the historical interest rate) then the investor would lose 50% of the money invested.

A topic I will continue to review through 2012 (and I hope you now understand its importance) is that the United States government is bankrupt. The balance sheet is toxic, and the government bonds should be rated junk, not AAA.

Does that seem ridiculous? Remember that the entire global financial system, the investment managers and traders who take home millions based on their "understanding" of risk models, bet everything they had with leverage on an investment called US subprime mortgages back in 2006. The rating on subprime bonds that year just hours before they collapsed? AAA.

Can prices move higher from here? Absolutely. During 1997, many of the greatest investors in the world took massive short positions on internet stocks that held sky high valuations. The stocks then soared higher for close to 4 more years, moving from bubble price territory to beyond extreme bubble priced territory. Many of the investors taking losses on their positions gave up and began to purchase internet stocks at the peak. An old saying goes that the market has the ability to stay irrational longer than you can stay solvent.

With that said, I do not believe that the US government debt bubble will burst this year. I think the European crisis and the coming crisis that is about to wash over the shores of Japan and the UK will keep investors (incorrectly) positioned in US treasuries and keep interest rates at their ridiculously low levels.

Does that mean that I want to keep my money parked there? Absolutely not. If I know that a bomb is going to go off in a building but I don’t know when, I don’t want to hang out in the building because it (probably) won’t go off for another year, especially when the return on your investment for taking the massive risk is almost zero.

So with all this turmoil in around the world, where can an investor find safety?

Next: 2012 Outlook Part 8: Gold And Silver

2012 Outlook: Gold And Silver

2012 Outlook Part 1: Introduction
2012 Outlook Part 2: How We Got Here
2012 Outlook Part 3: Sovereign Debt Review
2012 Outlook Part 4: Global Butterfly Effect
2012 Outlook Part 5: Japan's Debt Crisis
2012 Outlook Part 6: United States Stock Market
2012 Outlook Part 7: United States Bond Market
2012 Outlook Part 8: Gold And Silver
2012 Outlook Part 9: How To Invest
2012 Outlook Bonus: Real Estate

An important part of the discussion when looking at the future direction of precious metals are the shorter term fundamentals such as the physical supply available vs. the paper money and credit in the financial system, the new physical supply coming to market vs. current and expected investment and industrial demand, and overall sentiment toward the metals.

These are all very important factors when discussing precious metals and they are key concepts that I will return to on a regular basis throughout this year.  For recent discussions on these topics just click on the links provided in the previous paragraph.

Today, however, as we start this new year I would like to take a bigger picture look at the precious metals providing a broader scope of discussion.

In the financial world today there are essentially three categories of financial analysts/economics that become visible after a considerable amount of time studying market data and history.

Category 1: The 99%

The first category are the 99%.  This is the large army of people you see being interviewed all day long on television that work for financial firms.  They are your average money manager.  They tell you that a portfolio should be composed of a percentage of stocks and bonds based on your age.  They tell you that stocks go up about 10% per year and that bonds provide less growth opportunity but provide the safest location for your money.  They get a paid on a commission basis based on the amount of money you have invested with their company.  Their goal is not to veer to far away from their peers so if they are wrong they will be with the crowd and not singled out: meaning they will not lose their jobs. 

The consensus among the major financial firms entering 2012 is that stocks will rise 9% this year.  Entering 2011 it was that stocks would rise 10%.  The year before, the same.  The year before, the same.  When asked about precious metals they discuss the high risks, lack of dividends, and how they did not protect you from inflation from 1980 to 2000.  They never mention that they receive no commission for funds invested precious metals.

Category 2: The Inflationists

This is a group of financial analysts and economists that have a taken some personal time to study both market history and the current market conditions that exist in the world today.  They have to courage to move away from the group think and can feel that something is different now.

 They look at the balance sheet of the United States and understand that it is not possible to pay off our liabilities and there is a fork in the road that is right in front of us.  They believe this moment will be met with money printing to ease the debt burden.

Category 3: The Deflationists

The inflationist argument is easier to understand and it is why investors who first venture off the path are drawn to it.  I was first introduced to this world years ago through the eyes of money manager Peter Schiff, which then led me to the study of Austrian Economics.

After spending a considerable amount of time studying the argument laid out by the inflationist camp, my natural reaction was to look for those out there that both understood the inflationist argument and then had an opposing view that they could back up with a strong counter-argument.  I found that these people existed, but their numbers are extremely small due to the fact that 99% of the financial community does not understand the thought process of category 2 thus creating an even smaller group that has taken further steps to try and disprove them.

That is why I think the deflationists are very special and are composed of some of the brightest minds in finance today.  Some of the names in this elite group are Robert Prechter, David Rosenburg, and Gary Shilling.

The general argument for the deflationists is that there is a coming fork in the road ahead of us that is composed of an enormous debt burden the size of which the world has never seen.  Coming debt defaults will overwhelm any ability central banks have to print new money, causing the total money supply plus credit to shrink in size; the definition of deflation.

Where I Stand

Albert Einstein once said that the level of a man's intelligence should be judged based on his ability to hold competing ideas in his head simultaneously.

I spend time on Friday nights reading the work of Elliott Wave and Robert Prechter when they release their subscription newsletters.  Then on Saturday mornings I listen to a radio program hosted by Jim Puplava called Financial Sense where he discusses market events, interviews guests, and talks about his outlook for the future.

Prechter is strongly in the deflationist camp and Puplava is strongly in the inflationist camp.  By the time I finish listening to both arguments Saturday afternoon my head is hurting.  My mind is trying to simultaneously process both sides and come up with some sort of conclusion.  It is tough to describe, but I understand what Einstein meant with his quote.

I think this is why many members of the inflation camp do not spend time really studying the deflation side.  For example, those that have not taken the time to research the deflationary argument will usually say that the Fed is printing money and their balance sheet is expanding which means we have inflation.  What they do not understand is that the Fed is only one side of the balance sheet.  They must also look at the debt and credit contraction taking place and being removed from the system.  This process is far more difficult to process simultaneously.

You can take a few years to study the long arguments of both side (and I recommend you do so because it is extremely fun to research), but I will provide you with an opportunity now to skip to the end of the story and arrive at where both sides come to a head.  It can be summed up in two simple words:

Political Will

That is the key phrase.  Both sides understand and admit there is a debt crisis and the current economic outlook is terrible thus not allowing for a normal restructuring of the debt.  Both sides understand that central banks have the ability to print an unlimited amount of debt to ease this burden, and that the scorecard for both sides is based exclusively on the total supply of money and credit in the system, not the short term direction of any specific asset price.

The deflationists believe that the mountain of debt is now so enormous that when we reach that ultimate point, central banks are going to be overwhelmed and will not be able to stop the cascading debt defaults.  They will not have the political will to provide the amount of bailout money needed.  This is what occurred in 2008 when Lehman failed, there was no political will to save them.  It is what is occurring today as the European Central Bank has not yet entered the market with the force needed to stem the sovereign debt crisis.

Inflationists believe that when we reach the ultimate point, when the financial system has its back against the wall, that the central banks will step in with everything they have to keep their current system moving forward.

I believe that in order to have the political backing or will to do this we have to first have one more major "Lehman" type moment.  This will once again rock the markets and the financial system.  It could come from the failure of Greece, a French bank failure, a geo-political black swan event, a terrorist attack, or a natural disaster.  It is impossible to know what the catalyst will be. 

Up until now, just as we moved along during the subprime crisis in 2007-2008, governments and central banks have kept everything together with duct tape and glue.  They have bailed out Greece just as they bailed out Bear Stearns.  They have created bailout funds in the form of EFSF just as they created SIVs back in 2007-2008.  They have opened up borrowing lines in the form of global swap facilities just like they cut the Federal Funds rate back in 2007-2008.

The question is, will they let a Lehman even occur again this time, and if they do, will the cascade of debt defaults be too much for the central banks to backstop even if they enter the market after with a bailout?

Because the direction of the markets are now backed by the political will to bailout, it is far more difficult to navigate the future.  In a normal business cycle you can make investment decisions based on the analysis of a company's balance sheet and their prospects for future growth.  Now, in our globally central planned world, you must make investment decisions based on how much money you believe will be printed in Europe during 2012.

I believe that we have one more deflationary shock in front of us.  This shock will provide both governments and central banks with the political will to print the level of money needed to create an inflationary environment. 

So which camp am I in?  I am in both.  Deflation first, inflation second.  However, as an investor you must be prepared for both.  You must have safe cash ready if we enter a period of deflationary deleveraging so you have the ability to purchase assets before the next inflationary cycle. If they do not let a Lehman moment occur and central banks have the political will to inflate directly out of this current debt crisis, then you must be have some protection or insurance for that scenario as well.

Next: 2012 Outlook: How To Invest

2012 Outlook: How To Invest

2012 Outlook Part 1: Introduction
2012 Outlook Part 2: How We Got Here
2012 Outlook Part 3: Sovereign Debt Review
2012 Outlook Part 4: Global Butterfly Effect
2012 Outlook Part 5: Japan's Debt Crisis
2012 Outlook Part 6: United States Stock Market
2012 Outlook Part 7: United States Bond Market
2012 Outlook Part 8: Gold And Silver
2012 Outlook Part 9: How To Invest
2012 Outlook Bonus: Real Estate

I am not a financial advisor.  I would recommend speaking with one before making any investment decisions.

So after spending considerable time talking about where not to invest, where would I have money positioned to start 2012?

1. Ultra Safe Cash Held In US Dollars
2. Precious Metals

Ultra safe cash means money that is held in T-Bills rolling 6 months or less. Not at a bank, and not in Treasury bonds (1 year or longer).  American Century has a fund called the Capital Preservation Fund that holds only ultra short term bills.

Precious metals means physical precious metals or strong mining companies. I personally use a company called Goldmoney.  You can open an account in just a few minutes by following this link:

GoldMoney. The best way to buy gold & silver

Basically you are on the sidelines waiting.  I believe all other investments as of today (January 3, 2012) are either too expensive or do not have enough positive or negative sentiment to apply action.  This could change by this afternoon depending on what happens in the markets.  Or it could change tomorrow, next week, or next month based on how the market conditions change, but if I were holding $1 million dollars today heading into retirement that is how I would be positioned and I would sit back and let the market dictate my next move.

For example….

If the stock market begins to move considerably higher to begin the year, I would put on a “short” position in stocks meaning that I would profit if prices fell (and lose money if prices rose).

If the European crisis escalates, bringing down the value of the euro, and simultaneously bringing down the value of commodities or certain currencies (Canadian dollar, Australian dollar, Brazilian real, Asian currencies, New Zealand dollar), I would take some of the liquid cash and purchase commodity related stocks held in those currencies.

If the stock market crashed significantly, I would begin to invest in safe stocks with a high dividend, such as consumer staples (companies that sell items people have to buy such as toothpaste), utilities, and health care.

If the price of agriculture, oil, natural gas, gold, silver or related stocks fell significantly I would purchase these assets with the available liquid cash.

I will continue to monitor events on a daily basis and try to alert you when I feel assets have reached the point signaling a strong buying opportunity (future growth opportunity coupled with poor current sentiment).

Until then, I would take some time and do your own research on what is taking place in the world. I will update my recommended reading list with the “must reads” as they come out. I will continue to provide the most important news articles and interviews on the left column of this page every day.

Investors that come out of this period with capital available to invest are going to be able to invest early in the greatest bull market in history, but until we get there the turbulence is going to pick up significantly and the average lifestyle in terms of wealth is going to fall.

The 40 year debt fueled binge has come to an end, and now the bill is due.

For an additional discussion on how to purchase precious metals and precious metal mining stocks please see Purchasing Precious Metals: NAV Considerations.

For information on the American Century Capital Preservation Fund click here.

To open an account with Goldmoney in only a few minutes click the following link:

GoldMoney. The best way to buy gold & silver