Category: Thesis

In part 4, I had shown that Russia and China have been buying gold. Below is a chart of all global central bank purchases since 1971. The 651 metric tonnes is multi-decade record. In my most simplistic argument, if those that create policy are buying gold, then you should probably have an allocation as well.

I have also laid out fundamental reasons why the dollar will fall. Most people do not think about prices in this way, but the price of gold in the US is effectively the price of gold divided by the price of dollars. With that in mind, if the denominator in the equation was to fall (dollars), then the price of gold will rise. This is demonstrated below. As the dollar rises, gold tends to fall and vice versa. There is a potential scenario where both rise in tandem due to a race to safe and perceived safe haven assets in a time of distress.

Historically, gold was always tied to the US dollar. This meant that for most of history dollars could be exchanged for gold. This forced the government to spend within its means because if too many dollars were ever created, then there was the potential for too many gold redemptions to bankrupt the US. In 1913, $20 would buy an ounce of gold, but the US spent its way out of being able to hold that promise. Then, in 1933, the US said we can no longer allow gold to be redeemable at $20, and gold was revalued to $35 an ounce. This trend continued over time until 1971. The US government in the 1960s was spending too much money on the war in Vietnam and Lyndon B. Johnson’s “Great Society.” The rest of the world was skeptical that the US would be able to repay gold to all dollar holders at $35 an ounce, so there was basically a run on the gold at the United States treasury. In 1971, Nixon basically defaulted on the promise to repay gold at $35, and removed the dollar from the gold standard. Gold in the coming years would rise from $35 to over $800. The brief sequence of events demonstrates that gold has precedent as an insurance asset against government over spending.

During the 2008 financial crisis, the US deficits exploded and so did gold. Below, you can see a different chart showing forecasted deficits exploding going forward. Also, the data is sourced from government sources, and does not forecast a recession in the next 10 years.

Another case for gold is the rising cost to mine it. This is due to inflation and gold becoming harder and harder to find. If gold were to dive below 1000 for a lengthy amount of time, then some miners may need to cease operations due to not being able to produce gold at a profit. If some supply goes offline, then this will be bullish for prices. With this in mind, it is quite likely that there is floor around $1000 an ounce for gold.

Gold also appears to serve as an insurance policy against the inevitable failure of global quantitative easing. Until 2012, gold was rising in tandem with central bank balance sheets. I would speculate that around that time the market basically decided “quantitative easing worked, all is well,” and stopped buying insurance in the form of gold.

The chart below is the gold to dow ratio. This is a historical chart of the amount of ounces it takes to buy the dow jones industrial average. Over time, the ratio tends to revert to below 5. My suspicion is that we were well headed for that reversion prior to “quantitative easing working.” For this chart to revert properly the dow will either need to come down to around 6,000 from 25,000 or gold will need to rise to about $5,000. Some combination or the two is the most likely scenario.

One should not bet the farm on gold or any investment for that matter, but if you do not possess an allocation towards gold it may be unwise. There is a great deal of uncertainty in the world at this moment. By many metrics gold is cheap. If you know that the odds of recession are increasing, which is going to weigh on the dollar in long run, then it makes sense to buy the insurance before the storm hits. Once the economic storm is upon us, then it will be too late. Unfortunately, many individuals do not own gold because conventional wisdom has been brainwashed into hating it. They say, “it doesn’t produce a yield,” “it’s just a dumb rock,” or “it has no uses.” To me this ignorance is the buying opportunity of a lifetime.

Continuing from Part 3, if the FED reverses back to quantitative easing and rate cuts, then it is definitely bearish for the dollar with interest rate differentials in mind. The interesting thing is there is a lot more to the bearish case for the dollar.

Let’s start with the fiscal side of the dollar via government debt. The CBO (Congressional Budget Office) has a projection of what the deficits will be through 2028. The first issue with this is that this projection assumes that there will be no recession over these 10 years. With this in mind, one might ask why the US deficit is soaring prior to even having a recession? This comes down to weak politics and soaring past promises. If we have a recession, then one can safely assume that deficits will balloon even more as we can use a proxy for such a move in 2008. What I like about this chart is it proposes a key question. What happens if the deficits balloon and we have interest rates that are not historically low anymore? As you can see below, should interests rise, the deficit will rise even more.

What might cause interest rates to rise other than the ballooning supply of debt via growing deficits as presented earlier?

Treasuries used to be primarily sold to foreigners, but now our debt is funded primarily domestically. I believe this is due to the fact that the rest of the world recently has been looking to diversify against US investments, which I will get into reasons why later. Anyways, if we assume that at current interest rates foreigners have minimal demand for US treasuries, then these treasuries must be bought by the domestic citizen. Now, the question is if the economy slows in the US, will US citizens be able to fund higher US deficits? Bottomline, it is unlikely that the domestic citizen will be able to fund the US debt indefinitely, so rates will have to rise to bring foreign demand back in or increase domestic demand. My opinion is long term in nature. I do see the probability for lower rates during a recession via the flight to “safety” assets and assumed FED cuts to come.

On to the next problem. Most US debt is short duration, which means the national debt is very susceptible to rising interest rates. Even if interest rates do not rise, it is important to note that rates are not at 0% like they once were. Any debt that needs to be rolled over today that had been previously locked in at rates between 2009-2017, will still make an impact on rising interest payments and increasing deficits.

The elephant in the room is inflation.

Should inflation run hot, the FED’s corner will be as small as ever. In the event that the stock market is crashing and the economy is deteriorating, the FED would love to revert to the old playbook of cutting rates. The issue is that if inflation is running high, then our bond interest rates need to be higher to compensate lenders for inflation. The FED’s hand will then be forced between asset prices or inflation. The more politically palatable choice is likely to attempt to re-boost asset prices by cutting rates. Unfortunately, this should exacerbate the inflation. For starters if we cut rates, then those cuts and all future rate hikes will have to be repriced in the market. This is dollar bearish. For a country that imports most of our real goods, this will not bode well. This is due to the fact that the US consumer will be bidding for the same goods as before, but with a weaker dollar. This will make the prices of goods in dollar terms rise.

A picture of ballooning deficits coupled with inflation risks has now been presented. Let’s move on with an understanding of the significance of the current dollar monopoly on international trade.

A reserve currency is a large quantity of currency maintained by central banks and other major financial institutions. The purpose is to prepare for investments, transactions and international debt obligations, or to influence the domestic exchange rate.

The USD has recently made up 60-80% of global reserves by major financial institutions. All this really means is that most global savings are held in dollars.

The reasons that other countries use US dollars for reserves are tradition with the dollar being the last currency redeemable in gold, relative historical fiscal stability, strong rule of law, the fact that much of the current global debt is denominated in dollars, and the fact that essentially all oil is traded in US dollars. As of July 2018, the Yuan oil futures had a market share of 14.4%, compared with 28.9% for the Brent futures, and 56.7% for WTI futures. This means that in order to bid for about 80% of the oil in the world, one must first possess dollars. This I believe to be the main artificial driver of the dollar.

I view the dollar theoretically as possessing an artificial bid. This is largely due to other nations needing to have dollars to pay off dollar denominated debt and to purchase oil. The question to answer is what would cause this artificial bid to dissipate? Below is a simple diagram that demonstrates a graphical representation of the artificial bid. As one can see the removal or loss of this bid will revert the dollar to normal demand. It is nearly impossible to quantify the power of the artificial bid, especially since it is not likely that an event will occur that will take away all of it in a clear cut way to provide for hindsight.

The US understands its monopoly and has used it to its geopolitical advantage. In the event that countries do not follow the US global rule of law, then the US will punish them in the field of financial warfare. This includes the use of Fedwire and SWIFT.

Fedwire is one way for international entities to transact. Upon study it becomes understood that the US Government/FED has the ability to create chokeholds in the system in the event that they want to block out certain countries or businesses from using the service. This system is only for the use of dollars, which the US government believes they have total oversight and authority into every transaction no matter where it occurs as long as it is denominated in dollars. This type of issue is where you hear the US sanctioning foreign businesses or countries because the US deems some act of business to be wrong for whatever reason it may be.

The more notable international payment program is SWIFT. The USD continues to hold the greatest market share of use within SWIFT and has exercised that power. The US has essentially declared itself the defacto administrator of global trade and in a way, and has self-appointed itself the authority to decide what is right and wrong in trade. Whatever your view may be, I just ask you to put yourself in other nations’ shoes. Would you like being told what you can or cannot do?

So am I speaking nonsense or are the pieces starting to become visible to the public? Earlier I presented a chart showing that US debt has shifted funding from international to domestic. This means foreigners are less eager to lend us money. Also, around the same time, US SWIFT market share began to decelerate.

I also had mentioned the Yuan oil contract. What I did not mention is that it was launched in March of 2018. A notable takeaway that demonstrates the occurring change is that in 6 months, the Yuan futures have picked up the market share that it took the Brent futures 14 years to pick up. There is clearly international interest around the world.

I view the battle as of now as the US vs. China and Russia. The reason for this is that the rest of the pieces of the chess match are either too insignificant in solidarity or still technically can be swayed to either side of what the history books will call Cold War 2. With this in mind, let’s look at some strategic moves that have taken place by the main players. Please see below that both Russia and China have been selling US Treasuries and have been buying gold. This is a trend that is not unique to these two countries as many central banks around the world have been stocking up on gold in recent years.

Let’s play this scenario a little further out. What happens when the domestic buyer can no longer support the exploding debt? The answer is either debt restructuring, default, or debt monetization. Since debt is mostly held by domestic citizens, the government will unlikely default on its own people. Therefore, debt monetization is the most likely choice for future policy makers. This is the game over scenario for the USD.

If one day the FED has to resort to a form of QE4ever in order to contain bond yields low enough to keep interest payments on the national debt tame and to support asset prices and capital investment, then the dollar will tank. This type of policy will force the rest of the world to not be able to hold USD in reserve due to intense fiscal irresponsibility dragging down the dollars value.

So what I have been explaining through Parts 1 and 2 is a modern roadmap for how bear markets and recessions are brought on. To reiterate, the playbook for ending a recession has been to cut interest rates in order to make it easier for consumers to borrow to spend. On top of that, the bear markets end as sales increase for companies that benefit from this consumer spending and the declining discount rates used on their share via the net present value formula.

After the financial crisis of 2008, central banks embarked on an unprecedented amount of quantitative easing (asset purchases). This means that the FED and other central banks purchased assets on the market, by essentially creating currency. This speaks to the idea that cutting rates to zero was not sufficient in re-inflating asset bubbles. As you can see below, prior to 2008 the FED was not in the business of buying up assets on the market and holding them on their balance sheet. Also, below you can see the effect that this policy had on the M1 money stock, which includes physical currency and coin, demand deposits, travelers checks, other checkable deposits and negotiable order of withdrawal (NOW) accounts.

A common misconception that occurred back when this policy was undertaken was that it would cause inflation. Many individuals say that we did not experience any inflation due to this policy because the CPI (Consumer Price Index) never rose significantly. As I wrote previously, inflation is the expansion of the money supply, and rising prices are a byproduct. Do not forget that stock prices are prices as well. Stock prices experienced a rise of historic proportion the past 10 years, which has lulled many to sleep.

The market was of the belief that the FED will have success in normalizing its balance sheet and raising interest rates without causing another crisis, recession, or bear market. The bear market is upon us now though. Above, you may notice that the FED’s balance sheet has been shrinking. This is due to the balance sheet normalization effort known as quantitative tightening. If we agreed that quantitative easing boosted stock prices, shouldn’t we agree that quantitative tightening will lower stock prices? You should agree because right as global quantitative easing was ready to run negative for the first time since the 2015-2016 market drawdown, the stock market entered a bear market.

The narrative at the moment is that the stock market does not appear to be able to handle more rate hikes and quantitative tightening, but at the same time the FED has essentially already conveyed to markets that policy normalization would occur. This policy normalization pledge has aided the dollar due to the fact that on a relative basis interest rates in the US are more attractive than interest rates in the rest of the world. Also, remember that priced into the dollar is the idea that the FED will continue to raise rates over the long term.

So here lies the issue, the FED has policy normalized to the point of pricking the stock market bubble. Upon the realization of this, the FED has begun to talk up the markets by suggesting there may be less rate hikes than expected in the future. This has helped in creating the stock market bounce off the December lows. The issue is how much dovish (not looking to hike) talk can the FED convey before this communication policy runs out of juice.

FED policy is subject to something called policy lag. This means that when the FED does something such as raising rates, the effects are not visible until some time later. There is a valid argument to suggest that it is not the future rate hikes that will cause the recession, but the ones that have already occurred. Many will say that raising rates to 2.5% is not significant, but it is significant when the market was used to rates of 0% for about 7 years. Also, something important that many market participants are not aware of is that some economists claim that quantitative tightening has had the effect of quasi rate hikes per the chart below.

At the moment, the FED has the market in limbo of how many rate hikes are to come going forward, but quantitative tightening is still on “autopilot.” If the market resumes its downtrend, one should consider what the FED will do. Will they begin rate cuts? Will they end quantitative tightening? Will they resume quantitative easing? Any of these 3 outcomes would be very bearish for the dollar due to the suggestion that US interest rates would become less attractive, and the supply of US dollars would increase.

Stock market investors may believe that quantitative easing will save the day. I urge those to consider the possibility that the policy does not work again, the public does not allow the government to essentially re-enrich the wealthy, or the dollar declines to the point that the gains in real terms are not positive.

In part 4, I will take an in depth look at the dollar.

I have found that the terms recession and bear market are used interchangeably by some people. The two tend to occur at the same time, but are in fact independent events. Part 1 taught you that a recession is a time period in which the economy produces 2 straight quarters of negative GDP growth. A bear market is defined as a time when the stock market declines by at least 20%. When the economy is contracting it is quite likely that stocks will decline by at least 20%.

This can be explained via the PE ratio. A PE ratio is a price to earnings ratio. It is a valuation metric, and it tells you the multiple that each share of stock costs in relation to earnings. Intuitively, one can assume that when an economy is contracting (producing less goods and services) that earnings will come down. With this in mind, declining earnings (denominator of the PE ratio) will cause PE ratios to signal that stocks are overvalued, which will result in selling to adjust valuations to current earnings.

In Part 2, I would like to assume that a recession is on the horizon and discuss what the roadmap forward may look like. If we are assuming that recession is on the horizon, then we are also assuming that earnings are due to come down.

I previously discussed how rising interests rates have an effect on the consumer. I would like to now discuss the effect that rising interest rates have on stock prices.

Every decision you make has an opportunity cost. The opportunity cost is what you could have done instead of doing what you did. For example, when you buy stocks, your opportunity cost is effectively the rate of return on bonds. This comes into play in a calculation known as the Net Present Value formula. What you need to know is that if bonds are paying more, then stocks should be less valued today.

With the NPV formula and consumer access to debt for spending in mind, one can see how rising interest rates are a headwind for both the stock market and the economy.

I suppose it is necessary to touch upon why interest rates rise. Interest rates are the compensation that lenders get for not spending their money today. Borrowers compete for funding by offering to pay higher interest rates. If two companies that are totally the same need money, then you will choose to lend to the company that will pay you more interest for borrowing your money.

Another thing to understand in the determination of interest rates is inflation. Inflation is when the central bank expands the money supply, and eventually this expansion of the money supply shows up in the prices of everyday goods. If you lend someone money for 3% interest, but prices rise 4% during that time period, then you have lost purchasing power. The basic rule of thumb is that interest rates should be higher than the rise in prices for the same period. For the record, most people call inflation the rise in prices. I stress that the rise in prices is the result of the inflation of the money supply. When you want to look up what the government proposes the price rise to be, you will use the Consumer Price Inflation statistic though.

So companies and governments that would like to borrow money should offer an interest rate to compensate the lender for the price rise at the least.

For reference, the Federal Reserve sets the Federal Funds Rate for the US, which sets a standard for other interest rates. The Federal Funds Rate is the rate that depository institutions lend to each other. One way to think of this is as the wholesale interest rate.

The Federal Reserve uses the Federal Funds Rate to pursue its “dual mandate” of “price stability” and “full employment.” Unfortunately, I am of the opinion that over the years the FED has been politically corrupted to also include asset price preservation in that mandate. Differing ideologies make this a difficult topic to tackle. The bottomline is these mandates cause the Federal Reserve to react when situations take place in the world.

Below, for example, you will see that bear markets and recessions are met with cuts to the Federal Funds Rate. Since 1957, the average crisis Federal Funds Rate cut has been 4.7%.

Simplistically, each crisis causes interest rates to be cut, which creates asset bubbles that lead to crises when they pop. The game has become, “Can the Federal Reserve raise interest rates high enough without causing a crisis, so that when there is a crisis they can cut rates to get us out?” This game appears to have run its course. With the stock market already crashing from small interest rate hikes and the Federal Funds Rate only at 2.5%, it does not appear that interest rates can be cut by the historical average theoretically needed to get out of a crisis.

In Part 3, I will discuss where we currently are and examine the Federal Reserve’s decision making process with respect to rate hikes and cuts.

Recessions affect everybody in one way or another. With that in mind, I think it is important to define what a recession is and to examine if one is in the cards in the near term.

The academic definition of a recession is a contraction in the economy. This is still a fairly vague definition so the generally accepted definition is an economy that experiences 2 straight quarters of negative GDP growth.

Let us now define GDP. GDP stands for Gross Domestic Product. GDP is the total monetary (dollar) value of all the finished goods and services by a country. As you have probably heard, the GDP of the United States per year is about 20 trillion, so that means in the United States 20 trillion dollars worth of goods and services is produced per year.

I am going to take GDP one step further. At equilibrium GDP, GDP is equal to total spending. Total spending is made up of 4 categories. Using transitive property, GDP is equal to these 4 categories: consumer spending (~$14 trillion), government spending (~$4 trillion), investment spending (~$3 trillion), and net exports (~-$1 trillion). The main takeaway here is that consumer spending makes up about 70% of GDP.

With the importance of the consumer relative to the economy in mind, let us examine the current fiscal health of the US consumer. There are two ways a consumer can spend. The individual can either spend their savings, or the individual can take on debt to spend.

As you can see below, the US consumer is once again strapped for cash at ominous levels like those seen in the years proceeding the last two recessions. Recessions are marked by gray bars.

How long can the consumer continue to spend via debt then? Below you will see the year over year % change in bank credit. One can see that prior to recessions, banks tend to slow down the rate at which they provide loans to the consumer and businesses. In short prior to recessions, bank credit slowly dries up. This makes it harder for consumers to continue to spend more and more quarter after quarter.

The mechanics of bank credit drying up make sense, since interest rates have been steadily rising. As interest rates rise, loans become more expensive. Loans, like any other good, have a price. The price of the loan is the interest rate, so as interests rates rise, less people take on debt to consume. Below you will see a variety of interest rates, which are all rising.

What are the forecasts currently predicting? The Atlanta Fed’s GDPNow is currently predicting 2018 Q4 GDP growth to come in at 2.8%. For reference, Q1 GDP growth was 2.2%, Q2 GDP growth was 4.2%, and Q3 GDP growth was 3.4%.

Making predictions on GDP can be very difficult. The main issue in my opinion with the forecast is trying to quantify the human variable. My current stance is that the statistics are not placing enough respect on the non-sustainability of tax-cut sugar highs, the trade war reaction, and the reverse wealth effect.

The theory behind non-sustainability of tax-cut sugar highs is that the Trump tax cuts created a strong earnings boost and euphoria in the economy. First, many companies were essentially given free cash flow that they had not previously expected to have, which is theoretically positive for an economy (not going to get into the fact that the tax cuts were funded with debt). With this in mind, I am taking a bet that analysts will over extrapolate the benefits of the tax cuts into the future.

The trade war overreaction means that businesses decided to get ahead on the production of goods due to the coming tariffs. If you run a business, and you know that the goods you need to produce your product are about to be subject to tariffs, then you will purchase those goods in advance to avoid the tariffs. In Q3 0f 2018, inventories could be attributed to 2.33% of GDP. This means that without the rise in inventories due to preemptive tariff reaction, Q3 GDP may have been closer to 1%.

The last behavioral variable to hit the markets that I will speak about is the reverse wealth effect. This one can simply be defined as feeling richer or feeling poorer. For example, when your stock portfolio is appreciating, you may be more likely to spend due to the larger unrealized gains present in your portfolio. On the other hand, if your portfolio is depreciating, then you may spend less due to the fact that you will feel poorer as your unrealized gains will have fallen in value.

If we are heading towards recession soon, then Q4 GDP 2018 will need to show decline. It will be interesting to see if some of the behavioral variables end up creating a significant discrepancy of the outcome from the forecasts.