Archive for March, 2008

Reflections on our ‘predictions’

Thursday, March 13th, 2008

As we browse our own writings over the past year, we realise that a lot of our warnings, which seemed implausible at that time, are gradually coming into fruition. At that time, we wondered whether we would make a fool of ourselves by going against the grain of mainstream opinion or turn out to be ‘prophets.’ But, we realised that even if we turn out to be completely wrong, we would do no worse than mainstream chief economists working in a major bank. For example, compare what this chief economist predicted 12 months and what the result turned out to be: Economist said Australian interest rates have peaked?.

Even as late as 4 to 5 months ago, when we told a real-estate agent that we were expecting a recession and mortgage rates of double-digits, we were being laughed at (at least we felt that way). But today, with a bear rampaging in the stock market, rising interest (and mortgage) rates, unresolved credit and solvency crisis, reports of mortgage stress affecting even the affluent (see Now Sydney’s affluent hit), record oil prices, rising cost of living and consumer sentiment at record low since 1993, who is laughing now?

Specifically, at around 13 months ago, we were already sounding 3 alarm bells on the Australian economy:

  1. Recession
  2. Inflation
  3. Further property price deflation

For point 1 and 2, we said in Where are we in the business cycle?,

So, the greatest danger to Australia?s economy right now is price inflation.

Thus, we believe that Australia (and the US as well) is at the top of the business cycle.

For point 3, we said in Can Australia?s deflating property bubble deflate even further?,

… we still believe that Australia?s housing deflation is still vulnerable to even further deflation.

If you have been with us for a long time, you will know that we had been continuously warning of deflation, inflation (no, they are not contradictory- see Inflation or deflation first?), recessions, crash, etc throughout the year, singing a completely opposite tune from the mainstream.

So, what do you think is in store for Australia in the short to medium term? We will tell you what we think in the next article.

How is Australia’s mining boom sucking resources out of the economy?

Wednesday, March 12th, 2008

Back in Rising metals price=rising mining profits? Think again!, we questioned the rising profitability of the Australian mining sector,

The key point to note is that higher metal prices do not always translate to higher profit. Higher prices merely translate to higher revenue. Profit is the excess of revenue against costs. So, despite rising revenue, profit can actually fall if costs rise faster.

Rising costs is a sign that the economy is running out of resources to expand further. For the mining sector, these two articles in the news media illustrate the current situation:

  1. Fixing the resource boom’s bottlenecks
  2. THE good news is that the nation’s commodity exports fiscal year as the resources boom kicks in to full swing. But the question has become whether the mining industry can deliver the Australian Bureau of Agricultural & Resource Economics.

    Latest figures from the Australian Bureau of Statistics, released on Wednesday, showed exports of mineral ores were down 2.9 per cent in the December quarter while total mining production volumes slipped 1.6 per cent across 2007.

    A major part of the problem in taking full advantage of the once-in-a-lifetime resources boom is the clogged infrastructure on the eastern seaboard, namely the production chains leading up to and including the ports at Dalrymple and Newcastle.

  3. ‘Predator miners’ poaching sub crews
  4. CASHED-UP mining companies were lying in wait outside naval bases to poach submariners, fuelling a critical shortfall in crews for the Collins class submarines.

This is the dark side of the Australian mining boom. Although the booming metal prices is beneficial to the Australian economy, there is not enough resources (e.g. infrastructure and skills) in the Australian economy to fully take advantage of that. It has come to the point that the Australian mining sector is fighting against the rest of the economy for resources. As we said before in Why does the central bank (RBA) need to punish the Australian economy with rising interest rates?,

Therefore, in order to put the economy back into a sustainable growth path, consumptions and investments have to slow down in order to allow for the economy to catch a breather for the rebuilding of its capital structure. The rebuilding of capital structure is necessary for the economy to replenish its resources for the future so that growth can continue down the track. Unfortunately, this rebuilding itself requires resources now.

That is the reason why we believe the Australian economy is heading for a recession, which we had already sounded the alarm back in February last year (see Where are we in the business cycle?). It is actually a good thing, except that many Australians cannot afford to go through a recession because of debt.

Melting pennies for profit? Gresham’s Law arriving in Australia

Monday, March 10th, 2008

Back in Artificially undervalued coins: government interference cripple the free market, we said that,

Today, we look at the situation described in our previous article, One funny effect of monetary inflation: ?New rules outlaw melting pennies, nickels for profit?. This is exactly a repeat of what happened in the 1960s when the US government made it illegal to melt silver coins. The fact that the underlying value of a coin far exceeds its face value proves that there is a serious underlying problem in the monetary system.

The result was that silver coins ‘disappeared’ due to hoarding. This is Gresham’s Law, which says that an artificially overvalued money tends to drive an artificially undervalued money out of circulation. Today, we announce the arrival of Gresham’s Law in Australia as reported by this newspaper article: High metal costs may shrink local coins. When word of this gets round, we can soon see the Aussie 5c, 10c and 20c coins disappearing.

Thanks monetary inflation!

Marc Faber: Bernanke Policy Will “Destroy” U.S. Dollar

Monday, March 10th, 2008

Recently, Marc Faber was being interviewed in Chicago where he freely shared his thoughts. You can watch the interview at Bloomberg here. Below is the content of the interview as summarized and transcribed by us:

If the statistics were measured properly in the United States, the US would already be in a recession and would already be so in a couple of months.

See our article, How much can we trust the price indices (e.g. CPI)?.

If the US goes into recession, it will not be a total disaster for the rest of the world, except that in the rest of the world, we also have colossal bubbles [in asset prices].

Since the world is in a global boom from November 2001, then this will one day lead to a global bust.

It is very doubtful that the global financial market is de-coupled from the US because of the close linkages and connectivity. For example, if the US stock market goes down, the rest of the world’s stock market will be dragged down as well.

As Marc Faber acknowledged by psychologists’ study, a dosage of bust is more painful than the joy of an equal dosage of boom. In other words, the implication the coming bust will be more pronounced and painful than the euphoria of the preceding 75 months of boom.

In the US, they pursue essentially economic policies that targets consumption, which in my opinion is misguided. What they should pursue is economic policies that stimulates capital investments and capital formation.

We would agree with Marc Faber wholeheartedly, as we quoted Ludwig von Mises in The myth of financial asset ?investments? as savings. As the US began their aggressively loose monetary policy from September 17 2007 by cutting interest rates from 5.25% to 3%…

What is the result? I tell you what the result is! The stock market in September 17 by the S&P is down 10%, the US dollar is down 10%, gold and oil are up 40%. Well done Mr. Bernanke!

Will the stock market continue to fall? Marc Faber said that we have to ask Mr. Bernanke…

… because if he prints money- and I have to add here one point: had I been the professor who had judged his thesis for his PhD, I would not have let him pass. I would have told him actually, “Mr. Bernanke, I have one condition in which I let you pass, and this is you never join a central bank, because you are a destroyer of money as store-of-value function, of the function of money being a unit of account. The only central bank that I would allow you to go to is the one under Mr. Mugabe in Zimbabwe. And I tell you Mr Bernanke with his monetary policy, he will destroy the US dollar.

This is what we said before in Peering into the soul of Ben Bernanke.

As pointed out by the interviewer, the dollar was in decline before Mr. Bernanke took over. Does Bernanke need to ease monetary policy to ease the US economy from this “spunk?” As Bernanke studied about the Great Depression, his conclusion was that the lack of flexibility in the monetary policy that resulted in such a prolonged downturn. Marc Faber disagreed:

The Depression occurred not because the central bank was tied when the Depression occurred. But because it was far too easy in its monetary policy in the period leading to the Depression, from 1925 to 1929.

This is what we said before in What causes economic booms and busts?. As Marc Faber said, it is not only Bernanke is at fault. Greenspan is responsible too, with his loose monetary policies when he cut interest rates to 1% in September 2001 and keep it that way till 2004. That led to the “reckless lending” and “reckless credit growth,” which in turn led to the problems we have today.

Marc Faber said that if he is the central banker, he will raise interest rates much earlier to target asset and credit price bubble and would not have cut the Fed Fund Rate to 1% in 2001. This is because unlike the Fed, he would not base his monetary policy on core inflation (which excludes food and fuel) because all humans eat and uses energy. Now that the Fed had created a “gigantic” credit and asset bubble, which is deflating right now, it is very difficult to re-inflate the bubble because “we are in the process of de-leveraging” as the private sector is now tightening credit conditions, “not the Fed.”

According to Marc Faber’s latest Doom, Bloom and Gloom report, investing in the bond market (mainly Treasuries) is “financial suicide” because with such low yields, actual price inflation will result in negative real returns. Marc Faber believed that “at some stage, the corporate bond market will offer some value.” However, the 10-year and 30-year Treasury market is a “disaster waiting to happen.” As the Fed cuts the Fed Funds Rate to possibly zero, the Treasury market will “tank” at some point in time. Though he is not a US credit analyst, Marc Faber reckoned that in the junk bond area, there should be some good quality bonds from company that can survive and continues to pay interests. He continued,

The arguments for stocks is frequently that you take the earnings yield of the stock market and compare it with the bond yield and people compare it to Treasury bonds. I think you should take the earnings yield of equities and compare it with, say, a typical S&P company, and that is a yield that correspond to, say, a triple-B, and so, basically as of today, some bonds are more attractive than equity.

Over the past 4 to 5 years, US stock market has underperformed other markets, e.g. the emerging market and the commodity market. However, today, the emerging market is far more vulnerable (e.g. China and India market could easily fall by 30% to 40%). With the money printer in the Fed (Ben Bernanke), the deflation will more likely lead to the US dollar decline than an actual asset price deflation. Thus, relative to the Euro and gold, the US stock market is going down.

Some may argue that given the commodity market has risen so much since 2001, would it be too late to join in the bull market? Marc Faber disagreed with that argument. When the commodity market bottomed and rallied in the 1990s/2000s (note that not all bottomed at the same time), they were at the lowest level, inflation adjusted, in the 200-year history of capitalism. For example, gold was at around $250 when it fell from a high of around $850 in 1980 (which Marc Faber admitted is too high). But in the last gold bull market in the 1970s, gold rose 25 times from $35 to $850. The current gold bull market of several years rose only 4 times. Among the commodity markets, sugar is the cheapest commodity in real terms.

When asked, “Are we going to see a major US bank fail?”

“I hope so.”

“You hope so????”

Marc Faber saw that this is the only way to “introduce discipline” into the US financial system. By continuously bailing out banks, the Fed introduces moral hazard that “perpetuates the mistakes” that the Fed has already done. When asked, which major bank is more likely to fail, Marc Faber had no opinion because that depends on the banks’ derivative exposures, which is the next time bomb to explode. The ‘derivatives’ that he mentioned does not include the structured products (e.g. SIV, CDOs, etc). This will be the next major financial issue in the next 3 to 6 months. Marc Faber believed that we will not see the bottom of the stock market until we see stocks like Google falling 50% from their highs, hopefully more. In a bear market, one sector (e.g. home building) will fall first and then the goldilocks crowd will reassure the market that everything is fine. Then the next sector will fall, followed by next. And so, the bear market has to mature, like “good cheese and wine.”

Are you investing or speculating?

Thursday, March 6th, 2008

A few days ago, Warren Buffett released his annual shareholder letter here. We recommend that you take a read at his letter as it contains many pearls of wisdom on investing. As we read his letter, we noticed a paragraph that we feel is worth providing a commentary for:

I should emphasize that we do not measure the progress of our investments by what their market prices do during any given year. Rather, we evaluate their performance by the two methods we apply to the businesses we own. The first test is improvement in earnings, with our making due allowance for industry conditions.

A lot ‘investors’ do not think that way- they judge the merits of an investment based on its price performance. In the same way, many property ‘investors’ in Australia based their investment decisions solely on the expected ‘value’ (price) in the future even though the investment does not make present economic sense. At the current rental yield, many investment properties cannot even produce a better return then cash in the bank. Why would anyone take the risk of ‘investing’ in a property with such pathetic yield when relatively low-risk cash returns much better? In order for low-return property investment to make better economic sense than cash, rental yields have to rise substantially in the future. But in the present circumstances, is this a realistic expectation? Back in May last year, in Australian property good investment? Part 4?rising rent good reason to ?invest??, we wrote that

Rising property prices are fuelled by rising debt. What fuels rising rents? The answer is income! Renters do not borrow money to pay for rents?they pay rents out of their own disposable income. Therefore, with the current pathetic rental yields, do you think it is realistic for rents to rise (in the absence of income growth) to the point of making property a worthwhile investment? Remember, with the economy at full capacity, rising wages will be one of the last things that the RBA wants to see?they will raise interest rates to pre-empt price inflation.

Therefore, the only reason why these ‘investors’ want to invest in property is that they expect its price to increase at some point in the future. Of course, in the very long run, property prices will increase due to inflation (with periods of stagnation and even deflation).

Sure.

So do, food, fuel, wages, toys, curtains, clothes and other things. Stocks as well. In fact, any piece of junk that you ‘invest’ in Zimbabwe right now will rise in price through the sheer force of hyperinflation. But the past several years of money ‘printing’ in Australia (and US & UK) and the deflationary effects of Chinese factories had led many to believe in the ‘magic’ of property ‘investments’ (see The Bubble Economy). Stock investors are also prone to such irrational exuberance, of which the most infamous was the dot-com bubble. When the sole reason for ‘investing’ is the expectation of higher prices despite lack of economic soundness, then we know it is probably a bubble where speculators buy high and sell higher to other speculators.

Now, look at our quote on Warren Buffett. In essence, the investments that Warren Buffett makes must make economic sense. That is, he buys assets that produces superior earnings. He does not care about how that asset’s market price will perform. As far as he is concerned, the market price is irrelevant. Evaluating an asset’s earnings power means you have to understand the asset’s business, which means you have to think like a business person.

Many speculators think they are investors. Eventually, such speculators get burned and never get to learn about true investing.

Why does the central bank (RBA) need to punish the Australian economy with rising interest rates?

Tuesday, March 4th, 2008

Today, the Reserve Bank of Australia (RBA) just announced yet another rise in interest rates. There are signs that this is hurting, as many people on the street (especially those who are straining under enormous debts) are screaming at the madness of the RBA for doing so. Many economists are worried that the RBA may accidentally tip Australia’s economic boom into a bust. Why is the RBA spoiling the party by raising interest rates?

Think about this: if raising interest rates is ‘bad’ and cutting interest rates is ‘good,’ then why don’t the RBA set interest rates to zero, thereby putting the economy into a path of eternal boom (plus runaway inflation)? For those who think this is a good idea, then this article will set to let you understand why this is a bad idea.

Now, at this point, we recommend that you read our guide, What causes economic booms and busts? because what follows will not make sense unless you understand the Austrian Business Cycle Theory (ABCT).

Back in February last year, in Where are we in the business cycle?, you can see that we already knew that Australia (and the US) was already at the top of the business cycle:

How can we restore the economy back to equilibrium and ensure that it remains in a firm footing for the future?

The first thing that has to happen is to increase our national savings. As we said in The myth of financial asset ?investments? as savings, we need to restore and rebuild our stock of capital goods to ensure our future prosperity. Already, the quality of our education, health, telecommunication and transport infrastructures are in decline and they are in need of repair and upgrade. This means that the only way we are going to achieve that is to reduce our current consumptions and cut down our debt. When that happens, the economy will slow down and many businesses and investments will fail as a result. Since most of the Australian (and the US as well) is made up of consumer spending, in which much of it is funded by debt, we can see that this remedy will be painful. If the consumers do not slow down and get their act together, we can expect the RBA to impose a restraint by raising interest rates.

The Australian economy was already running at full steam. Accelerating price inflation is a sign that there are insufficient resources in the economy to allow for all investment projects to succeed and all consumptions to carry on. If this trend is not arrested, the economy will run out of resources, resulting in a crash. Therefore, in order to put the economy back into a sustainable growth path, consumptions and investments have to slow down in order to allow for the economy to catch a breather for the rebuilding of its capital structure. The rebuilding of capital structure is necessary for the economy to replenish its resources for the future so that growth can continue down the track. Unfortunately, this rebuilding itself requires resources now. Therefore, current wasteful consumptions have to be curtailed and mal-investments have to be dismantled to make way for the rebuilding. The curtailment of consumption involves consumers spending less and saving more, while the dismantling of mal-investments involves retrenching workers, liquidating businesses, e.t.c. These involve pain for the people of Australia.

That is why the RBA has to raise interest rates to ‘punish’ the economy. What if it don’t? Then the economy will crash, either in nominal terms (e.g. deflationary depression) or in real terms (e.g. hyperinflation)- see Recipe for hyperinflation.

What is the future of silver?

Monday, March 3rd, 2008

Today, we will continue from The behaviour of silver and gold prices and explain what we believe the future of silver ought to be. The assumed knowledge of today’s article will be Why should you invest in gold?. As we explained before in our previous article,

But please note that since there is a difference between what we think should be and what the market thinks is the case, then there will be a difference between what we think ought to happen and what will happen.

If you think we may sound a bit too verbose with this explanation, it is because we want to make it absolutely clear that we are not making any claims on the future of silver prices, especially in the short to medium term. This is because no matter how logical our deductive reasoning is (assuming that it is sound in the first place), there is no guarantee that the market will behave rationally. As Keynes famously said, “The market can remain irrational longer than you remain solvent.” Therefore, bear that in mind. Investors have lost money because they forgot that (including Warren Buffett, who suffered a loss in a bet against the US dollar).

Anyway, here comes the meat of this article: Will silver regain its monetary status once again, as a junior partner of gold?

First, why was silver ever money in the first place? In A brief history of silver and bimetallism,

As we said before in Properties of good money, a commodity has to be sufficiently rare to qualify as money. But it cannot be too rare. Silver, the less rare sister of gold, was useful for smaller transactions because gold was too rare for further smaller sub-divisions.

Now, assuming that gold will one day function as money (i.e. play an important role in the global monetary system), will there still be a need for silver to function as small change money? The answer to this question is the crux of what we believe the future of silver ought to be.  We believe the answer is “No.”

Why?

Obviously, even if gold is going to function as money in the near future, it is highly unlikely that no one will carry physical gold in their wallets. The inconvenience of carrying physical gold was real even more than 100 years ago. That is why, as we said before in Entrenched perception on the value of paper money, warehouse receipts for gold, which existed in the form of paper, was invented. Warehouse receipts for gold slowly evolved into today’s fiat paper money.

Today, we have a very powerful technology that can solve the convenience and sub-divisibility problem (see Properties of good money) associated with gold money- computers. All we need is a trusted central repository of gold (perhaps today’s central bank can change its institutional role for this purpose) and let computer systems keep track of ownership and transfer flow of gold money. In other words, the gold is physically kept in a secure central location while the finer sub-divisions and change of ownership of gold money is recorded as bookkeeping entries on computers. No physical movement of gold is necessary. In a sense, this is already happening with fiat paper money today. Much of today’s commerce is happening in the form of electronic transactions, with relatively minuscule amount of physical cash involved. Therefore, it should be possible with gold money. If those who still have doubts of such a possibility, we would like to point out that this idea is already implemented at GoldMoney.com. We have no doubt it is possible to be implemented on a national and international scale.

In this case, will there still be a need for silver? If not, silver is better off being a purely industrial commodity.

The behaviour of silver and gold prices

Sunday, March 2nd, 2008

When it comes to gold, our conviction is clear (this article assumes you have read Why should you invest in gold?). But when it comes silver, the answer is not that straightforward. As we explained before in A brief history of silver and bimetallism, silver used to function as money alongside gold, albeit as a junior version of gold. Assuming that one day, gold will once again play a very important monetary role in the global financial system, will silver be reinstated as secondary money along with gold?

In the past, when silver was money, there was hardly any industrial use for it. As we said before in Properties of good money, it is due to the lack of consumable industrial and practical use that makes a commodity suitable for functioning as money. Today, there is widespread industrial use for silver- see this Wikipedia article for more information on that. In 2006, industrial usage of silver accounts for 63% of silver supply. It is expected that the industrial usefulness of silver will increase, which will, on the other hand, be offset by secularly declining usage in photography (supplanted by digital photography).

This is in stark contrast to gold. As we explained before in Is gold an investment?,

Therefore, conventional supply and demand analysis cannot be applied for gold because it is not a commodity (see Is gold a commodity?). This is because with its extremely limited industrial use, gold will not be worth that much at all. It is worth so much because its value is largely derived from outside the realm of industrial and pragmatic usage (i.e. monetary value). Similarly, how much industrial and practical value is a piece of crisp US dollar? If there is no pragmatic use for a piece of paper called the US dollar, then why is it in so much demand (e.g. drug dealers use them for transactions)? Therefore, in conventional supply and demand analysis jargon, the monetary value of gold is consigned into a conveniently labelled group called ?investment demand.?

The same could not be said for silver because currently, it has both the properties of an industrial commodity (e.g. iron, zinc, copper) and money (e.g. gold).

Since 2001, silver and gold prices have been consistently moving together at a correlation of 0.98 (0.00 means completely no correlation and 1.00 means perfect correlation). Though they tend to track each other, the ratio between them tends to vary. During the days of bimetallism (A brief history of silver and bimetallism) in the 19th century, the prices were fixed by law at a ratio of 1:15.5. During the 20th century, the ratio was at an average of around 1:47, from a low point 1:38 in 1910 and 1:101 in 1990. Currently, it is at a ratio of 1:49. There are some who analyses the trend of this ratio as an indicator of what the price of silver will be. We have not comment on that yet.

However, relative to gold prices, silver prices tend to be more volatile because of its perceived dual nature (industrial and monetary). Assuming that (1) gold and silver prices will still maintain a tight correlation, (2) gold prices (measured in terms of fiat currencies) is on a long-term up-trend (perhaps even exponentially), silver can be interpreted as a ‘leveraged’ hedge against loss of confidence against fiat money (see What should be your fundamental reason for accumulating gold?).

Now, coming back to the original question: Will silver regain its free-market status as secondary money? We have our opinions on what the future of silver should be. But please note that since there is a difference between what we think should be and what the market thinks is the case, then there will be a difference between what we think ought to happen and what will happen. This means that in the short to medium term, our ‘predictions’ will not be ‘fulfilled.’ But if we are right, then it will be ‘fulfilled’ in the long run.

We will continue on what we think the future of silver should be in our next article.