All Roads Lead to Zimbabwe

Reddit

U.S. new home sales clocked in at their lowest pace on record today, according the U.S. Commerce Department. Americans bought new castles at an annual pace of just 331,000 according to yesterday’s release. It revealed a 14.7% decline in sales in the month of December alone. What’s more, the median price for a new U.S. home fell by 9.3% in the last year to US$206,500.

So sales of new homes in America are down 38% year-over-year and prices are at their lowest level in the last five years. The gains of the housing boom are melting away. But does it have anything to with Australia? Or are we just trying to whip you into a frenzy of despair and doom on a Friday afternoon?

Well, no. We’re not trying to do that. But we are trying to suggest that the collapse of housing booms in the U.S. and the U.K. IS something that could happen here in Australia, too. It is possible. And if it’s possible, it’s wise to work out how it might happen and what, if anything, you can do to prepare for it.

But if the whole concept of a house price crash leading to more trouble in an economy offends you in some way, it’s probably best not to read the Daily Reckoning.

Before we move on, a quick note about Jim Davidson’s new letter we told you about yesterday. The odds are that the letter does indeed cater to North American investors. We’re investigating and will report back. We would say that Jim’s insight is worth reading even if the investment advice is not practical for Australian investors. But please note we are not far away from our own “big picture” product that DOES speak to the needs of Australian investors specifically. Stay tuned!

Now, what about stocks? The S&P 500 reversed four strong days of gains to give up 3.3%. The bad housing data and a weak durable goods orders report didn’t add much to Wall Street’s mood. There’s one line of emotional exuberance (not thought) that revels in the idea that an $850 billion government stimulus will lead to an earnings recovery for S&P 500 firms. And then there is reality.

Australian reality is that the Reserve Bank will probably serve up another 100 basis point interest rate cut next week. You’ll probably see another “stimulus” plan from the government, too. How exactly more credit and a cash binge will support asset values escapes us.

But it’s possible that Australia is now in lock-step with every other central bank and government in the world, and that all monetary roads lead to Zimbabwe, where a brave but brittle paper currency has gone to its god like a soldier, to paraphrase Rudyard Kipling.

Rest in peace, Zimbabwe dollar. Robert Mugabe and Gideon Gono have blown out your brains and gutted the Zimbabwe economy. Yes, the Zim dollar has gone to that great paper currency shredder in the sky overnight. ‘Twas ever thus with fiat money. Just yesterday we were discussing the fate of the Zim dollar with Swarm Trader Gabriel Andre.

This was after the lights went out in Melbourne around 3pm under stifling 40 degree heat. Your entire crew at the Old Hat Factory quickly decamped down the street to Cafe Presse, to liberate the beer at that fine establishment before it was fatally compromised by the heat.

Up on the wall behind the bar at the Cafe and in amongst the bottles of wine (the Krinklewood Francesca Rose from Broke in the Lower Hunter Valley being our favourite in these torrid conditions) are samples of paper money from all over the world, some already dead, others still dying. And right smack in the middle was a billion dollar note from Zimbabwe.

That’s billion with a “b”. And before yesterday, you couldn’t even buy a beer with it. That’s beer with a “b”.

As of last night, that currency is now worth what everyone suspected: nothing. The Zimbabwean monetary authorities said last rites over the scrap of paper and declared a trinity of currencies-the U.S. dollar, the British pound, and the Botswana pula-as legal tender.

Beware!

Competitive currency valuation is a dangerous game. To be fair, Zimbabwe didn’t engage in what you’d call a normal competitive currency devaluation. It simply printed so much money so quickly that prices ceased to have anything to do with reality.

That is one reason why values-all sorts of values, mind you-become so distorted during inflation. Social cohesion is strained and economic activity disintegrates as people have no reliable medium of exchange. If you can’t trade, you barter, beg, bargain, or steal. Unless you’re the government, in which case theft is legal (either through taxation or inflation).

In the global competitive currency devaluation sweepstakes, the United States seems to be winning at the moment, if you can call it winning. By “winning” we mean that the U.S. central bank cut its interest rates the fastest and the furthest before other central banks followed. This rate-slashing effort, along with all the fiscal measures since (TARP, US$850bn stimulus) are designed to combat the credit depression, the housing crash, and lately, rising unemployment.

Normally, a country deliberately sells its own currency (or holds down its rate of appreciation against the currencies of its trading partners) in an effort to boost local exports. In fact, competitive currency devaluation has been the exact strategy of Asian exporters to the U.S. for, well, for the last thirty years. Keep your currency weak against the greenback and your goods are cheaper in the world’s largest export market.

This vaguely mercantilist system all operated on the premise that the U.S. consumer could afford all the production of the world’s factories. And he could! At least for awhile, and with the help of consumer credit, or lines of credit based on asset values (stocks and houses).

But now, that whole relationship (we think, they sweat), is broken because the credit has been cut off. Yet the rest of the world is now following U.S. monetary policy down the path of devaluation. It is exactly this simultaneous global paper currency devaluation we advised people to prepare for in the last issue of Diggers and Drillers (How to Prepare for the Coming Devaluation). And now it’s here!

So how is the U.S. winning this race? Well, now that the rest of the world is slashing interest rates to zero and marching down the paper path, the U.S. dollar looks relatively more attractive. The U.S. has already taken a lot of currency debasing steps. It has a sort of first-mover advantage in destroying the purchasing power of its currency for its citizens. Expect the dollar to strengthen against other paper money, but to weaken against tangible goods like gold and oil.

And if you’re worried that the U.S. has finished debasing itself, don’t!

There will be more debasement to come. The U.S. has not yet begun to defile itself! The Fed is now prepared to print money to buy U.S. Treasury bonds in an attempt to bring long-term interest rates down and get the credit market going again. Yes dear reader, there is some major defilement ahead.

This raises a disturbing prospect. But since we walked down this line of inquiry, we may as well follow it to its logical conclusion: the insolvency in the financial system is a preview of the insolvency that could hit many households in America, the U.K. and Australia.

As our friend John Robb puts, it, “Here in the West, the crisis we are seeing might have started in the shadow banking sector with the collapse of subprime mortgages. However, the unexpected happened: it revealed the US/Euro middle class as insolvent and forced a shift in behaviour (towards something new). That insolvency and shift in behaviour will sink chances of economic recovery from gov’t stimulus (you don’t add debt in a debt driven crisis) and financial sector bailouts.”

Next week, we promise to tell you more about the “something new.” And it will not be nearly as gloomy. In fact, it’s quite exciting.

In the meantime, the public erroneously believes that bailouts and stimuli will cure the ills of a mutli-decade addiction to credit and living beyond one’s means, both personally and as a nation. Maybe that’s why stock prices were up this week, as the Obama plan moved through Congress. But did you notice that gold is back up over $900?

But wait! Before we drone on about gold, a reader doth protest! Appropriating our royal we, he writes:

“We at DR are really really smart and we think gold is just great, it is really really nice stuff. In fact if we were in charge we would not go for these stimulus packages, they just stuff up the free market. Instead we would put all that money into gold, we really love it. Gold Gold Gold, we do not have gold fever, just think of what you could do with the stuff, you could buy it and hold it and lust over it and hope it goes up. Yippy. We even found someone who reckons the Bundesbank would be mad to sell it at today’s prices, they should just hold it like we would, remember all those things you can do with it. It is really really nice stuff, it should go to at least 2,500, if you love it as much as we do, you would pay anything for it. It’s not good fever, it is solid investment advice. We can think of just so many reasons why gold should go up, it is such remarkable stuff, I bet if I left it under my bed while I had a wet dream about it, it would just elevate all by itself. Those bloody Germans must be nuts to sell something like that.”

Phillip D.

What’s that? Sorry! We couldn’t hear you. We had two big gold nuggets stuffed in our ears, while dining on a breakfast of gold flakes, and downing a tall glass of liquid gold. An outstanding start to the day, but a bit rich.

Yes, it’s true. You can’t eat gold. You might also have trouble buying a latte with it. But you shouldn’t be concerned so much with gold becoming the next everyday medium of exchange in the real world. Instead, you should wonder how to preserve your net worth from falling share prices and falling house prices.

But hey, if we have gold fever, we’ve got plenty of company. “Combined with an aggressive fiscal policy, it is clear that the authorities are going ‘all-in’ to try to mitigate the near-term effects of the economic collapse,” says David Einhorn, head of the Greenlight Capital hedge fund. “Our guess is that if the chairman of the Fed is determined to debase the currency, he will succeed. Our instinct is that gold will do well either way. Deflation will lead to further steps to debase the currency, while inflation speaks for itself.”

The illustrious Adrian Ash at Bullionvault.com has more in a recent article quoting other voices on the Street and in the City. “I think gold is rising because of fiscal deterioration and the prospect that the US [Treasury’s debt] may be downgraded,” says Tom Sowanick at the $22 billion Clearbrook Financial funds in Princeton, New Jersey.

“They are printing trillions of dollars worth of currencies,” agrees Robert Lutts of the $400 million Cabot Money funds in Massachusetts, also speaking to Bloomberg, “and there is no real asset behind it. So every single Dollar in my pocket is going to be worth less and less every day.”

Where is it all leading? Probably to a gold bubble. “Inevitably, low interest rates lead to a gold bubble,” says David North, head of asset allocation at the UK’s No.1 institutional investor, Legal & General. But as all five year old children ask on the way to Grandma’s, are we there yet?

Not likely. But that’s your risk as a precious metals investor. Gold doesn’t pay a dividend. It costs you to store it. And it can’t increase its earnings. All it can do is sit there, intrinsically worth nothing, but traditionally a store of value and wealth as monetary authorities resort to trickery and fraud in their attempts to dupe the people and preserve power. But hey, if you trust these guys, don’t go for the gold!

More reader mail. Is your editor a hypocrite? Or just an inconsistent imbecile who likes to refer to himself in the third person? One reader takes issue with our taking issue with Sheila Bair’s scheme to blow public money on bad bank assets.

“I love your statement “How can the “fair value” price be rational while the market price is not?

The delicious irony of this is that very nature of your business is to then tell your subscribers that the market price of this security that we’re tipping you should buy or sell is not rational….the market has it all wrong and we know so. So on the one hand its suites you to assume the market price is efficient but on the other…..Mmmm

I also love the idea that someone can just join the dots to arrive at a conclusion i.e. this happened because of this and therefore if this happens and this happens and add in a dab of this all of sudden this will happen…..AND you can make money from it.

But then i spose the very nature of you business is to create what seems like a logical narrative about the future that people will associate with when logically you, me, or anyone else for the matter, have no idea about what the future holds…..never ends to amuse me!!

Regards

David

Well played Sir. We are happy to amuse you. But you are not quite right!

Why are market prices for toxic assets “rational” when stock prices for certain securities are not? There is a great debate to be had between “mark-to-model” accounting and “fair value” accounting. We will not have it here today, though.

But you can make a perfectly logical distinction between mispriced stocks and misprices mortgage-backed securities and collateralised debt obligations. What you’re willing to pay for a stock depends on what you think of its future earnings prospects. While not entirely subjective, this is what accounts for the difference between buyers and sellers. They both reach different conclusions about the present value of the future earnings of a given business.

Maybe have the same knowledge about the business, the management, and its earnings history. Maybe they don’t. They are both equally unaware of what the future holds. The fact that they reach different conclusions about what the future holds is what makes a market. One of them will be right. The other will not. But in both cases, it comes down to how accurate their assessment of the earnings power of the business is and whether the current price puts those earnings at a premium or a discount.

Investors in individual securities CAN have an advantage over other investors. Sometimes this advantage is informational and specialist (i.e. they know more about an industry like pharma and what drug will work). Other times, it just comes down to good old fashioned security analysis, where you can spot a dollar’s worth of earnings on sale for fifty cents, or you find a company selling for something close to net tangible assets (Buffett and Graham). But the market misprices stocks all the time based on incomplete knowledge and inexact forecasts of what the future holds.

You’re right that we have no idea what the future holds. Nobody does, or can! But you can read what we think will happen every day right here in this space. Maybe we’re right. Maybe we’re wrong. Either way, the share tips we make in our paid publications are based on a world-view, security analysis, and reflect our synthesis of the two. At least it’s transparent. And if you don’t like it, you don’t have to buy it!

Securities backed by housing values don’t have any earnings variability. They don’t have any earnings at all, in fact. They derive their value based on house prices, and house prices are falling as foreclosures rise and the credit bubble deflates. Bair wants to pay “fair value” for the securities because her real goal is to transfer taxpayer money to bank balance sheets to shore up capital while excising the non-performing, decomposing mortgage assets to the public sector.

We are against this on principle.

But if you want to use logic, we’d say her method of price discovery is “inductive.” She begins with a particular goal (recapitalise banks and quarantine the sludge at a “bad bank”) and arrives at a general conclusion: we must pay fair value!

Our approach to investment is deductive: begin with general observations to arrive at a particular conclusion i.e. look for businesses that increase earnings quickly, have solid balance sheets, and where you can measure management’s historic performance with shareholder capital, or, in the case of small cap companies, you position yourself to profit from rapid earnings growth that may happen (your risk is that it doesn’t.)

In any case, we’d say the main difference is that Bair’s estimate of “fair value” isn’t strictly wrong because it’s at odds with the market price. It’s wrong because she’s not buying the assets as an investor. She’s buying them as a regulator and policy maker, and she’s using other people’s money. Her motivation it’s rational or logical, it’s political. That alone should make you suspicious, if not deeply sceptical.

That’s it for the week. Thanks for bearing with us. There are some questions about the sustainability of global growth that we never got to in this space. But the answers to those questions-at least our attempt at answers-belong in the category of “things that suggest there is a lot of money to be made in the next ten years.” More on them next week. Until then!

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
Reddit

Comments

  1. The Futures Fund should put that some of their (your) money into Australia’s gold juniors. This would create/restore far more jobs and money than propping up failed finacial institutions or the value of those asset clases which are now unafforable. Gosh, the taxpayer would even turn a profit!

    (King Solomon knew a thing or two about where to invest government money – and was clearly far wiser than the current mob of idiots.)

    As for the AUD what will happen next? Any predictions? My guess is that against the currency “basket” the AUD will drop in value by about half as much as the hit the USD and the UK pound will soon realise. They’re all still tied at the navel whether we like it or not. The prospect of this followed by double digit inflation won’t help my (thus far unshrunk) super balance. What can I do? Ostensibly nothing except perhaps to incrementally place some of the funds into shocking baskets of Aussie and/ or OS shares. There is no box to tick for energy and no boxes to tick for gold or global ag. In a nutshell we all just need to be bloody lucky with the timing of our log jumping plays.

    Have a good weekend all!

    Coffee Addict
    January 30, 2009
    Reply
  2. You quote David North, head of asset allocation at the UK’s No.1 institutional investor, Legal & General.

    Is this the man that decides where Legal & General funds are allocated in order to maximise returns?

    If so, I would put no stall in his opinion.

    My personal pension contributions from 1995 until Nov 2005 (over 10 years worth), at which time I migrated to Australia and now have an Australian pension fund, is worth less than the money invested into it. In other words taking the plum advise from my Granny to stash the cash under my matress is better than any advise this man and his organisation could offer me. Proof by example I am afraid.

    Let’s look at all those investment returns between 1995 and 2005.
    OK a couple of hickups such as the telecoms crash and in quick succession the tech wreck, but, all those dividends, the value of gold and other mineral assets, the cost of housing (yes I know in decline) … Just adjusting for inflation …. Oh my God (I say that as an exclamation as I do not believe in one), come to think of it, my pension has performed abysmally and this guy shares the blame.

    Reply

Leave a Reply

Letters will be edited for clarity, punctuation, spelling and length. Abusive or off-topic comments will not be posted. We will not post all comments.
If you would prefer to email the editor, you can do so by sending an email to letters@dailyreckoning.com.au