January 27, 2014
Until inflation becomes recognized, the investor holding gold as a hedge must have both patience and the ability to hold for an extended period.
Historically, the price of gold protected the purchasing power of the currency invested in it, as the price rose in some reasonable correlation with existing or expected inflation of that currency. But today, the price of gold is set in a speculative market where traders and hedge fund managers make bets, and little or no attention is paid to gold’s traditional role. (See the first part of this article, Why Gold Prices Dropped in 2013.) According to John Hathaway of Tocqueville.com, in 2010, the physical gold market consisted of 121 million ounces. With a growth rate of about 1.5% per year, there are currently about 127 million ounces in existence, as of Hathaway’s writing. Using futures and options data, and OTC clearing data from the London Bullion Market Association, Hathaway calculates that the paper gold market is 92 times that of the underlying physical market. If each investor in a paper gold ounce believes it is backed by an ounce of physical gold, then each physical gold ounce must have been loaned or hypothecated, on average, 92 times. If everyone decided that they wanted physical possession, which of the 92 paper gold ounce owners really owns the physical metal?
That, of course, explains why it took so long (17 months) for the London banks to deliver the physical gold that Hugo Chavez’s Venezuela demanded. They either didn’t have it and had to purchase it in the open market, or they had to unwind trades where the gold was loaned or pledged as collateral, or both. As for the seven years that it will take for the US Fed to deliver Germany its gold, the only conclusion can be that the web of hypothecation must be long and complex.
Let’s now consider the characteristics of the London financial markets, where gold’s price is fixed twice each day. Nearly every well-known financial calamity over the past 20 years has originated from London offices of major financial corporations. That’s because in the UK, financial institutions have little regulatory oversight. Just think about JPMorgan’s (NYSE:JPM) $6+ billion 2012 loss from its London trading office. We learned from the MF Global (OTCMKTS:MFGLQ) fiasco that client assets can be hypothecated and re-hypothecated an infinite number of times, and that there are no customer protection rules. If you have been wondering what happened to Jon Corzine’s (MF Global’s CEO) clients’ funds, you now have a pretty good idea.
Recently, we’ve seen major UK financial institutions pay hefty fines for manipulating certain commodity prices and for fixing the price of LIBOR, a short-term rate that plays a key role in the world’s financial markets. Apparently, the illegal activity had been going on for years. There are five London banks that control the two daily London gold price fixes. Given the known shenanigans of the London banks regarding LIBOR and other commodities, and the infinite re-hypothecation allowed, how much confidence should we have that the daily gold price-fixing is impartial, that in a crisis or panic the hypothecations can be unwound with every paper claim on gold made whole, or, in fact, that some of the underlying gold even exists in the vaults? As Hathaway says, “It would be hard to imagine that the culture of [London] did not extend to gold.”
There has been a great deal of political angst by Bernanke and Co. over the demand by some members of Congress for a Fed audit, and great political maneuvering to avoid it. Some commentators, like John Williams (Shadowstats.com), believe that the Fed and government officials disdain rising gold prices because that suggests that the government and the Fed are not doing their jobs in maintaining price stability. Hence, Williams believes that heavy selling in 2013 was an orchestrated government intervention. In his January 8, 2014 issue of Hyperinflation 2014 – The End Game Begins, Williams says, “A number of times, very large sell-orders from one customer were placed in the global markets before the open of US trading. For someone looking to move out of gold, orderly sales would make the most sense in terms of getting the best prices. Instead, these actions were designed to pummel the gold markets, and they did.”
Remember what happened to credit default swaps, issued by AIG (NYSE:AIG), just five years ago? Remember what happened to AAA-rated mortgage-backed securities that turned out to have a lot of sub-prime loans? Could something like that happen to the paper gold market?
If it’s discovered that some of the underlying gold has disappeared from the vaults, or in a panic the competing hypothecations for the underlying gold ounces tie up the assets in a long-term court battle, or, as in the case of General Motor’s (NYSE:GM) senior secured bondholders and some depositors in Cypriot banks, it becomes politically correct to single out a class to bear losses, some holders of paper gold could be out of luck. It might be very painful one day to wake up to find that the paper gold investment you thought you had turns out to have not been collateralized.
So, what should gold investors do?
First, understand the difference between hedging and speculating. If it is your intent to hedge against an inflation that you believe will inevitably come due to current worldwide monetary- and fiscal-policy excesses, then the systematic purchase of gold, like mutual fund dollar-cost averaging, is a good practice.
In what form should you hold your precious metal assets? What about the ETFs traded on the exchanges? If you want to keep the gold in your brokerage account, there are some funds or ETFs that say that they hold bullion in a vault and do not hypothecate it. You need to do careful research to make sure this is the case and know if the paper you hold is convertible into the underlying asset. Gold mining stocks are another way, since the gold is there in the ground. Unfortunately, the typical gold mining company continuously dilutes shareholders with new rounds of equity offerings as they continue their search for the “mother lode.” So, research here is also essential.
The safest way, of course, is to hold the gold yourself, i.e., take physical possession and put it into a safety deposit box or in your own safe. Many Americans are doing this, but the Chinese and Asians are way out ahead in this area. To do this you need to find a reputable gold or coin shop that will sell to you for a reasonable commission, say 3-4%.
Today’s gold investors must also understand that the price of gold is currently a 100% function of hedge fund speculation. In the future, as inflation becomes recognized, this may change, but until it does, the investor holding gold as a hedge must have both patience and the ability to hold for an extended period — oh yes, and the ironclad belief that the laws of economics haven’t changed, i.e., that “this time is different” is a lot of bunk.
May 24, 2012
The turmoil in Europe, trading losses at JPMorgan (JPM), and recent revelations about naked short-selling by Goldman Sachs (GS) and Bank of America-Merrill Lynch (BAC) should be giving every American and every policy maker heartburn because each and every one of these issues has potential to cause systemic financial shocks. It all ultimately comes down to the continuing saga of “Too Big to Fail,” or TBTF. TBTF nearly brought the financial system down in ’08 and ’09. It was supposed to be fixed by the Dodd-Frank legislation. But today, the TBTF institutions are even bigger than they were in ’08.
On a daily basis, reports indicate that instability is growing in the European Monetary Union’s (or EMU) banking system. There have been outright runs on Greek institutions and rumored runs on Spanish banks. In Greece, it’s been reported that some businesses will not accept euro notes (i.e., the paper currency) issued by the Greek central bank for fear that if Greece leaves the EMU, those notes will be turned into new drachmas, which will be worth only a fraction of what real euros are worth.
In the US, the paper currency is issued by a Federal Reserve Bank. There is a number on each bill (1 to 12) that shows which Federal Reserve Bank was the issuer. Like the US, each participating central bank in the EMU can issue currency; the first letter of the serial number is coded to indicate which bank issued it. Currency issued by the Greek central bank is coded with a “Y.” Some Greeks are demanding currency coded with an “X” ( i.e., Germany).
There are growing worries about European bank solvency, and Moody’s recently downgraded a significant number of the larger Spanish and Italian banks. If Greece leaves the EMU, contagion could result. If funding markets for European banks freeze (causing one or several institutions to be unable to meet their daily liquidity requirements), there is a high probability that any contagion would spread to US financial institutions.
At the very least, the interrelationships between large US and European institutions will cause significant issues if a fat tail event occurs on the continent.
In fact, on March 21, Fed Chairman Bernanke warned Congress that the risks of impacts from such events on US banks and money market funds appeared to be significant.
Lack of Internal Controls at TBTF Institutions
On May 11, Jamie Dimon announced that JPMorgan had lost $2 billion or more in a failed “hedge” trade. Since then, the estimates of the loss have escalated; some think it could be as much as $5 billion – $7 billion. This shows that even the best-of-breed bankers, like Mr. Dimon, are unable to place sufficient internal controls over the riskiest of operations.
Over the past several years, we’ve seen such trading blow-ups at several of the TBTF institutions. The so-called “Volcker Rule,” a portion of the Dodd-Frank legislation that is supposedly effective this fall, should prevent “proprietary trading” at the TBTF institutions. But many think that such rules will be easy to get around; Mr. Dimon has indicated that this huge loss was due to a failed “hedge,” and not proprietary trading. JPMorgan had $182 billion in capital according to their March 31 filings, so the loss of a few billion isn’t going to put this institution in any danger or require any taxpayer assistance.
However, on the Monday after the JPMorgan announcement (May 14), President Obama appeared on ABC’s The View and commented that it was a good thing that JPMorgan had plenty of capital, noting that had this happened at a weaker bank, “[W]e could have had to step in.”
Think about this statement. The first reaction to stress in the financial system is for the government to step in! Compare that to the first Chrysler bailout in 1979. At that time, Lee Iacocca, Chrysler’s Chairman and CEO, had to beg Congress for nearly four months for a loan guarantee (not a direct loan) of $1.5 billion.
In fact, the day before Mr. Dimon announced JPMorgan’s large loss problem, the FDIC’s acting Chairman, Martin Gruenberg, announced plans and procedures for the FDIC to seize large financial institutions “when the next crisis brings a major financial firm to its knees.” Instead of getting rid of TBTF, it is now institutionalized. The FDIC’s announced plans are simply in accordance with Dodd-Frank.
During the week of May 14, the lawyers representing Goldman Sachs and Bank of America-Merrill Lynch in a lawsuit filed by Overstock.com filed an unredacted set of documents with the court (i.e., the whole document was submitted instead of only certain parts), thus putting them into the public domain.
Those documents revealed that these TBTF institutions knowingly ignored the laws and regulations against “naked” short-selling. When one sells “short,” one must first borrow the stock, or else there is nothing to prevent someone shorting (i.e., selling) so many shares as to significantly and negatively impact the market price for the stock (which is what a short-seller hopes for). “Naked” short-selling occurs when the stock is sold without borrowing it from another owner, and three business days later, the seller “fails” to deliver the stock.
Because of their size and power, the TBTF banks could depress the stock price of any company they choose. If one of their units puts a “sell” recommendation out and the trading department “naked” short-sells, then the “sell” recommendation becomes a self-fulfilling prophecy. This, in fact, is what Overstock.com’s lawsuit has been about.
So let’s review:
4. It has come to light that some TBTF institutions have skirted laws and regulations.
If there were no TBTF institutions in the US, then little of the above would be of concern. Instead:
4. Without the power that comes with being TBTF, the “naked” short-selling and other abuses would be much less effective or profitable.
5. The TBTF institutions are so complex that even the likes of a Jamie Dimon can’t provide effective internal controls and risk management. Smaller institutions that have such issues won’t cause systemic risk.
The lessons of the ’08-’09 near systemic meltdown were clear: TBTF is a huge policy issue. Unfortunately, after Dodd-Frank, not only are TBTF institutions bigger and systemically more risky, but we now have a government all too willing, and maybe even eager, to “step in.”
March 15, 2012
From early last October to the end of last month, the S&P 500 rose 25%; amazing for an economy that is struggling to stay out of recession. Then again, the equity markets are hooked on the liquidity drug.
When Federal Reserve Chairman Ben Bernanke, in his recent semi-annual testimony before Congress, did not hint that QE3 was just around the corner, the market sold off. When the European Central Bank broke its traditional role as lender of last resort and morphed into a gift giver to its member banks (to the tune of more than a trillion dollars), much like our Fed, the equity markets soared.
Money printing can’t go on forever, can it?
In every historical context, whenever the equity markets have a run up not based on economic fundamentals, eventually, they return to what those fundamentals dictate. And here are some of the underlying economics:
- There is no doubt that American manufacturing is undergoing a renaissance. Labor costs in Asia are on a steep rise while wages here have been stagnant for several years. Shipping costs, quality control and culture are other factors. But, manufacturing represents less than 12% of GDP. It, alone, cannot drive significant economic growth.
- Gasoline prices are up more than $.60/gallon year to date with talk of $4.50 gas by summer. That cost/gallon is already here in some markets. Every penny increase drains $1.5 billion annually from other consumer discretionary spending. That’s about $90 billion so far for 2012. And what happens to gas prices if the Middle East flares up again?
- While the first quarter is far from over, early data suggest a much softer than expected GDP. Retail sales have been soft except for automobiles (pent-up demand or just a rush to buy fuel efficient vehicles ?). Consumers (70% of GDP) have shown no real income growth for many quarters, and incomes are tumbling in Europe. Inventories appear to be on the high side given the level of demand. So additional production won’t be forthcoming.
- Despite a reinstitution of 100% depreciation for capital equipment, much of that demand was pulled into 2011, as the business community was uncertain as to whether or not the tax break was going to be reinstated in 2012. The state and local government sector is still in contraction, and, given the slowdown evident in the rest of the world, exports aren’t likely to add to GDP. Of course, the market may like the softer side of GDP, as it likely ensures another dose of the liquidity drug from the money czar, Bernanke, the king of money printing.
- Europe is sicker than the markets have priced in. The hoopla around the Greek bailout is just another can kicking. Because the Greek populace hasn’t accepted the idea that they have lived beyond their means for the past decade, austerity won’t be successful. Politicians who promise to end the austerity are likely to be elected. Eventually, Greece will need to have their own currency which can fluctuate in value vis a vis other currencies with commensurate interest rate levels.
- It is rare that all of Europe is in recession at the same time. The current market expectation is that Europe’s recession will be mild. But, don’t forget, Germany’s biggest export clients are other European countries. In fact, as a general rule, all of Europe’s economies export heavily to each other. Being in recession together is going to have a large impact on those exports. In addition, if the Euro remains at its current lofty level (above $1.30), it will be more difficult to export to non-EU countries.
- The determination by the ISDA (International Swaps and Derivatives Association) that Greece officially defaulted on its debt when it invoked its recent legislatively passed “Collective Action Clause” to force investors to take losses is actually good news for the other so-called troubled European sovereigns (Portugal, Spain, Italy, Ireland) because it assures private sector investors that if they buy the so-called troubled foreign sovereign bonds, hedge them with Credit Default Swaps (CDS) and a Greek style default occurs, they will be paid at or near par value. If the CDS payout had not been triggered, the private sector investors would view the purchase of such sovereign debt as having significantly more risk, and that would result in a much higher interest cost of that sovereign debt to the issuing countries. In addition, it would throw the whole CDS concept into confusion, potentially impacting even the higher quality sovereigns like, Germany, the U.K., Canada, Australia, and even the U.S.
- This is not to say that the world is now safe from financial contagion, as, in the context of world markets, Greece’s default is an expected and well prepared for event. The real worry should be if Spain (debt > $1 trillion) and/or Italy (debt> $2 trillion) default. In addition, the CDS market is not transparent, and no one knows where the CDS obligations lie. While a Portuguese and/or Irish default would have about the same individual impact as that of Greece (economies slightly smaller and not as indebted), we should worry that a rolling set of smaller defaults would eventually cause a major CDS insurer to fail due to the cumulative impact of the several defaults. After all, it is likely that the CDS insurers who dabbled in Greek CDS, are also involved in CDS insurance of the other high debt European countries. And, if a significant CDS insurer defaults (e.g., an institution similar in size and stature to AIG in 2009), we could, indeed, have contagion.
- But even ignoring Greece for the short term, the ECB’s LTRO 1 and 2 appear to make Europe’s banks even more vulnerable. Unlike the Fed, which purchased questionable assets from bank balance sheets and put them on its own, the ECB has not followed suit. In fact, it stepped in and, by force majeure, inserted itself as senior to other bondholders holding the exact same Greek bonds, thus avoiding any losses in its own portfolio. That makes losses for the private sector even greater. Worse, it sours potential investors in European sovereign debt, seeing that they cannot easily quantify their risks as they can’t know how much of the same sovereign debt they own may be owned by the ECB. This partially reverses the positive impact that the triggering of the CDS default will have on the European sovereign debt market.
- Finally, the LTROs may make European banks even more insolvent than they are now, as they have been encouraged to take the cheap ECB funding and purchase European sovereigns for the interest spread (by Basle II and III rules, the debt of the European sovereigns is “riskless” and requires no capital backing on a bank’s balance sheet)! Further sovereign debt crises, e.g., Portugal, Spain, or Italy, will eat away at already scarce European bank capital. Contagion could very well result.
Looking at the GDP of Europe relative to China, if one includes all of the European Union countries and those closely related, Europe’s economy is about twice the size of China. If China’s GDP growth went from 9% to 3%, the equity markets would certainly have a huge sell off. But, it is likely that Europe’s GDP will fall from about 1.5% in 2011 to -1.5% in 2012, maybe even more than that. Do the math! This is equivalent to a Chinese hard landing. As the European recession unfolds, the equity markets are likely to wake up.
Speaking of China, a slowdown is clearly developing. They actually ran a trade deficit for the first two months of 2012 signaling a real slowdown in exports. Retail sales have been softer than expected and the real estate bubble there appears to be in the process of popping as property sales and prices are plunging. No wonder the government recently lowered its official growth forecast from 8% to 7.5%. This is not to say that China, itself, is entering a recession, but a slower growth rate there (2nd largest economy) in combination with growth issues in the US (largest economy), Japan (3rd largest), and a significant recession in Europe bodes ill for worldwide growth and will eventually play out in the equity markets.
The profit implications for multinational corporations of the severe recession in Europe, and a slowdown in China and elsewhere are significant. Analysts have continued to forecast rapid earnings growth and high profit margins even in the face of rising energy and food costs and stagnant U.S. and falling European incomes. Using such rosy profit forecasts makes the market look undervalued. However, a 15% – 20% profit decline is normal for a recessionary world. If you plug that in, the equity markets look overvalued today.
Wasn’t it somewhere around this time last year that the equity markets were also priced for perfection? Didn’t we hear that the economy had achieved “escape” velocity and that the recovery was about to accelerate? And, didn’t the market sink when the economy fizzled and needed the QE2 liquidity drug injection? In fact, the S&P 500 ended 2011 at exactly the point where it began, with a lot of volatility in between. So far, 2012 appears to be following 2011′s path.
Robert Barone and Joshua Barone are Principals and Investment Advisor Representatives of Universal Value Advisors, LLC, Reno, NV, an SEC Registered Investment Advisor.
Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.
Universal Value Advisors, LLC is a registered investment adviser with the Securities and Exchange Commission of the United States. A more detailed description of the company, its management and practices are contained in its “Firm Brochure”, (Form ADV, Part 2A). A copy of this Brochure may be received by contacting the company at: 9222 Prototype Drive, Reno, NV 89521, Phone (775) 284-7778.
Robert Barone (Ph.D., Economics, GeorgetownUniversity) is a Principal of Universal Value Advisors (UVA),Reno,NV, an SEC Registered Investment Advisor. Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Company where he chairs the Investment Committee.
Information cited has been compiled from various sources which UVA believes to be accurate and credible but makes no guarantee as to its accuracy. A more detailed description of the company, its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at:9222 Prototype Dr.,Reno,NV 89521. Ph: (775) 284-7778.
February 8, 2012
Over the past four years, the slow creep of government into the private sector has become a gallop. Unfortunately, a high level of structural unemployment is the unintended consequence of social engineering, picking winners, over-taxing and over-regulating every aspect of the business process.
The conventional wisdom is that a balanced budget will be a magic solution to the sluggish economy and the employment situation, but if it is done with just austerity and tax hikes but without relief from an overbearing set of governments on the business sector, what we will get is an “austerity death spiral.” Federal Reserve Chairman Ben Bernanke said as much to the Senate Banking Committee on Tuesday.
Intervention is the Norm
We now live in a world where government intervention in the business process is expected. When any sort of economic issue arises, government is now expected to fix it.
- Financial institutions in trouble? No problem – the taxpayers, via the government are expected to bail them out!
- Domestic auto companies historically made awful decisions around retiree medical and pension issues and, as a result, can’t compete and are staggering toward bankruptcy. Again, no problem. Ask the government to shore them up, even if it means trampling on bondholder contract rights like in the General Motors case.
- Some homeowners can’t, and others don’t want to make their mortgage payments. That’s easy. Ask the government to intervene, stop or slow the foreclosure process, and, perhaps, even require the lenders to reduce principal balances! This deal is in the works now with the government prepared to offer big lenders like Citigroup, Bank of America, Wells Fargo and JPMorgan Chase money to offset losses on short sales.
The markets now expect intervention. When the government intervenes in an economic issue, the markets rise. If the government doesn’t, it falls precipitously. On September 29, 2008, the Dow Jones Industrial Average (DJIA) fell 778 points when Congress failed to pass the initial TARP legislation; From the time QE1 began in November, 2008 until it ended in March, 2010, the DJIA rose 28% or 2,378 points.
QE2 elicited a similar market response, 1,199 points (10.7%) from November, 2010 to June, 2011, even more if you go back to August when Bernanke articulated the strategy in Jackson Hole, Wyo.
In late November, 2011, on the day when the Fed gave unlimited swap lines to the European Central Bank (ECB), the DJIA rose 490 points; it rose 337 points just before Christmas when the ECB opened its lending facility to 540+ European banks.
I suspect we will see similar market reaction if the Fed goes through with its hinted at QE3.
Unfortunately, nearly every government intervention carries with it unintended consequences, and, if such interventions interfere with the free market processes, they have long-term negative implications on economic growth. Recent examples in the U.S. include the Keystone Pipeline and the National Labor Relations Board’s attempt to block Boeing from opening a plant in South Carolina.
Nearly every economic malady that exists today is directly traceable to the unintended consequences of government interference in the economic process or via its attempt at social engineering:
- Sub-prime and housing crisis: It is widely recognized that this was caused by three concurrent factors: 1) an extended period of low interest rates engineered by Greenspan’s and Bernanke’s Fed; 2) the social engineering goals of the Community Reinvestment Act (CRA); 3) the political and monetary aspirations of Fannie Mae and Freddie Mac executives and sponsors;
- Social Security and Medicare unfunded liabilities: As the baby boomer generation reaches retirement age, unfunded liabilities will increase by more than $3.5 trillion each year. To show how absurd this is, the payroll tax reduction, in effect since January 1, 2011, and currently an issue in the Congress, simply puts the Social Security system ever deeper into debt that cannot be repaid without hugely inflated dollars;
- Unfunded pension liabilities: While some private sector corporations have unfunded pension liability issues, the bulk of the problem lies at the local, state and federal levels;
- High structural unemployment: As alluded to earlier, impediments to business from all levels of government, but especially from the federal government, are a huge issue. Recent legislation, including Sarbanes-Oxley, Dodd-Frank, and Obamacare, is crushing small business. In addition, business must be confident that the future environment will be friendly. So, the notion of a “temporary” tax reduction doesn’t reduce business uncertainty, as businesses invest for the long-term.
This last item is particularly poignant. In a three part op-ed series published by Bloomberg in mid-January, Carl Pope, former chairman of the Sierra Club, bemoans America’s loss of manufacturing jobs. “It’s not the wages, stupid!”, he says. If wages were key, how is it that Germany, where wages are higher and unions stronger, enjoys a growing manufacturing base?
For the auto industry, which in 1998 had over 70% of the U.S. domestic auto market but now has 44%, it was the health care and pension costs of its retirees that caused the industry’s economic crisis, he says. Since the turn of the century, America’s manufacturing base has shrunk by one-third, not because of wages, which are similar to wages paid in the rest of the world, but the lack of support or even outright hostility on the part of government. (When even the Sierra Club recognizes that government is choking free enterprise, the issue must be terribly obvious!)