From Bad To Worse?

By: David Chapman | Fri, Feb 13, 2009
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Owners of capital will stimulate the working class to buy more and more of expensive goods, houses and technology, pushing them to take more and more expensive credits, until their debt becomes unbearable. The unpaid debt will lead to bankruptcy of banks, which will have to be nationalized, and the State will have to take the road which will eventually lead to communism.

- Karl Marx, Das Kapital, 1867.

An eye catching quote for sure and you may already have seen it. Although as far as we can determine it is a hoax. It wasn't actually written by Marx. But it is making the rounds on the internet and tries to make him out as some sort of seer. Given in particular the events of this past week with the bailout plans for the giant banks, it does somehow seem appropriate.

There is absolutely no doubt, however, that we have come through an incredible period of debt growth. It has now come to an abrupt end. That it has done so is no surprise. What was a surprise (or maybe not) was that it was allowed to go on for so long and to reach such dangerous levels. It will take years to undo the damage. Bouncing back quickly, as speculated by Bank of Canada governor Mark Carney and many others, is just not in the cards.

How much has debt grown? In 1980, US household debt was about 50 per cent of US GDP. In 2008 it was 100 per cent. If you add in business debt, the 1980 ratio was just over 100 per cent; by 2008 it was 173 per cent of GDP. Total debt outstanding in 1980 was 144 per cent of GDP. By 2008 it had leaped to 229 per cent. (Source: Flow of Funds Accounts (FFA) of the United States.)

While US GDP rose 433 per cent in those 29 years, debt exploded by 750 per cent. The situation is not much different here in Canada. Some would argue that the debt-to-GDP ratios are even higher than stated, particularly for consumers.

The FFA considers only the debt held by the public. As of December 2008, that stood at $5.8 trillion. But intergovernmental debt adds another $4.2 trillion to constitute the $10 trillion that makes up the current debt ceiling. This gives a debt-to-GDP ratio of almost 75 per cent in the US. For the public debt alone, the ratio is only 40 per cent. (In 1980 it was 27 per cent.) US public debt has leaped 692 per cent since 1980 and 58 per cent this decade alone. All debt (as reported by the FFA) has leaped 91 per cent this decade - a demonstration of how the consumer and business have dominated the massive increase in debt.

Of course, assets have leaped in value as well. Once again according to the FFA, the balance sheet of US households for the third quarter of 2008 was $71.1 trillion. Amazingly this was down seven per cent from the end of 2007. Assets peaked in the third quarter of 2007. Total household liabilities totaled $14.6 trillion, which is 1.4 per cent higher than the fourth quarter of 2007.

While net worth is clearly positive, the largest assets, real estate and pension reserves, are not easily turned into cash in the event of catastrophe. And assets are distributed unevenly; we wouldn't be surprised to learn that 20 per cent of the population owns 80 per cent of the assets.

An interesting detail in the household numbers is owners' equity in household real estate. That number peaked at $12.5 trillion in 2005. By the third quarter of 2008 it had fallen to $8.5 trillion, an astounding decline of 32 per cent. As household assets were falling along with owners' equity in real estate, debt just kept on rising. Of course this collapse has not impacted those who simply continue to live in their homes, many of them in homes that are mortgage-free. Except for suffering a paper loss, the vast majority remain pretty much intact.

What broke the market was a sharp rise in the default rate, to levels that were considered improbable or impossible. The impossible and the improbable became reality and the result has been an unprecedented collapse in not only the US financial system but the global financial system.

The players (banks, investment dealers, hedge funds and others) were highly leveraged, expecting the markets to continue moving upward. Households were highly leveraged. As a result, the economy was leveraged. Leverage, as we all know, works wonderfully when the market is rising but becomes a nightmare when the market turns down.

As we noted in our last Scoop ("It's a bailout world!" - January 31), the wizards running the huge portfolios of the financial institutions had planned for a default rate of say six per cent according to a normal distribution curve. The odds of it going outside those boundaries were astronomical, they believed. At a 6.5 per cent default rate, the financial system blew up. Well, the default rate rose well beyond 6.5 per cent. (Note: this is an example and not a statement of actual numbers.)

Now what? The task in front of the authorities is so immense that money is now routinely measured in trillions. Treasury Secretary Tim Geithner's plan to save the banking system suggests that the size of the bailout could reach $2 trillion. No wonder the stock market choked on it. In fact the market must have been choking on it before even hearing about it, as the Dow Jones Industrials were already down about 250 points before he spoke. The same day the $838 billion stimulus plan was passed by the Senate (and is currently hung up in Congress).

While everyone trots out platitudes to camera about how they are guided by the lessons of financial crises throughout history, the truth of the matter is that there is no precedent for what is taking place. Those were different times and different circumstances.

The US government will continue to throw huge wads of money at the problem. They will never mention where the money is going to come from, and journalists will never ask. The US (and Britain) are in effect nationalizing their banking systems, although naturally they don't call it that. The rules of world capitalism are being re-written.

So was Marx right? Okay, the quote is a hoax and this will not lead to communism. But we have no idea where any of this will take us, whether it will work, whether there are more and deeper losses to come (the mortgage crisis is not over and credit card delinquencies and bankruptcies continue to rise), how many more corporations will be forced into bankruptcy, or how many more people will lose their jobs.

We already hear about unrest in China, Greece, Iceland, Bulgaria, and about strikes in France, Britain, and Russia. Millions of workers have lost their jobs in China as factories close due to plummeting demand from Europe and North America. World trade is shrinking at an unprecedented rate (Canada experienced its first trade deficit since 1976), China has seen its exports collapse 17.5 per cent from last year, while the US trade deficit is narrowing because its imports are falling faster than its exports. No wonder protectionism is on the rise; out-of-work workers want jobs, and a trillion-dollar stimulus package would be of questionable benefit to the local economy if it were all spent offshore even if the infrastructure they are building does benefit the local economy.

We note again the enormous amount of new debt being incurred or will be required just to get the economy moving again. It was massive increases in debt to keep economies afloat that got us in this mess in the first place. To believe that getting credit flowing again will get us out of it is to live in a fool's paradise.

We noted again in It's a bailout nation - Technical Scoop, January 31 2009 that through the 1950s, 1960s and 1970s it took $1.50 to $1.70 of new debt to purchase $1 of GDP. That rose to $3 of new debt to purchase $1 of GDP in the 1980s, as the world struggled out of the recessions of 1973-75 and 1980-82.

That 3:1 ratio rose further as we struggled out of the 1990s recession. As we struggled out of the high tech/internet collapse and the mild recession in 2002, it required $5.40 of new debt to buy us $1 of GDP. So what will that number grow to now? Given the fragility of the consumer's financial situation right now, he is more likely to save or pay down debt than he is to spend. No matter, if the massive increase in debt brought us this crisis what kind of crisis would we face if we doubled the amount of debt to buy a $1 of GDP as we appear to require every time we have a serious recession. At some point throwing all that money either doesn't work anymore (as Japan discovered through the 1990's and the past decade which is really a collapse in the money multiplier) or it creates hyperinflation because of the huge amounts of money that are printed. Either way it ends badly.

How will all these huge requirements for funding be financed? It sometimes seems that nearly everyone is seeking bailout funds or stimulus packages. That is not easy to answer either. Already there are signs of buyer fatigue from the major holders of US securities (China, Japan, and Saudi Arabia). There have been musings that the Fed would buy the debt. Naturally all of this raises the specter of massive debt requirements from major sovereign entities (USA, Britain and others) or essentially the printing of money, with the potential for pushing inflation up and pushing bond prices down (yields up). Already US Treasury Bond interest rates have jumped almost 100 basis points at the long end on the mere thought of all this supply. Recent Treasury auctions have been anything but robust.

It then should come as no surprise that Moody's Investment Services (the credit rating agency) has said that the USA and the UK credit ratings were being "tested". What it meant was they were in the process of splitting various AAA sovereign credits into three categories supposedly based on their ability to weather the current crisis. Ireland and Spain would be the weakest. Indeed Ireland is on the brink of becoming the next Iceland and unemployment is already approaching 10 per cent. The US and the UK would be in the middle while the top credits would be Germany, France, Canada (yes) and the Scandinavian countries.

Talk about a gimmick for a polite way to say that the US and the UK are slowly sinking in a morass of their own debt. Lower debt ratings means higher interest rates for these countries and it will put pressure on their currency. Naturally there is a big problem in downgrading the US and the UK outright. Pension funds all over the world can only hold AAA rated government bonds. So the financial world has a vested interest in protecting the ratings of their massive bond holdings.

S&P already cut Spain's rating to AA+ so pension funds won't be carrying their paper any longer. But gimmicks to protect the US and the UK would soon be seen for what it is. A downgrade in everything but name. As we note though an outright downgrade would cause a crash in the bond market. Given the US bond market is already overvalued it may happen anyway. No matter what the massive debt financings required by the US and the UK in particular means that they are on the road to downgrades with all its serious ramifications. China and Russia in particular are becoming increasingly nervous with their huge holdings in US denominated assets (mostly bonds).

A downgrade of the US would of course impact negatively the US Dollar's right to remain the world's reserve currency. A collapse of the US Dollar (they are still complaining about the Chinese in particular and their currency) would be an earth shaking event and have grave implications for the international monetary system. There has been numerous calls for a new Bretton Woods and even tomes in the Wall Street Journal and the Financial Times for a return to some form of gold standard.

There is also the risk of currency devaluations as countries jockey for position to try to boost flagging export industries. This is protectionism with a different face. There is no country in the world that is not suffering, and indications are that things will get worse before they get better. Every country is rushing out the stimulus packages and they sound nice but how much benefit will they bring, and to whom, and how long will it take to get things going? The stimulus packages of the 1930s had little real impact; unemployment actually rose even as they were being provided. It took war to get everyone working again. We will save that cheery thought for later but war is a staple of all major economic depressions as getting into them or starting them against real or perceived economic enemies is seen as a way out of the morass.

All of this brings us once again to Gold. Certainly if Gold were once again to become a reserve currency the current price is probably too low. Gold is the one asset class that is actually up this year. Consider the following performances since the beginning of 2009:

All losers....

Dow Jones Industrials - down 9.5%
Dow Jones Transportations - down 14.9%
S&P 500 - down 7.7%
NASDAQ - down 3.0%
TSX Composite - down 3.0%
TSX Financials - down 9.6%
US 10-Year Treasury Bonds - up 50 basis points or 22% in yield
Oil - down 19.4%
XOI Oil Index - down 5.2%

But on the other hand.....

Gold - up 6.8%
Silver - up 19.9%
Gold Bugs Index HUI - up 5.0%
TSX Gold Index - up 8.0%
BMG BullionFund - up 15.4%
Central Fund of Canada (CEF.A/T) - up 6.5%
SPDR Gold Trust (GLD/NY) - up 7.4%.

Against virtually all asset classes, gold has outperformed since January 1. We included the BMG BullionFund, Central Fund of Canada and GLD as they are alternative ways of holding bullion. But there are differences between each of them and there are some other alternatives as well. But these are the primary vehicles as we see it.

The BMG BullionFund (Note: I am a director of BMG Inc. the manager of the BMG BullionFund) is a mutual fund trust investing equally in gold, silver and platinum. Bullion holdings are fully insured and are held at the Bank of Nova Scotia on a fully segregated allocated basis. The holdings are audited annually by KPMG. The fund is always available at its net asset value (NAV). BMG also offers bullion bars in gold, silver and platinum.

Central Fund of Canada (CEF.A-TSX, CEF-AMEX) is a closed end fund investing in roughly 57 per cent in Gold and 40 per cent in silver. They also hold cash and some other assets. Central Fund trades on stock exchanges and it can go to substantial premiums or discounts to NAV. The current premium is 12.5 per cent. The market cap is about US$2 billion or Cdn$2.4 billion.

The SPDR Gold Trust (GLD-NYSE) is an exchange traded fund (ETF) that reflects the price of gold trading at roughly 10 per cent of the price of gold. The SPDR Gold Trust says it has gold as an underlying with its website noting holdings of 970 tonnes of Gold. They recently noted that its gold holdings increased by 45 tonnes in the past month. But there have been many who have asked "where did they get all the gold. Certainly it would not have come from the world's gold exchanges as the transfers would be visible. Lease arrangements are possible although their prospectus says no. The holdings are substantial and it would make them if they were a central bank the world's 7th largest with holdings behind only the USA, Germany, the IMF, France, Italy and Switzerland.

We have a series of Gold ratio charts below, all weeklies, showing the performance over the past few years against the Dow Jones Industrials, oil, bonds, and gold against silver. In our previous issue we showed how Gold has performed against currencies. Gold has been outperforming against most currencies and is now outperforming against the DJI, oil and bonds. Silver is now outperforming against gold. Gold is money. In a world where fiat paper currencies are becoming more worthless every day and the banking system is essentially insolvent holding Gold will have its rewards in protecting assets.

Dow Jones Industrials/Gold Ratio

Note how the DJI/Gold ratio has broken down again into a steeper down channel. This may be a hint that we are entering a new and more dangerous phase for the ratio. Gold could either soar in this phase or the DJI could collapse (although not right away as we try to work through the current ongoing consolidation). We maintain some long term targets that are still telling us the ratio will go to 1:1.


After a number of years of oil outperforming gold the market shifted clearly in favour of gold this past year. With the collapse in oil prices and gold holding up and rebounding strongly from its lows in November the ratio has shifted clearly in favour of gold. We are now back into levels seen throughout the 1980's and 1990's. While there will be periods of oil strength vs. gold the message is now clear that one should hold gold over oil.


For almost 20 years from 1980 to 1999 bonds were clearly favoured over gold. That began to change in 1999/2000 and ever since it has been beneficial to hold gold over bonds. An exception was the sharp correction in the ratio from July 2008 to December 2008. This was when bond prices soared and gold prices had a sharp correction. This has now shifted back once again in favour of holding gold over bonds. The short sharp correction is typical of a corrective move and not the start of new trend favouring bonds. We still need confirmation of a new uptrend getting underway with new highs in the ratio but with massive financing needs required by the US government we would not now be wanting to hold bonds.


The collapse in silver prices from over $20 to below $9 last year saw a sharp rebound in the gold/silver ratio favouring gold over silver. This rally now appears to be over and the past several weeks have seen a shift back to favouring silver over gold. Investors should also maintain some exposure to silver. At a sharply lower price it gives true meaning to the term "poor man's gold".

The ratio charts are telling us that Gold is now favoured over the key asset classes of stocks, bonds and oil. We believe we are at or near the cusp of a period that could see the best gains in gold (and silver). Gold is money and investors need exposure to it to protect their assets in a period where things are going to get a lot worse before they get better.

Note: Charts created using Omega TradeStation. Chart data supplied by Dial Data.



David Chapman

Author: David Chapman
Technical Scoop

Charts and technical commentary by:
David Chapman of Union Securities Ltd.,
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Toronto, Ontario, M5E 1K3
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David Chapman is a director of Bullion Management Services the manager of the Millennium BullionFund

Note: The opinions, estimates and projections stated are those of David Chapman as of the date hereof and are subject to change without notice. David Chapman, as a registered representative of Union Securities Ltd. makes every effort to ensure that the contents have been compiled or derived from sources believed reliable and contain information and opinions, which are accurate and complete.

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