The Rise to Ruin
This essay was first published by Whiskey and Gunpowder.
"Everything in the world may be endured except continued prosperity." - Goethe
"The path of least resistance and least trouble is a mental rut already made. It requires troublesome work to undertake the alternation of old beliefs. Self-conceit often regards it as a sign of weakness to admit that belief to which we have once committed ourselves is wrong. We get so identified with an idea that it is literally a "pet" notion and we rise to its defenseman stop our eyes and ears to anything different." - John Dewey
Every day I get numerous e-mails from well-informed readers of my newsletter commenting on the housing market. Some support my view that Anglo-Saxon countries rein a colossal home price bubble, while others argue articulately that there is no such bubble.
As a result, I continually have doubts about my own views and concede that, as John Dewey remarked, "Self-conceit often regards it as a sign of weakness to admit that a belief to which we have once committed ourselves is wrong. We get so identified with an idea that it is literally a 'pet' notion and we rise to its defense and stop our eyes and ears to anything different."
I occasionally try to forget my economic background and rationalise investment bubbles. We all know that investment bubbles involve easy money, excessive credit growth, lax lending standards, leverage, "new era thinking", and a loss of touch with reality, excessive expectations about future profits, and so on.
However, often bubbles also involve a loss of faith in the value of paper money. Let me explain.
In the late 1970s, investors became increasingly concerned about accelerating consumer price inflation. Since consumer prices were rising at more than 10% per annum, the then prevailing view was that cash was depreciating by approximately 10% per annum.
People rushed into precious metals and drove the price of gold and silver to US$850 and US$50, respectively, in January 1980. At the same time, investors were dumping bonds, which became known as "certificates of confiscation". US long-term government bond yields soared to more than 15% in September 1981. I would argue that there was at the time a real panic about the role of paper money as a store of value.
Loss of Paper Money's Purchasing Power as a Result of Asset Inflation
Today, we have a similar situation. However, people are not concerned about paper money losing its purchasing power as a result of consumer prices rising, but as a result of paper money losing its value because of rising asset prices.
If, on given income of 100, consumer prices rise from 100 to 110 the real income will have declined by 10%. But if on an income of 100 and cash assets of 1,000 which only yield 2%, real-estate prices rise by 10%, both the income and the cash assets will have lost their purchasing power compared to real estate.
Therefore, if real estate prices rise for an extended period of time at a faster rate than incomes and interest rates on cash deposits, it is only natural that people become concerned that they won't be able to afford to purchase their own home in future.
Their concern about future affordability, which is nothing else than the fear of their income and savings losing their purchasing power, then induces them to purchase their homes now rather than later.
This incremental demand drives prices even higher and attracts speculators who want to capitalise on the rise in prices, which is driven first by the genuine buyers and later by themselves as well.
As a result, prices then overshoot and lead to even deeper apprehension about the loss of purchasing power of paper money on the side of the household sector. A general rush from liquid assets to" illiquid assets" inevitably follows and creates a bubble.
This is nothing new. The first well-documented instance of such a loss in the purchasing power of paper money was John Law's Mississippi Scheme. In 1716, John Law had opened, under the patronage of the French regent, a bank (Banque Generale), which issued paper money backed by gold. With the help of the regent, the bank became an immediate success. Its banknotes were very convenient, since the government accepted them for tax payments.
Based on this first success, in 1717 Law managed to convince the regent to grant his new venture, the Mississippi Company, a monopoly on all commerce between France and its French territories in North America, which included the present states of Louisiana, Mississippi, Arkansas, Missouri, Illinois, Iowa, Wisconsin and Minnesota, in return for accepting outstanding notes of the French government in payment for the Mississippi shares.
This arrangement basically amounted to nothing other than a partial conversion of France's government debt into shares of the Mississippi Company.
The operations of the company didn't prove to be profitable, partly because when it issued shares it hadn't received cash, but debts of the French government, which had been converted into shares of the Mississippi Company, and partly because very few French wanted to emigrate to the territories in America.
Still, the shares of the Mississippi Company performed well after the regent took over Law's bank and began to run its money printing press around the clock. (Presumably, Law gave him the bank in exchange for having obtained so many privileges.)
But, whereas John Law had always maintained a small balance of gold reserves to back up the paper money the bank issued, he now advised the regent that the public had gained sufficient confidence in paper money and, therefore, gold reserves in the bank's vault were no longer necessary.
As a result, in 1719, the government increased the money supply dramatically and lowered interest rates by lending money for as little as 1-2%.
The vast increase in the supply of paper money, combined with the ability to purchase shares in the Mississippi Company on margin, led not only to the shares rocketing towards the end of 1719 to over 20,000 livres (from 300 at the beginning of the year), but also to rapid price increases across France.
The cost of bread, milk, and meat had risen six-fold, while cloth was up by 300%. The horrendous inflation made the holders of Mississippi Company shares and of paper money nervous.
In January 1720, just two weeks after John Law had been appointed as comptroller general of finance(minister of finance), a number of large speculators decided to cash out and switch their funds into "real assets" such as property, commodities, and gold. This drove down the price of the Mississippi Company shares since the speculators could only pay for real assets with banknotes.
As confidence in paper money was waning, the price of land and gold soared. This forced Law, who still enjoyed the backing of the regent, to take extraordinary measures. He prevented people from turning back to gold by proclaiming that henceforth only banknotes were legal tender. (By then the Banque Generale had practically no gold left.)
Thus, payments in gold and silver above 100 francs were prohibited; in addition, the ownership of gold exceeding 500 livres in value was declared illegal.
(Severe penalties were imposed on people who hoarded gold. To enforce this most blatant expropriation, Law encouraged the public to turn informer by handing out large rewards to those who assisted in the discovery of gold, which was then confiscated.)
At the same time, he stabilised the price of the shares of the Mississippi Company by merging the Bank Generale and the Mississippi Company, and by fixing the price of the Mississippi stock at 9,000 livres.
With this measure, Law hoped that speculators would hold on to their shares and that in future the development of the American continent would prove to be so profitable as to make a large profit for the company's shareholders.
However, by then, the speculators had completely lost faith in the company's shares and selling pressure continued (in fact, instead of putting a stop to the selling, the fixed price acted as an inducement to sell),which led the bank once again to increase the money supply by an enormous quantity.
The result was another round of sharply escalating prices. (In four years, the supply of circulating medium had been trebled.)
John Law suddenly realised that his main problem was no longer his battle against gold, which he had sought to debase, but inflation. He issued an edict by which banknotes and the shares of the Mississippi Company stock would gradually be devalued by 50%.
The public reacted to this edict with fury, and shortly after Law was asked to leave the country. In the meantime, gold was again accepted as the basis of the currency, and individuals could own as much of it as they desired.
Alas, as a contemporary of Law's noted, the permission came at a time when no one had any gold left. The Mississippi Scheme, which took place at about the same time as the South Sea Bubble, led to a wave of speculation in the period from 1717 to 1720 and spread across the entire European continent.
When both bubbles burst, the subsequent economic crisis was international in scope.
Still, although accounts are not available about real estate prices during the monetary inflation and the subsequent bust of John Law's experiment with paper money, I suppose that early buyers of real-estate fared better than the holders of paper money, which lost all its value.
The economist Richard Cantillon fared even better. He kept his wealth intact, which he acquired from successfully speculating in the shares of the Mississippi Company, by converting his profits into gold and moving to Holland.
By doing so, Cantillon inadvertently followed an important investment wisdom, which states that once an investment mania comes to an end, the best course of action is usually to exit the country or sector in which the mania took place altogether, and to move to an asset class and/or a country that has little or no correlation with the object of the previous investment boom. Modern Day John Laws.
I have no faith whatsoever in the Federal Reserve Board, nor in any other central bank around the world, doing anything other than printing money over the long term.
In fact, I believe that, given the very high levels of debt we have in the US and other industrialised countries compared to the size of their economies, the central banks have no other option now but to print an ever-increasing quantity of money.
I am a firm believer that Mr. Greenspan, Mr.Bernanke, and their colleagues in other central banks around the world are modern-day John Laws who, like him, will not only manipulate and intervene in markets but, over time, will also totally destroy the value of paper money.
Whereas John Law tried to fix the price of the Mississippi Company by printing money, the Fed chairman has tried (and managed - at least so far) to inflate asset prices through an extraordinary money and credit expansion.
Therefore, while long-term US government bonds could rally somewhat further in the near term, as the economy slows down, I very much doubt that they will provide a satisfactory return over their future life span, as money printing will lead to a loss of purchasing power of money. Future Loss of the Dollar's Purchasing Power.
Countless speculators and future funds have lost much money this year by betting that the US dollar would depreciate against the Euro and other currencies. The mistake these speculators made was failing to understand that a currency can also depreciate or lose its purchasing power against other assets than just other currencies.
Thus, if all the central banks in the world were to increase their money supply in concert annually by, say, 20%, currencies could remain stable against each other but lose in value against consumer prices, precious metals, commodities, art, real estate, and so on.
I point this out because, although I have been positive for the dollar for the last six months, I remain a firm believer that it will go down or continue to lose its purchasing power, as it has done since the establishment of the Federal Reserve Board in 1913 - however, not necessarily against the Euro.
I recently had the pleasure of being on a panel with Jimmy Rogers, founder of the Rogers International Commodity Index (RICI) and cofounder of the Diapason Rogers Commodity Index Funds. The subject of the discussion was commodities.
As my regular readers will know, I am presently not particularly positive about industrial commodities (see also below), whereas I believe that agricultural commodities offer significant upside potential with about 15% downside risk.
Jimmy, however, argued that he was the world's worst market timer and that in his view this commodity up-cycle would last for at least another 10 to 15 years.
Based on the past, commodity cycles (Kondratieff price cycles) tend to last 45 to 60 years. Therefore, if we assume that the last peak of the cycle was in 1980 rally somewhat further in the near-term, as the economy slows down, I very much doubt that they will provide a satisfactory return over their future life span, as money printing will lead to a loss of purchasing power of money.
Hence, if Jimmy Rogers is right in saying that we are in the early stage of a commodity bull market that will last for another 10 to 15 years, a view that I share, then we should also assume that consumer price inflation will gather steam in the years ahead.
Needless to say, rising CPI inflation would further reduce the purchasing power of paper money and be negative for long-term bonds as well as for the valuation of equities (P/E contraction as a result of rising interest rates).
And while I don't think this will happen right away, as I shall argue below, in the absence of one's ability to time market events, the risk is obviously that even industrial commodity prices could continue to rise without much of a correction. This could be particularly true of oil.
We have argued for a number of years that oil prices (and uranium as well) have a significant upside potential. We based this view on Asian demand (3.6 billion people)doubling from 21 million barrels a decurrently to around 40 million barrels a day in the next 10 years or so.(Current daily global oil production is around 84 million barrels a day.)
Recently, however, I sounded a note of caution about oil prices, because some froth had developed as oil prices, at around US$55 to US$60 a barrel, were clearly not as inexpensive as they were a few years ago.
In 1998, the S&P was expensive and oil ridiculously inexpensive. Today, however, when about 20 barrels of oil are required to buy one S&P index, the undervaluation of oil compared to the S&P 500 is less compelling.
Still, we shouldn't rule out that we could go back to the S&P 500/oil ratio, which prevailed in the 1970s and early1980s, when less than five barrels of oil were required to buy one S&P index.
At the last major oil peak in 1980, it took less than three barrels of oil to buy the S&P 500!
If this were to happen again, it would imply - assuming an S&P 500 index of 1200 - an oil price of US$400....I mention this because I recently came across a paper by Eric Sprott, of Sprott Securities in Toronto.
Eric analyses the oil market with particular emphasis on the supply side. As our readers will see from Sprott's study, if he is right about the supply of oil diminishing and I am not totally out of line with my forecast of Asian oil demand doubling over the next 10 years or so, then prices will rise dramatically.
As energy prices rise, geopolitical tensions will increase and lead to even higher prices. Eventually this will lead to World War III in the 2010-2015 period, as energy shortages become acute. Few Bargains and a Volatility Spike.
In the 1970s, money's purchasing power was eroded by high consumer price inflation rates. Since the early1980s this loss of purchasing power of paper money has continued as a result of asset inflation. In particular, over the last few years, depositors have been penalised as real short-term interest rates have been negative
As we have maintained for sometime, there are very few bargains in today's world of inflated asset prices. In fact, I only find relative values. Asian property prices ex Japan and Hong Kong are inexpensive compared to US and European property prices.
Asian shares are reasonably valued compared to equities in Western industrialised countries. Asian currencies are cheap compared to the US dollar and especially the Euro.
Grains are a bargain compared to oil and copper (farm product prices are at a 200-yearlow compared to energy) I should like to remind our readers that in drought periods grain prices can rise dramatically.
From their lows in 1968/69 to their highs in 1973/74, wheat rose by 465%, soybean oil by 638%, cotton by 317%, corn by 295%, and sugar by 1290%. Gold is also relatively cheap compared to oil. It now takes only seven barrels of oil to buy one ounce of gold.
These relative values aside, I continue to be concerned about several issues. Despite the fact that I always question my own views, it increasingly looks as if we have a gigantic bubble in selected real estate markets.
All the symptoms typically associated with an investment mania and bubbles are there. Can the bubble become even larger?
Possibly, but the end result will be even more painful than if the bubble begins to deflate shortly. The Economist concluded the editorial I referred to above by stating: The whole world economy is at risk.
The IMF has warned that, just as the upswing in house prices has been a global phenomenon, soapy downturn is likely to be synchronised, and thus the effects of it will be shared widely.
The housing boom was fun while it lasted, but the biggest increase in wealth in history was largely an illusion. (The Economist, June 18 -June 24, 2005) assets such as homes and commodities have risen substantially in value.
Given the propensity of central bankers to print money, I find it difficult to envision an environment in which paper money would not continue to lose its value over the long term. The only question is: against what will paper money lose its value in future?
The US dollar remains vulnerable, but possibly not so much against the Euro as against gold and silver and other commodities such as oil and grains. At the same time as we have had a housing boom in the US, we have experienced an unprecedented investment boom in China.
If both turn down at the same time, the global economy could weaken more than is now perceived. Such a synchronised downturn in the US and China would almost certainly badly depress industrial commodity prices. This would, however, not alter our long-term favourable opinion of the commodities complex.
In a global downturn, the bond bulls might very well have the upper hand for a while longer. But I have no doubt whatsoever that central banks, led by the US Fed, would, faced with economic weakness, print money like never before. However, this time the money printing operation may not work.
In the same way that asset price inflation - unexpectedly, I might add- replaced CPI inflation in the early1980s, in the near future CPI inflation and rising commodity prices could begin to exceed asset inflation rates, and in particular home price inflation.
This would likely depress long-term bond prices and lead to a very unappealing global economic and financial environment and eventually discredit central bankers and bring about the end of central banking as we know it today.
Given these uncertainties and the potential for oil prices to continue their ascent, I am surprised at the low-level of volatility. Low volatility, we pointed out at that time, tends to lead to big market moves, whereby the direction of the move isn't indicated by the low volatility.
Still, looking at the shape of stock markets around the world and at industrial commodity prices, some significant downside volatility wouldn't surprise us.