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September 15, 2008

Pivotal Events
by Bob Hoye

The following is part of Pivotal Events that was published for our subscribers Thursday, September 11, 2008.

SIGNS OF THE TIMES:

Last Year:

"Banks Seem Fine"

"Margins Can Absorb Hit From Credit Fallout"

- Wall Street Journal, September 8, 2007

"Events that models only predicted would happen once in 10,000 years happened every day for three days."

- Wall Street Journal, August 11, 2007

This gem was from a quantitative analyst whose model was designed without basic market history. By this measure, recent events must be in the order of 20,000 years.

"Lowering interest rates will certainly help the stock market. There is no question about it."

- Bloomberg, September 11, 2007

Now let's look at the record. On that date the three-month bill yielded 4.09% and the Dow was at 13308. Now the bill yield is 1.56% and the Dow is at 11231. According to modern portfolio theory the Fed lowers rates and it revives the stock market and prosperity, so the stock market decline with declining rates must be at least a 10,000-year event. Actually the theory has been spun out of thin air and throughout all of market history short rates go up with a boom and decline with the contraction.

One can't help but wonder why this isn't taught in economics or business courses.

This Year:

"The hot dollar is melting steel prices. Hot-rolled is down by 30% since July."

- Business News Network, September 3, 2008

"Intervention Ain't What It Used to Be"

"Government intervention is losing its market mojo. The one-day stock rally sparked by the rescue of Fannie and Freddie was erased by fresh worries about Lehman."

- Wall Street Journal, September 10, 2008

With a more realistic approach to numbers - It is not every day that you see the end of a 95-year experiment in government manipulations of interest rates and currency.

* * * * *

Stock Markets: The sunshine expected in the first week of September failed for the commodity-side of the market after one day, but the teeter-totter with rising banks took the BKX up to 73.6 on Monday. With news of fresh disasters the sunshine window that could have run into this week is now history.

And so is the stock market. The NYSE Comp has declined to new lows. For the past month we have been going on about the developing disaster in corporate bonds. On August 15 spreads widened beyond the distress reached with the July panic - and have continued to widen.

This has been shouting that liquidity is becoming scarce and that all of the heroic efforts by policymakers have not been working. The other reminder we kept putting in has been that there is no evidence of the senior central bank ever preventing the contraction that is consequent to a boom. With all the promotion about the wizardry of government manipulations one of the basic lessons from financial history has been ignored. This is that the boom causes the bust.

History shows it and the Austrian School also figured it out from first principles. Von Mises' Human Action is a lengthy read that this writer summed up as "the up causes the down and that the bigger the up - the bigger the down". That was decades ago and just the evidence of the similarity of booms and busts has provided a very simple and very persuasive argument about the futility of interventionist dogma.

Perhaps there should be an introductory course on "marginal futility".

Technically the market has not been healthy as each rally has had indifferent A/Ds and Lowry's measures of buying and selling power have been weak.

The models (1973 and 1937) identified the May break to the downside as an important step to a 25% slump from the high. That was accomplished in July from which a sharp rebound was possible. This would lead to a choppy August and the brief "sunshine" as fund managers returned from vacation.

Those models also called for a full bear market decline of around 49 percent. It is still uncertain that this can be completed in this immediate season of financial disorder. Also there is no certainty that the ultimate decline will be limited to 49 percent.

Gold Sector: The gold establishment has been surprised that gold and silver have been declining during a financial crisis.

Wasn't gold meant to be a safe haven in times of distress? Under such conditions shouldn't one have enough gold to at least bribe the border guards?

As we have been discussing it is important to rely upon thorough research rather than popular folklore.

The 1873 bubble in financial and tangible assets occurred while the U.S. was experimenting in a fiat currency so there was a price for gold. It declined into November during that fateful crash. In 1929 gold's price was fixed and the real price declined during that infamous crash - until November.

We have been expecting gold in nominal and real terms to decline with the liquidity crisis likely to culminate around the end of October.

The other important point has been that silver would plunge relative to gold, which it always does in a financial panic. The key turn in the gold/silver ratio was the low at 50.7 on May 23 when the credit markets resumed the horrendous trend to contraction.

In discussing the transition we noted that at the end of the last U.S. banking calamity in late 1990 the ratio reached 100, which has been our target on this financial catastrophe. The breakout was at 54 which was exceeded on August 11 and this in itself was a signal on this crisis. The ratio is now at 71.

However, gold's action is becoming impetuous and technically working itself into a pattern that can pop a relief rally.

Once past October, gold's real price has been likely to increase for a couple of years. This would restore prosperity to the whole gold sector in the face of a weakening economy.

Link to September 12, 2008 'Bob and Phil Show' on Howestreet.com: http://www.howestreet.com/index.php?pl=/goldradio/index.php/mediaplayer/950

Bob Hoye
Institutional Advisors

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