Sunday, December 10, 2006

It was good (for some) while it lasted

The global Ponzi Scheme is on the verge of coming unravelled. The first leg down was from 2000-2002, but that was just a minor taste of what is yet to come. I am compelled to write now to describe the coming phase for two reasons: 1) because I think the pieces are now in place for an imminent decline 2) In case there is anyone, even one person, who reads this and benefits from the conclusions.

Today is December 10, 2006. The latest issue of Barrons indicates that all 9 financial commentators in their "big money" poll are currently bullish on the outlook for stocks for 2007. The stock market has been rallying strongly and unrelentingly since mid-July and all major indexes (except Transports) are at or near multi-year highs. For someone who is net short like me (albeit with a couple of long-side hedges: BUD, SUNW), it has not been an easy 4 months; however, I am maintaining my perspective that history is replete with examples where the indexes spike to new highs just before turning down. Look at a chart of the early 1970s DJIA to see what I am talking about.

The housing market is in decline, as widely reported, however the vast majority of people believe that the worst is over and the "bottom is in". This is wishful thinking of the highest order and completely ignores the history of the housing market. Housing prices move relatively slower than stock prices and take much longer to work through their corrective cycle. Since this housing cycle took prices farther out of their historical range than any of the past housing cycles (except one in the early 1960s of similar magnitude), one should expect that we are in the earliest phases of this down cycle.

Read in a vacuum, the above scenario doesn't really sound that bad. However, it is merely context for my major assertion:

The U.S. economy peaked in the late 1960s and early 1970s in terms of industrial output (manufacturing), real median wages, and innovation. This trend was very apparent during the 1970s, but since the early '80s has been obscured by the massive "blowoff top" the Elliot Wave folks call a fifth wave. Unable to rely upon innovation and manufacturing capability, starting with Reagan, the U.S. has been financing the last 25 years' prosperity with debt. Debt at all levels (personal/household, local government, federal government), relative to income levels, is at the highest levels in recorded history.

The party looked to be stalling out in 2000-2001, but the Fed engineered another "recovery" by taking interest rates down to 1% (lowest level in history) and encouraging consumers to borrow yet more money to finance the current pseudo-recovery. The current 4 year expansion is a pseudo-recovery, because it is not self-sustaining. How else to explain that in the 4th year of an economic expansion, all economic constituents from households to government are still incurring debt? All of this debt, used to finance consumption and the Bush tax cut, will severely limit the Fed's ability to stimulate the economy during the next economic downturn. Apparently very few economists, let alone people, comprehend how debt shifts consumption from the future to the present. Only debt that is spent to build/buy productive assets will enhance the growth of the economy. Debt spent to finance consumption is a burden on the future economy.

Meanwhile, the global 'economy' resembles a classic Ponzi (pyramid) scheme, in that a lucky few at the top are prospering at the expense of the majority at the bottom. In order to continue however, a Ponzi pyramid requires unrelenting growth. Meanwhile, the short-sighted wealthy sponsors of this Ponzi scheme are eagerly commoditizing every factor of production and job function so that they can package and sell the income streams and move the money to offshore cash accounts. This 'cashing in' on the world economy is in top gear as new derivatives and financial instruments are being invented to capitalize income streams. This year, even as the minimum wage stands at a mere $5.15/hr and is lower (inflation adjusted) than it was in 1973, Wall Street is taking home a record $40 billion in bonuses. The average Wall Street bonus is $398,000 and the average total pay is over $600,000. Meanwhile the jobs of the majority at the bottom are being commoditized and rationalized, both through outsourcing and automation. Land fills are topping up with cheap junk and destroying the physical environment, while developing nations are competing to see who can offer the lowest wages and worst working conditions, in their bid to get a ticket to this insane lottery. Don't get me wrong, I understand that economic rationalization is a crucial part of capitalism, and I am not against private enterprise, however all levels of government have been induced to look the other way to ensure high returns on capital at the expense of returns on labor. This is classic 'Supply Side' economics aka. 'favor the employer over the wage earner'.

All of the above last point is moot, however, because all Ponzi schemes eventually fail. They fail because there are diminishing marginal returns to growth. Also, the scheme requires ever-increasing numbers of low income workers to expand the bottom of the pyramid. This constant flow of low wage workers into the world economy has increased profit margins to the highest levels in history, as high income workers in developed countries are swapped out for low income workers in developing countries. Beleaguered American workers, in a bid to maintain their lifestyles, have turned to debt in all forms. It's becoming ever more apparent that this strategy has now reached its predictable bad ending, as the decline in real estate prices takes its toll on the consumer's primary collateralized asset - the family home. Once we fall off that cliff into the next recession, Dr. Bernanke won't have the tools to rescuscitate the patient. The American consumer will be dead on arrival.

Here is what happens next:

The stock market (S&P 500) has been in a bearish rising wedge since early 2003, characterized by a large rise in 2003, followed by a slow grind higher with no significant pullbacks in 4 years. This is a dangerous market, because volatility is at historical lows and most investors are lulled into a false sense of security. Once the move to the downside begins, it will go far lower, far faster than the vast majority predict. My ability to time the market leaves something to be desired, but I honestly believe this major reversal could occur within a matter of days or weeks.

Once the stock market tanks, the economy will stall out and fall into severe recession, accompanied with massive layoffs. Initially the Fed will be slow to react, which will cause prices to fall, including commodities and precious metals. The Fed will eventually panic and begin to rapidly lower interest rates, which will have no effect (as indicated above) since consumers will be unable to borrow and lenders will be unwilling to lend. The Fed will finally resort to 'printing money' and governments worldwide will engage in competitive debasing of their currencies. Near or at that point, I will be looking to be a buyer of gold and silver (via CEF - Central fund of Canada).

Looking out further, people will lose their homes and jobs en masse and discontent will rise to levels last seen in the Great Depression. The major difference however, is that Depression-era people were hardy folk with useful manual labor skills. Also there were still a large proportion of family farms and farm jobs that were largely self-sustaining. Today's population of software developers (Me), accountants and Starbucks baristas won't have any useful skills to fall back on in a basic survival-based economy. Therefore, crime and violence will sky-rocket and personal security will become a high priority for everyone.

Looking out a few years:

1) The U.S. will abandon Iraq and Afghanistan to the terrorists

2) The Middle-East will descend into chaos beyond anything heretofore imagined

My strategy:

1) Avoid/and or short the stock market

2) Look for a large pullback in gold/silver and then start averaging in to CEF

3) Invest in personal security

Have a great 2007 !