NOTHING IS POSSIBLE

“WHO SAYS NOTHING IS IMPOSSIBLE?
SOME PEOPLE DO IT EVERY DAY!” MAD
MAGAZINE E.C, PUBLICATIONS INC.

The money flowing out of Washington is so large and has happened so fast, that only the tooth fairy understands what just happened. What we do know is that the mammoth infusions of fiat money is hyper-inflationary over the next five years, and probably does very little to “Put America Back on its Growth path”. The Euphoria over the election of the new President is about to come to an end. Our Congress and President have lost it.

The Stock Market which represents the best and brightest minds in America, and back their opinions with real cash, have voted on all the Politicians bail-out’s, and “Saving America Programs”, and have posted the following results from Election Day to 2/20/09: SP500 lost 26.70%, NASDAQ lost 21.12%, DOW 30 lost 26.76%, DOW Transportation Index lost -41.13% and the Wilshire 5000 lost 25.86%.

How do you like the vote by real people who invest real money? To add insult to injury, the loss in dollars, since election day (measured by the Wilshire Index, above), is $2.303 Trillion.

Since the peaks of the American stock market and housing, $8.05 Trillion has been lost in the stock market and $7.5 Trillion has been lost in housing. Investments in stocks and housing (since the peak in October 2007), have lost $15.5 Trillion. Globally, the estimated losses from the peak in stocks and housing are $30.0 Trillion for stocks and $ 30.0 in housing. A whopping $60.0 Trillion has been lost because of excessive liquidity and the expansion of irresponsible credit. You think that providing bee keepers with insurance will set the US Economy on fire?

We have a big problem. Yes, someday housing and stock prices will advance, but today, World investors are mad, and do not trust housing and stocks as an investment. It is my experience (since 1968) that investors are not quick to return to investment alternatives that buried them. Housing will again be a place to live and the Stock Market will be a trader’s arena, with the general public staying away.

The chart below indicates the ratio of Money to the market value of the Stock Market. The average ratio since December 1991 has been 54.07%. For the seven days ended 2/9/09, the ratio is 107.24%. Note that the Ratio rose over the average from 1/14/02 and peaked on 3/10/03 at 81.14. After the peak, money still exceeded the stock market and occasionally dipped under the market value of stocks but never got a major foothold. As a result the stock market has been rather boring on the upside and only recently got interesting with its crash. The possible good news is that there is a lot of liquidity standing around waiting for an opportunity in investing in something other than boring old cash.


Money in the chart above is MZM which is defined as: Currency in circulation plus demand deposits plus Large Time Deposits plus Term Repurchase Agreements minus small denomination time deposits plus Institutional Money Funds. The stock market value is defined as the Wilshire 5000 index.

Is the Stock Market today really cheap? In my opinion, no, and I’ll tell you why. Over the past 20 Years, the advent of individual retirement plans increased the demand for stocks exponentially. Add to it Hedge Funds, and other investors of OPM’s (other people’s money) and you had the perfect formula for a Bull Market. The supply did not keep up with the demand. New suppliers emerged (Mutual Funds, ETF’s etc) to accommodate the new demand, but the stock supply didn’t match up with the new demand. Since Mutual Funds and 401K Plans were “always” invested in the Stock Market, it was this set of players that created of one of the greatest bull markets in the History of America.

The Bull Market from November 1990 to August 2000 was the longest in history lasting 118 Months. The most current bull market was the third largest on record lasting 56 months from March 2003 to October 2007. The second longest Bull Market lasted 71 months from November 1923 to September 1929 (remember that one?). In the most current bull markets, most decisions were made by men that had never seen a market crash.
Due to the advancing prices, new theories of value emerged. The old school of value that said “buy good stocks that had a 5 to 12 PE multiple and a 4% to 6% dividend.” was dismissed as “out of touch”.

From the period December 1973 to October 1990, the average of the price earnings ratio and dividend yield for the SP 500 was 11.75 and 4.32% respectively. From November 1990 to December 2008 the PE and dividend yield on the SP 500 was 23.71 and 2.04%. The demand and supply increased to the point that everybody was invested one way or another in the stock market forcing up the PE and driving down the yields. Old school investors learned the hard way, that investing in stocks can be very risky. In the good old day’s stocks carried a risk premium.

At this writing the SP 500 closed at 770.05. Per share earnings estimates, for the years 2009 and 2010 are $41.88, and $51.48 and dividends per share estimates are $12.62 and $23.20. This results in a PE ratio for 2009 of 18.39 and 14.96 for 2010. The dividend yield for 2009 and 2010 would be 1.64% and 3.01%. This hardly represents a risk premium. To arrive at a historical “stocks are cheap” basis the S&P 500 would have to be at 617.76 to achieve a 12 times PE (2010 Earnings). On a yield basis, the SP based on 2010 dividend expectations would have to be at 464.00 to yield 5.00%. Using 2009 earnings and dividend estimates would make matters even worse.

I suspect that the earnings and dividend estimates for 2009 and 2010 are overstated, because historically analysis’s are slow to change their estimates (they work for the very people that are trying to have you buy stocks).

As a concept: buy stocks when they are cheap and sell when they are expensive is common sense. In his book “Irrational Exuberance” Robert J. Shiller (Professor of Economics at Yale University) did a study of returns on stock investments and showed that PE ratios and Dividends indicate to a great extent when stocks are cheap and when they are expensive. He says:

“…as a rule and on average, years with low price-earnings ratios have been followed by high returns and years with high price-earnings ratios have been followed by low or negative returns.” (Page 187 2nd Edition). And, “As a matter of historical fact, times when dividends have been low relative to stock prices have not tended to be followed by higher stock price increases in the subsequent five or ten years. Quite the contrary: times of low dividends relative to stock prices in the stock market as a whole tend to be followed by price decreases (or small-than-usual increases) over long horizons, and so returns have tended to take a double hit at such times, from both low dividend yields and price decreases. Thus the simple wisdom—that when one is not getting much in dividends relative to the prices one pays for stocks it is not a good time to buy stocks—turns out to have been right historically.” (Page 188 2nd Edition).


We need to watch two statistics that will determine the investment strategy for the next 2 to 5 years. The first relationship that bears watching is the ratio of Gold Prices divided by 10 Year Bond Prices. In determining the war of Inflation/Deflation, Gold and 10 Year Bond Prices should de-couple. Currently, both Gold and 10 Year T-Bonds Prices have been going up together. For Deflation to be the winner, the ratio above should start going down. If Inflation is the winner, the ratio should be going up. Note the chart above indicates, the Ratio is going up, which translates to a brief victory for Inflation.

The 2nd thing that you have to pay attention to is the yield to the Chinese in investing in US Bonds. The above chart reflects what the Chinese yields are in Yuan, in investing in 10 Year US T-Bonds for a holding period of 1 year (including interest).
Note the yield for the year ended 2/20/09 is 7.70%. However, the yield is declining. The significance of this chart is, that if the Chinese start losing money on owning US Treasuries, they will be inclined to sell these Bonds, which would drive T-Bond yields higher, and contribute to an Inflationary expectation.

I continue to advocate buying Gold on dips (10% to 20%), and short term Cash Instruments such as T-Bills, and Federally Insured CD’s. The stabilization of the World Economies will take a long time (2 years or more), and in the interim, stay liquid, out of debt, and own some Gold.

Game Theory 101

Many moon’s ago, the Mathematics Department of various Universities, came up with the notion of “Game Theory”. The theory dealt with games from Business to Monopoly. The results of those studies were profound. The basic principals of the theory centered on the concept of “fair games”. That is, a game is “fair” when the player has a 50% chance of winning, and a 50% chance of losing. Thus, “fair” produces no winners or losers.

In investing, the propositions of Game Theory are:

(1) Never play fair games (other than for amusement). Find games that have a higher probability of success than failure.

(2) Never play games unless you understand the rules. The rules must be articulated in an understandable way. The rules cannot change during the game. Do over’s etc cannot be allowed.

(3) Make sure you know the players in the game, and their skill level. Your skill set should be as good, or better, than the other players in the game.

(4) You must understand the game. Life is short – If you don’t understand the game, find another one. If there are no games you understand, become a spectator.

In the current crisis, most players in the game are under 50 years old, and have never seen a “game” this tough. Folks under 50 did not play the bear markets of 1969-1970, 1973-1974, and 1976-1978. In business school they probably did not even study the Depression of the 30’s. Currently, there is no game you can play (other than Gold), that gives you a fair chance of success. Stocks, Real Estate, Commodities, Foreign Currencies, Bonds – they all suck! Why?

(1) BECAUSE THERE ARE NO RULES, AND THE RULES CHANGE DAILY.

(2) Who are the players? You, me, the Federal, State, and Local Governments, Banks, Other World Sovereignties, Finance Companies, Special Interest Groups, the Unemployed, etc. In short - everyone on this planet.

(3) The Game today is totally incomprehensible. Do-overs are now allowed. Without understanding the game or rules, you must sit on the sidelines and allow the other players to fail.

There is a major war going on between Deflation, and Inflation. We all know that there is a credit collapse. The market value of assets is under siege. Liabilities against those assets in many cases exceed the asset value. The collapse of asset values and credit is clearly deflationary. Wait – here come our favorite rule changers, the US Federal Government. The Fed’s always gets us with taxation and inflation.

Our Governments boondoggle (TARP, Stimulus Plan, etc) is presumably going to “get our Economy back on its feet”. As of this writing I have seen nothing that will materially stimulate the Economy. In fact it appears that most of the money has been thrown at Banks and Auto Companies that are Bankrupt and social programs that provide no stimulus. Our beloved leaders, (President Obama, Nancy Pelosi, Barney Frank and Harry Reed) are running amok. The package totals $819 Billion, and may run up to $900 Billion.

There is: $345 Million for the Agriculture Department computers; $650 Million for TV converter boxes; $15 Billion for college scholarships; $1 Billion to deal with the Census problems; $88 Million to help move the public Health Service into a new building next year; $2.1 Billion to pay off a looming shortfall in public housing accounts; $870 Million to combat the flu; $400 Million to slow the spread of HIV and other sexually transmitted diseases such as chlamydia; $380 Million for a rainy day fund for the Women, Infants and Children (WIC) program that delivers healthful food to the poor (this group got $1 Billion last fall), $87 Billion to bail out the States providing Medicaid, Bee Keepers Insurance, and Medicare funds for Illegal Aliens.

Also everyone that has an Income Tax ID card (which includes those that do not have a Social Security Card) will receive a tax rebate of $500 if single, and $1,000 if married. People that do not pay taxes get the tax credit too. Remember the last Tax Rebate program didn’t work because people saved or paid bills with the windfall.

There is more nonsense in this package, but you get the idea. Upon being questioned on the bill, Rep David Obey, D-Wisconsin, one of the chief authors of the house package and chairman of its appropriations committee said, “If the house is burning, you’re not going to worry about which hose you grab, so long as you get water on the fire.” Is he crazy? The printing presses are going wild. As Richard Russell the guardian of the Dow Theory (www.dowtheoryletters.com) said (tongue firmly in cheek), “buy Paper Stocks.”

The forces of Deflation have been strong. Yet Gold and TIPS (Inflation indexed US Bonds) are rising, suggesting that: (1) There is an Inflation expectation over deflation, or (2) There is a major fear that the Worlds paper currency will become worthless or (3) both of the above. The Worlds currency today is referred to as fiat currency or fiat money. By definition fiat money is currency or money whose usefulness results not from any intrinsic value or guarantee that it can be converted into gold or another currency, but instead from a government’s order (fiat) that it must be accepted as a means of payment. For example the US $100 Bill is only worth $100 because our government says it is. Obviously there is no intrinsic value of the bill except maybe the value of the paper (5 cents?)

The game is now very complex. Stocks in my opinion are not cheap but overvalued considering where we are in the economy. A SP 500 Index to be cheap would be 600 or less (currently at 850). US Government Bonds are not cheap (a 10 year yield of 2.842%, is not my idea of a risk justified return). Income producing Real Estate is not cheap, due to vacancy rates rising and a substantial oversupply of rental space. Housing isn’t cheap, since you can’t buy a house today and rent it out at a profit. All other investment alternatives are in a state of uncertainty, because of the absence of rules.

In my opinion to make money over the next three years, the proper investment game to play will be decided on the direction of the price level, and the “real” value of the Dollar and other World paper (fiat money) currencies. If the “people” ever figure out that the current mass flooding of paper money causes inflation, and that our currency is really worthless, we will have the largest Economic and Political crisis ever faced in modern times. Below are some of the charts I use to follow the Deflation/Inflation, worthless US dollar sentiment. Below are three charts that indicate the ratio of Gold Prices divided by: the Ten Year US Treasury Bond Price; the Inflation Indexed US 10 Year T-Bond (TIP); and the US Dollar Index. Also there is one chart indicating the ratio of TIP to the 10 Year T-Bond Price.




Note that the TIP is also rising against the 10 Year T-Bond. Like all market data (that reflects investor sentiment), this could all change tomorrow morning. What’s interesting about the TIP to Bond chart is that it shows the initial Deflationary sentiment (dropping ratio). Currently however the TIP shows strength, and with it confirms the other Inflationary sentiments. My opinion is the stimulus package will stimulate very little except Inflation. It seems likely we will continue our credit and asset collapse followed by high rates of Inflation.







It is prudent to be very risk adverse today. Invest in Federally insured Cash Instruments, and some Gold. If you have a Mortgage that has an interest rate of more than 3.673%, make extra principal payments. Stay liquid, and out of debt. This economy and the Federal Solutions thereon will not have a happy ending.