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Record
liquidity in the markets has temporarily welded the optimism of both bulls
and bears in stocks and commodities. The Dow closed at 9712.28, up 15% in the
third quarter, the best quarterly performance since 1998, and up 52% from the
March bottom. Gold appears to have stabilized above $1,000 per ounce, the highest
level since March of 2008 during the Bear Stearns meltdown. There may be a
showdown for stocks and commodities, with High Noon rapidly approaching.
Strong
performance in the stock market may be only a reflection of restored
confidence in financial institutions. Despite the rapid climb, the stock
market may not be overvalued. Market indices have attained only a level
of 15x to 17x earnings, which is close to average for the last couple of
decades. Full value at this level suggests that a point of equilibrium
may have been reached based on earnings expectations for 2010 and 2011, but
are these reasonable expectations? There is growing skepticism of a
“V-shaped” recovery in the financial media and even whispers that
the recovery may indeed be “L-shaped.” (Depending on your
font type, an “L” may not necessarily turn up at the end.)
Gold,
from a U.S. perspective, has appreciated to new highs based on the weakness
of the U.S. dollar. From a less provincial point of view, gold continues to
perform well overall from a global perspective. The origins of this stem from
moving off a gold standard with central banks achieving financial stability
by managing interest rates and the international arbitrage of currencies.
This has allowed nations in Europe to fund entitlement programs, and in the
U.S., fund both the Cold War, the recent Gulf Wars, and as of late, the
stimulus and preservation of the global financial system.
It is
unsettling that it is not gold that has appreciated, but rather it has been
the accelerating depreciation of global currencies that is accountable for
this movement. Globally, central bankers, aware of the damage of
inflation following their stimulus programs, are ready to increase interest
rates. Recently, Australia hiked its rates a mere 25 basis points, sinking
the U.S. dollar and sending U.S. dollar denominated gold to new highs. The
U.S., on the other hand, has committed to a program of trillion dollar
deficits and wealth redistribution to spur growth in climate-sensitive
alternative energy solutions. The Federal Reserve is talking tough on raising
rates, but the financial media is beginning to hedge its bets. With few
alternatives for protection, more bubbles may be on the way.
The
Financial Media is Looking for Inflation Hedges
With
gold piercing the $1,000 level and resting easily, the financial press is now
comfortable bringing, for investment, options to hedge against inflation.
Much space has been devoted to Treasury inflation-protected securities (TIPS).
At first glance these may be the safest option to hedge against inflation.
These financial instruments are tied to an inflation benchmark and are
expected to have a high correlation to inflation.
There
may be some issues to be aware of with TIPS. These securities have not been
tested during periods of high inflation or volatile changes in interest
rates. Returns may actually come up short during low inflation, or if the
inflation index understates inflation. Yields on these securities might be
subject to demand and supply, and there may be tax consequences for gains on
principal as well as interest. While other drawbacks may exist, TIPS may
provide more protection against inflation compared to money markets or common
stocks.
Gold
remains one of the best hedges against inflation due to its high correlation
to inflation over the long-term. This is intuitive, based on the expansion or
contraction of money relative to a fixed amount of gold. Investing in gold
mining stocks may provide additional benefits due to a high beta to gold as
they potentially represent increased fundamentals for resource expansion or
operating upside. Potential upside when investing in mining stocks contains
“company risk,” and stock selection and timing is important.
An
increasingly popular and simple means to get exposure to gold as a hedge is
through a gold ETF. Some may prefer to own physical gold as a literal
store of value to address concerns over confidence with markets and rule of
law. While physical gold does not pay interest, currently Treasuries
don’t pay much either, and contain a potentially commensurate level of
volatility.
Warning!
Is the Fed a Paper Tiger?
Fed
Officials appear to keep straight faces when offering testimony to the U.S.
Congress. One can only wonder what they are really thinking. Certainly they
are confident in their positions (potentially their careers) and their
ability to withdraw a trillion dollars from the monetary base to avert
inflation. The Fed and the Obama Administration, along with the U.S. Congress,
have made their bed, and the addition to the money supply is passing the
point of being considered temporary.
The
question at hand is will the Fed seek to restrain inflation and bolster the
dollar with higher interest rates, or will the Fed fund ongoing deficits
through monetizing the debt and unfunded entitlements? Certainly, inflation
will push more workers into a higher tax bracket through a progressive income
tax scheme. In addition, all will pay more with inflation; as Milton Friedman
may be quoted, “inflation is a tax without legislation.”
Gold,
in its many forms, appears to remain as the best hedge against looming
inflation. Despite the apparent direction for gold, there may be
significant volatility given Fed actions to fight perceptions of inflation. Beating
gold down through raising interest rates, “moral suasion,” or
other means is certain, which imply greater volatility.
Fed
Chairman Ben Bernanke testified that “There is no immediate risk to the
dollar; it’s a relatively long term issue.” He added the
following qualifying statement, “If we don’t get our macro house
in order that will put the dollar in danger, and the most critical element
there is long-term fiscal stability.” Still, he remains
“confident that we can manage our policies to support the economy
without inducing inflation in the medium term.” In conclusion, he has
said, “We are committed to low inflation and we fully believe we have
the political tools and the political will necessary to achieve
that.” This was a calming statement, but considering improving
visibility on the size of the deficit, “political tools and the
political will” sounds ominous.
Fed
governor Kevin Warsh warned that the Fed could “begin
normalization…possibly with greater force than is customary.”
Considering the trillion dollars in excess liquidity, it would be shocking
and irresponsible if he said otherwise. When combined with Bernanke’s
“political tools and the political will” comment, this does imply
that a potential shock is ahead for traders or others presuming a steady
upward glide for gold prices. Whether or not the Fed is a paper tiger, as
long as gold appreciates to higher levels, more volatility may be expected in
the near-term due to Fed actions to manage the money supply and blunt
inflationary expectations.
Equation
of Exchange Suggests Inflation Ahead Through Lost Production
Irving
Fisher’s Equation of Exchange (MV = PQ) warns that inflation is
possible even without an increase in both demand and supply of credit or
increased consumer confidence (increased circulation of money, or
Velocity). It is logical that with the Fed significantly increasing the
money supply, if velocity should increase and reserves multiply increasing
liquidity, either higher production (Q) or inflation (P) on the right side of
the equation would follow. The most frightening parallel of the current
downturn with the depression of the 1930s is that inflation did exist due to
ample liquidity not offset by increasing production.
If
the equation holds, and optimistically the Fed shrinks the money supply and
seamlessly offsets increased circulation of money (Velocity), without an
increase in real production inflation is a given. In reality, lending and
confidence appear muted by precarious attitudes toward jobs by the employed. Even
the employed are universally familiar with those who have either lost their
jobs or whose wages have been squeezed. Analysis of small business
activity, while not showing up in marquee financial indicators, may be at the
heart of an anemic recovery.
The
Fed is now at risk of taking the fall for failing to achieve its primary
mission: to promote price stability and full employment. While the Fed has
influence over reserves and lending regulations, it does not create jobs. It
is generally accepted that small businesses and entrepreneurs are the
backbone of economic development, the source of future innovation, and the
creators of wealth in the U.S.
Stock
Market Performances Obscures Crisis for Small Business
Blame
for the economic downturn in 2008 may be attributed to Congressional neglect
and failure of the capital markets at the highest level. While this was
beyond the direct responsibility of small businesses and individual workers,
they unfairly continue to bear the brunt of the folly. These innocents
are outside of the protection of the government’s “Too Big To
Fail” doctrine or governmental stimulus for non-governmental
organizations. Wall Street, with friends in high places, is on the rebound,
but the impact on Main Street or Back Street may present an unappreciated
drag on the recovery.
The
purchasing managers’ index of manufacturing activity prepared by the
Institute for Supply Management indicated an increase to 54 in September from
52.9 in August. An index greater than 50 indicates a potential expansion
in the factory sector. This seems to be consistent with inventory replacement
and increasing exports, which would provide assurance to the stock market.
The index may overstate the strength of the economy as it surveys midsize and
large manufacturers with greater access to credit than smaller manufacturers.
Small
businesses employ about 50% of the workforce and contribute 38% of the GDP in
the U.S. About 80% of small businesses depend on credit cards as a vital
source of funding, and an equal percentage find this source of funding has
been decreased materially. Credit card lines have been reduced by 25% since
2008, and by about $1.25 trillion over the last two years. Some industry
experts anticipate this will be reduced by an additional $1.5 trillion by the
end of 2010. Also, home equity lines of credit have become problematic as a
source of credit, with close to a third of the homes in the U.S. worth less
than their mortgages.
Governmental
Stimulus May Not Trickle Down to Long-Term Unemployed
The well-publicized
September jobs report indicated a loss of an additional 263,000 jobs in
September. This marked 21 consecutive months of job losses, increasing
the unemployment rate to 9.8% from 9.7% in August, to the highest level in 26
years. Temporary workers, an early indicator of increasing demand, were also
down for 20 months in a row to the lowest level since 1995. An estimated
7.2 million workers have lost their jobs since the end of 2007. The official
total number of unemployed is now 15.1 million.
For
the first time in 30 years, more than a majority (54%) of the unemployed are
not temporarily but permanently out of work. The proportion of those
unemployed longer than 6 months increased to 35.6% from about 33% in August.
As the labor force declined 571,000 in September, increasing unemployment
suggests that some workers have given up trying to find work, thus swelling a
growing number of unreported long-term unemployed.
The
increasingly competitive labor market currently benefiting Wall Street has had
a most dire impact on Generation Y. Overall, the unemployment rate for
teenagers is 16% above that of adults. Teen unemployment increased to 25.9%
in September, the highest rate since WWII, up from 23.8% in July. The most
unfortunate demographic was black male teens, which increased to 50.4% in
September, up from 39.2% in July. Teenagers are five more times likely than
adults to earn the minimum wage. An argument can be offered that minimum wage
laws meant to help provide a “living wage” have reduced the
demand of unskilled labor by setting an artificially high price. This
increases the numbers of unemployed and presents yet another challenge to
small businesses.
Interestingly,
about 330,000 teens have lost their jobs since a minimum wage of $7.25 per
hour took effect in July of 2009. Congress raised the minimum wage to $5.15
per hour in July of 2007. Since that time, there are 691,000 fewer teens
working. This would support studies that the least skilled and the young
are penalized when the minimum wage is increased. While minimum wage
jobs are generally considered “starting wage,” most get raises
within a year on the job. The most perverse loss in fewer teens working is
not the loss of tax revenues but the loss of useful work experience. Teenagers
that don’t work tend to have lower long-term wages and less
employability for longer terms.
A
reduction or elimination of the minimum wage would stimulate the economy by
moving demand and supply of labor to equilibrium. The experience gained by
teenagers on the job may provide valuable education “tax free” to
the public while increasing the nation’s human capital. The increased
business activity would increase production relative to liquidity which would
be anti-inflationary. Considering recent announcements to spend millions of
stimulus dollars on at-risk youths in Chicago, the repeal of minimum wage
laws may be one of the simplest, long-lasting, and most cost effective
policies not up for consideration.
The
U.S. Congress is now advancing a second stimulus plan to maintain payments
for 65% of the cost of health insurance policies under the COBRA program.
They are resisting the call for an extension to be a second stimulus plan, as
it may suggest growing insolvency of the economy. Presently, only about 60%
of the initial $787 billion stimulus package remains unspent, not obligated
to projects. Some consider the money unspent and not obligated to appear
as a political “slush” fund. As payrolls are cut, the $787
billion stimulus program may grow to over $900 billion. Extending the
unemployment benefits through 2010 may cost $100 billion.
Wall
Street may find out sooner than later that increasing the labor force and
reducing unemployment is important for increasing confidence and consumer
spending. Factory orders increasing inventories above base levels is
essential evidence of a growing economy. It is also important to absorb
excess liquidity and avoid inflation. Not least important is that
increasing employment and spending raises taxable income and the tax base.
Employment
Crisis Spilling Over to Government
The
economy is still anemic outside of temporarily stimulated sectors such as
autos and housing. These efforts may have sustained confidence but may
be short lived as they have cannibalized future sales. Construction,
manufacturing, and professional and business services are down big, 8% to
20%, since the beginning of the recession in 2008. Mining and logging are
down 4.7%, or flat.
Health
care and social services is the only sector up in September and since the
beginning of 2008. Government, utilities, and educational services, all
up since the beginning of the recession, were off in September.
Interestingly, Government was a big loser in September, erasing gains made
since the beginning of 2008. While it has been said that “a
recession is when your neighbor loses his job” it may be a depression
is when a bureaucrat losses his job.
There
has been an alarming drop in Federal, State, and Local tax revenues while
expenditures escalate. Falling business profits and consumer confidence
have put a crimp on income and sales taxes. At the local level, falling real
estate values have reduced the tax base and lowered property taxes, often a
major source of funding. Alaska’s state tax revenues declined 72%
in the first quarter of 2009. All other states but five suffered declining
revenues. Of the five enjoying an increase, Wyoming experienced the greatest
increase of 19.8%. The pain was fairly evenly distributed across the
lower 48 states and Hawaii.
The
decline in government revenues was brought on by a sluggish economy and
growing ranks of unemployed. States unable to print money (save California
printing IOUs) will be forced to either increase taxes or reduce spending to
balance their budgets. There is the looming prospect that states may abdicate
their independence by soliciting assistance from the Federal government, as
states may also be considered “too big to fail.” Failing to
accept fiscal responsibility at the state level by accepting Federal
assistance is inflationary, and a potentially ominous permanent expansion of
the Federal government. In any event, with increasing budget deficits, it is
difficult to imagine a situation where the government would not immediately
look to increase taxes, which would reduce output and produce inflation.
Looking
Ahead: Who Makes The Golden Rules
U.S.
Senator John Thune (R – South Dakota) recently made the claim that the
federal government now owns 600 financial institutions and banks, two automakers,
an international insurance conglomerate, and other businesses. While stopping
short of a comparison to fascism, clearly the U.S. President now has
unprecedented control, unthinkable by previous administrations, by
consolidating power of independent public companies, and is in a position of
directing their activities. Sen. Thune is arguing for winding down the
TARP by the end of 2009.
The
way in which the U.S. Congress handles unspent stimulus funds or an extension
of TARP should be instructive for those pondering bubbles in the stock market
or commodities. Sen. Thune argues that about $300 billion available to TARP
that has not been deployed should be applied to reduce the deficit. It may be
argued that failure to do so may signal either expected difficulties in banks
deemed less than “too big to fail” or a design to maintain a
slush fund to meddle in the market. In either case, extension of TARP
in its present form with undedicated funds is inflationary, and even worse,
may be an indication that markets in the U.S. are now less free and less
attractive due to erosion of the rule of law. This would make the U.S.
stock market less attractive relative to owning physical gold.
Mike Niehuser
Beacon Rock Research.com
Also
by Mike Niehuser
Mike Niehuser is the founder of Beacon
Rock Research, LLC which produces research for an institutional audience and
focuses on precious, base and industrial metals, and substitutes, oil and
gas, alternative energy, as well as communications and human resources. Mr.
Niehuser was nominated to BrainstormNW magazine's list of the region's top
financial professionals in 2007.
Mr. Niehuser was
previously a senior equity analyst with the Robins Group where he was a
generalist and focused on special situations. Previously he was an equity
analyst with The RedChip Review where he initially followed bank stocks but
expanded to a diverse industry range from heavy industry to Internet and
technology companies.
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