Financial Sense Newshour
The BIG Picture Transcription
December 16, 2006
- Booms, Busts & Extensions
- It's Where You Borrow the Money That Counts
- Time to Shift to Large Cap Growth Stocks
- Emails and Q-Calls
- Other Voices: Bill Murphy, GATA
- More Emails and Q-Calls
Booms, Busts & Extensions
JOHN: I don’t know, this is always the funner part of the program � funner is good grammar, you can tell what kind of a school I went to, right?
We both graduated from Catholic schools didn’t we? Oh boy, Sister Mary Holy Water would really get on my case right now. Anyway, it brings back fond memories. I better get on the script here, Jim.
We’re both strong advocates of Austrian economics. I know for a long time on the show you have highlighted the effects of the Austrian business cycle as probably one of the best means for understanding what happens in the economy. And very obviously and clearly, the Austrian philosophy differs from the Keynesian philosophy � they’re clearly almost 2 different monetary world views. And you really believe the Austrian philosophy is a far better modeling of economic realities than Keynesian philosophy is.
JIM: Sure, because if you take a look at the Austrian economic school, they’ve been more accurate in their predictions of what’s going on in the economy. It was the Austrian economists who predicted the Great Depression for example. And what you have here, in essence, is the Austrian theory of the business cycle, which really emerges from a simple comparison of what we call savings induced growth, which is sustainable, versus a credit induced boom which is not. And what you get when you get an increase in savings by individuals, and a credit expansion orchestrated by a central bank, when they’re both set in motion they give you a similar effect. In other words, the economy’s capital structure moves forward, the economy begins to grow, but they both create a boom in the economy � the difference is whether the boom is sustainable. [2:01]
JOHN: From the onset they both look the same, and that means they can be deceptive to people as you’re looking at it. But there’s obviously a difference between the two, so what is it?
JIM: Savings gives you genuine growth, because credit expansion or printing money out of thin air as we do today gives us a boom but the problem is that boom is going to be followed by a bust � this boom and bust cycle that we’ve gone through ever since the Federal Reserve was created. And what credit creation expansions give us is an artificial boom. The credit booms that are created are a result of new money creation, and its infusion in the economic system in the form of new loans which are not the result of an increase in savings coming from the general public. It gives you a boom, but because the money creation wasn’t backed by real savings you get economic distortions. Just take a look at some of the bubbles we had in technology in the 90s, the bubbles that we have right now in real estate. These distortions get us investment errors, malinvestments, credit squeezes, banking crises, and eventually unemployment and an economic recession. [3:15]
JOHN: I’m assuming that the distortions will accentuate over time. In other words, they become more and more violent � is that a fair assessment?
JOHN: Part of the mission of this show is to educate our listeners. We’ve got a lot of listeners who understand or who are familiar with this Austrian school of economics, but I’m also sure that a lot of our listeners are not as familiar with it, so without giving in to the temptation to launch into a 3 hour classroom lecture, can you give us a quick synopsis of what defines the Austrian school?
JIM: Well, there are primarily six microeconomic causes that trigger a bust that is created by an artificial credit expansion. And there are six steps in this process, and I’m just going to go through these very quickly.
In the first step, the first is the rise in the price of the original means of production. In other words, costs start going up and prices begin to increase. More money and credit that are created through credit increases demand, which causes prices to rise. So, extra money coming into the system causes demand to rise artificially, that gives way to price increases. And we’ve certainly seen that in the last 3 or 4 years.
Step 2 price increases in the early production process then leads to an increase in the prices at the consumer level. And I think, John, here we can safely say nobody believes the core rate of inflation. Anybody that gets outside of their house has to do grocery shopping, pays the bills at the end of the month, knows that their personal rate of inflation is greater than 2%.
The third step in this process is you get a rise in accounting profits of companies that are closest to the final stages of consumption � for example, retailers. And this rise in profits is somewhat artificial in the sense that you get this large jump in the price of goods.
Step 4 is you see a drop in real wages. One of the comments that have been made in this whole economic recovery is that wages have stagnated. People are falling further behind, which to me is one reason why we’re seeing more people use home equity financing or credit card debt and go deeper into debt, because the real cost of goods and services are rising at a faster rate than their personal wages.
Step 5 an escalation or increase in the loan rate of interest as people begin to see higher prices, they see higher inflation rates. Bond investors are people that lend money and want a higher rate of return to compensate for the higher rate of inflation. So that was step 5.
And then, step 6 is you begin to see profit losses in companies that are operating in a far distant stage of consumption, which leads us to a crisis and a recession. The best example I can give you is what’s going on in the manufacturing sector today, and especially in the automobile sector. [6:16]
JOHN: Well, is this boom bust cycle primarily part of capitalism per se, or is it part of Keynesian economics per se? In other words, could we exist without this boom bust cycle?
JIM: There would be fewer boom and bust cycles, they would be less frequent, less severe, if we operated on a true capitalistic system, and we had a currency that was backed by gold � in other words, real assets, real savings, a stable currency. But because we operate on a fiat currency system, a fractional reserve system, money continuously depreciates I don’t know if anybody is listening to the program has seen the graphs but since the creation of the Federal Reserve the dollar has lost 92% of its value. [7:04]
JOHN: Let’s see if we can do this again. I know we went through a synopsis here, take us back one time more through the process so we get this in our heads.
JIM: Let’s make this a little simpler. In essence, printing money creates artificial demand for goods, which are stimulated through low interest rates or cheap credit. Just go back to the recession of 2001, Greenspan slashed interest rates, brought them down from about 6% down to 1%. The lower interest rates created greater demand for goods and services � look what the automobile companies were doing, they were giving interest free loans. So this gives us what we call the boom. Unfortunately, it’s not a real boom, you get a lot of malinvestments, and usually there is some sector of the economy � it was tech stocks in the 90s when they were inflating, and it was real estate in this decade � where the boom takes place economically. In other words, it doesn’t take place across the whole economy in a healthy way, it usually gravitates to one particular sector.
The crisis is created essentially due to a lack of real savings or resources with which to complete investment projects. You start seeing companies expand; in the case of real estate we over built, so today we’re sitting on over 7 months of supply in real estate. And many of the projects started were too ambitious and were started on false economic signals � in other words, they were assuming these artificially low interest rates would remain permanent. Just think of all the people that got in to homes with adjustable rate mortgages, urged by Greenspan to do so, thinking that rates would remain low. Well, look what’s happening to these people. The crisis is usually brought to a head by excessive investment such as we are seeing in real estate, or going back to the over-expansion in the tech boom in technology products in the late 90s. Too many people get sucked in on the boom thinking it’s going to last forever. The crisis usually starts in the capital goods industry as we’re seeing in autos, computers, high tech industry, shipyards, or now in construction. [9:12]
JOHN: I think I understand this, but you know the Fed’s always posing itself as an inflation fighter, a recession fighter, like these are forces out there in the markets that are just naturally there and they’re the caped crusader trying to do that. And they claim they try to fight a recession by lowering interest rates and printing more money. But this just seems to start the cycle all over again.
JIM: You’re absolutely right. And indeed, as soon as the crisis arrives, whether it’s a recession or a bear market in equities the first thing the Fed begins is they start the process all over again. And what they really do is they never allow the economic patient to heal itself before they’re injecting more credit drugs into the patient. So instead of letting the patient or the economy go through a hangover, work it out, and get healthy again, they’re administering more credit drugs. [10:03]
JOHN: I would imagine thought that that is painful, and there must be some reasons why they don’t say, “Ok, it’s time for a blow-off, let’s just let everything heal itself.” Why not?
JIM: Plain and simple: politics. What politician wants a recession on their watch. We know what happens in a recession. The party in power gets thrown out, that’s why politicians always favor loose money. Low interest rates and plenty of pork barrel projects are new entitlements. In fact, there’s a story on Bloomberg today with Harry Reid, the new head of the Senate � or could be the new head of the Senate depending on what happens with the gentleman who just had the stroke � he passed some pork barrel projects at midnight even though he promised not to do it. And that’s just the nature of politicians � they believe that’s what gets them reelected. So as a consequence, our business cycles have been extended over the last 3 decades, as the Fed prints more money to postpone the day of reckoning. But we all know that day of reckoning eventually arrives. [11:03]
JOHN: It would seem that the real consequence of all this is that inflation keeps rising, real wages keep falling because they simply don’t keep up with the real rate of inflation, meaning people can buy less and less with what they’re earning, or they have to work harder and harder or take on two jobs and do more and more and more. Basically, at this stage the politicians and banking groups try to postpone the next recession.
JIM: The arrival of an economic recession can be postponed if additional loans unbacked by real savings are granted at an increasing rate. In other words, we have to run faster and faster on the credit tread-mill. What is very important here too, as they’re inflating through the credit system it can’t be anticipated by consumers and investors. So you have, for example today, commercial and industrial credit which is growing at 16 �% over the last 3 months; you have commercial bank credit growing at an annual rate of 9 �%; all the while, the money supply is growing at close to 10%.
And going back to the last recession, the Fed began raising interest rates in 1999, and in 1999 total new credit that was added to our system was $2 trillion; in 2000, total new credit dropped to only $1.6 trillion. But from the beginning of this century, 2001, all the way to the present, we’ve seen a massive expansion in credit: in the year 2001 total new credit was 2 trillion (I’m rounding these numbers off); 2002 it was stepped up to almost 2.2 trillion; 2003, 2.7 trillion; 2004, when the Fed began raising interest rates 2.8 trillion. Now we really begin to accelerate: 2005, total credit of almost 3.35 trillion; 2006, almost 4.4 trillion. So you can see here now, in order to keep us out of a recession they have to keep expanding the amount of credit in to the system at a much, much faster rate, which is what we’re doing. Total credit this year total borrowing as a country this year � will increase by almost 32%. [13:27]
JOHN: There comes a point where people just can’t keep up with this it seems to expand beyond what is sustainable. How long can this whole game be kept going? Obviously, there is a day of reckoning, there is a reality of economics here.
JIM: The reality is in a fiat currency system as we operate today globally not just here in the United States � you can postpone the inevitable for relatively long periods of time. However, there’s a cost to that: printing endless amounts of money and credit, we know in the end is doomed to failure. Once the inevitable recession hits it will be deeper and much more painful when it arrives because of all of the excesses. That’s what we saw for example in the recession of 1991. The recession of 2001 was a mild one by comparison, because if you take a look at the increase in the money supply, especially after the week of 9/11, you can see that the Fed literally went into overdrive in its money printing; and also, it got very aggressive in the way of slashed interest rates taking it from 6% down to 1% - the lowest interest rates we’ve seen in nearly half a century. [14:40]
JOHN: You know you mention that the scam is kept going by expanding credit not at a linear rate, it seems to be going up exponentially. Why does it have to go up at faster and faster rates?
JIM: You need to increase the rate of credit expansion. It rests on the fact that in each time period � in other words, every cycle � the rate must exceed the rise in the price of consumer goods, because you do have the price of consumer goods going up as a result of inflation. So a rise results from greater monetary demand for the goods, following the jump in the income of the original factors of production. So you’ve got to keep running and running and running, because if the price of a Twinkie goes from 50 cents to a dollar, you need more money to pay for that same Twinkie. So you’ve got to keep running faster, faster and faster. And the fact that they keep telling us that we have moderate inflation rates � look what a house costs in California today compared to what it cost 20 years ago; look at what the cost of an education at a regular university costs today, versus let’s say two decades ago; look at the cost of an automobile today. So what happens is the currency is constantly depreciating and as long as we see asset bubbles (a lot of that inflation goes into these bubbles), people don’t notice it as much; and then also we get distracted by such nonsensical ideas that real estate is not a bubble, that’s not inflation, tech stocks selling at 100 times earnings � that’s not inflation, that’s a bull market; and the core rate of inflation. [16:20]
JOHN: Well, that’s what always seems to be irksome in this whole thing is the fact that the Keynesians won’t take responsibility for what they’re causing. And they keep trying to explain it away under some different issue, but you would think sooner or later despite all of that everyone catches on to the fact that something is wrong. So then where does the finger pointing go from there?
JIM: Well, eventually, and I’ll get to that when I describe the possible scenarios in terms of how all this unfolds, but credit expansion must accelerate at a rate which does not permit investors or consumers to adequately predict it. They’re always trying to keep the public fooled because if they could they would begin to correctly anticipate rate increase and that would trigger the six steps I highlighted earlier that lead us to the bust. And indeed, if expectations of inflation spread, the price of consumer goods would rise faster than the price of the factors of production, and market interest rates would soar. That is why this started to happen between the first and second quarter, and that’s why in the month of May you saw the Fed’s Open Mouth Committee working over time in an effort to counter rising inflationary expectations, because the Fed knows that when expectations of inflation rise they could lose control over the battle. [17:44]
JOHN: It would also seem that part of the game is keeping everybody forced into the system as well, otherwise if people catch on and begin to protect themselves then that starts to destabilize things as well.
JIM: Sure. But you know, the day of reckoning eventually arrives and it can be triggered by either of 3 scenarios. The first is that the rate of credit expansion either slows down or stops due to credit fears experienced through bad loans and defaults by bankers. And think back to 1991 and the S&L crisis. I can remember when the real estate bust hit during that period of time � bankers were very tough, they wanted more money down, they wanted to see higher credit scores. You compare that today where just about anybody can get a loan � you have no doc loans, 100% loan to value � and so you don’t have that what I call bad experience yet in the credit cycles. So the bankers aren’t losing a lot of money yet. So that’s the first way that this can come to an end is the bad loans and the defaults start to rise at such a rate that bankers get more cautious, and you get a credit contraction.
The second way it unfolds is the rate of increase does not accelerate fast enough to prevent the six steps of the business cycle from unfolding. You reach a point for example where the price of consumer goods increases faster than the rate of increase in monetary income, or wages. The third scenario, which is I think more likely, is that investors and consumers become aware of the monetary scam, they no longer buy the core rate of inflation for example. They know there’s inflation because they’re dealing with it on a daily basis with their budgets. So what you begin to see is a flight towards real goods which takes place, along with an astronomical jump in the price of goods and services as money velocity starts to increase � people don’t want to hold onto cash, they start buying things now because they know the price is going up. You saw this take place in the United States in the 70s, but eventually this leads to an eventual collapse in the monetary system � an event that follows the hyperinflation process as the purchasing power of the currency is destroyed as investors and consumers start to use another type of money (gold or hard assets). This process has already begun. We have central banks like China diversifying out of their dollars and buying real assets from oil, iron ore, base metals, raw materials. [20:24]
JOHN: So in anticipation of this I would assume that’s why you’re bullish on �things’ as you like to call it, because that’s where things are going to move � away from paper.
JIM: Most definitely. We’re now in the process of transitioning from an era of paper assets to an era of tangible assets. [20:42]
JOHN: Well, I guess that means I should be buying more silver and gold, and at the same time bigger bottles of Maalox and a parachute to be used simultaneously.
It's Where You Borrow the Money That Counts
I try to pay my bills most always on time
I got to do it then or keep falling behind
I don’t like the feeling of being in debt
As I can’t make money out of nothing yet
But everyday a new offer comes in the mail
“Use these checks, buy something on sale
Take that vacation, go anywhere,”
Pretend that the money came from nothing but air
I want to make some money out of nothing but air
Like governments are doing most everywhere
Spend all I want, just not have a care
If I could make money out of nothing but air
How long will we keep on acting like fools
Letting our government abuse its own rules
No one there but Dr. Ron it seems
Putting an end to Fed Reserve and all of its schemes
Politicians, pundits on the TV tube
Talking about money like they’ve got no clue
Got to spend it here, must spend it there
They truly think that money comes from nothing but air
I want to make some money out of nothing but air
Like governments are doing most everywhere
Spend all I want, just not have a care
If I could make money out of nothing but air
I need some quick dollars to send to a friend
Who’s run into trouble, he’s at his wits end
I wish I could follow our government’s lead
And print up the money, whatever I need
I’d like to make some money out of nothing but air
Like governments are doing most everywhere
Oh wouldn’t it be cool if we just didn’t care
And we could make some money out of nothing but air
If we could make some money out of nothing but air
I want to make some money out of nothing but air
JOHN: The music of Steve Dore getting us back into the next segment of the program.
You know, you hear a lot of talk nowadays about the inverted yield curve and why that is the big hallmark of upcoming recessions. For our listeners, an inverted yield curve means short term interest rates are higher than long term interest rates. And we probably need at some point to tell why that’s important.
JIM: That used to be the case I would say before we moved to a global capital market, maybe 2 or 3 decades ago. Today, banks can borrow anywhere in the world in the flash of a second. So if interest rates are high here in the US and loan rates are lower (which reduces a bank’s profits), they can borrow money where interest rates are lower in order to maintain profit margins. [24:46]
JOHN: So why in the past then did an inverted yield curve lead to a recession?
JIM: Well, if you think about it, when short term rates are higher than long term rates, it effectively lowers a bank’s profit margins because banks make money by borrowing short term usually from depositors, and then they lend that money long term at higher rates of interest. I mean, that’s how they make their money: they pay low interest rates, and charge higher interest rates when they lend money. When you get an inverted yield curve you have just the opposite. What they have to pay for short term money is higher than what they can loan money out, so there’s no incentive to lend. And so typically, when banks no longer want to lend you get a credit contraction and you usually get a recession. So when they have to pay depositors a rate of interest that is higher or not much further than they can lend that money, there is less incentive to lend money. So if you’re a business and you’re trying to expand it may be more difficult for you. So you might get credit contraction which would eventually as I pointed out lead to a recession. [25:54]
JOHN: But as you say, they don’t have to borrow here. I mean they can go where the cost of money is cheaper, say Japan, or somewhere else.
JIM: Exactly, and that’s why the yield curve of any one country is less meaningful today where capital is mobile. It is the global yield curve that is more representative of world wide lending conditions. So when you’re analyzing the economy, or you’re analyzing investment markets, what this means is that when it comes to credit, if a bank can borrow more cheaply in one country, and lend more profitably in another, it will. So you have big banking institutions today like Bank of America, Citigroup, these are international banks, they operate globally and they can borrow today and lend in different markets simultaneously. And that is one reason why you’ve seen credit expansions extend much, much further as a result of today’s globalization. [26:53]
JOHN: Ok, so an inverted yield curve then, like we have now, given this new globalization here, is really not a reason to panic � at least with an inverted yield curve in the US per se.
JIM: No, exactly. There’s no reason to panic at this point because global yield curves are still positively sloped, and it’s more important that you look at what global rates and the global curve are doing than rather just for example than the United States. For example, a 10 year Treasury note in the US today is 4.6%, but if I go to Europe I can borrow money in Switzerland at 2.4%; and if I go to Asia, I can borrow money at 1.65% for example in Japan. So what you have here is if you’re shopping in terms of where your cost of money is you can go all over the globe today and get much, much lower rates than what we’ve got here. [27:47]
JOHN: So what are the interest rates looking like globally if that’s where the focus is? We know that the short term rates are higher here in the US, and that’s primarily as a result of the Fed’s rate hikes.
JIM: Well, let’s look at for example Japan. If we look at Japan today and you look at their yield curve, it’s still positively sloped. You’ll love this one � one year interest rates in Japan are at about a � %; if you take a look at if you want to borrow long term, a Japanese 10 year Treasury note is not much higher than 1 �%; and if you look going out 30 years on the Japanese bond it’s probably 2 �%. Compare that to the United States where a 10 year note is at 4.6%. And it’s not just here, you can go to other countries, for example, like Germany where their yield curve is still positively sloped. You can look at one year rates in Germany at 3.8%, and you look at the German yield curve it’s closer to 4% on the long end of the market. So this will just give you an example. But what is more important I believe as you look at these situations, is not just to look at one particular country and what that yield curve is, you go globally. Now, for example, you have an inverted yield curve in Canada right now, which means that the Canadian markets are less likely to perform as well as other markets. [29:16]
JOHN: What are the investment implications then of these inverted yield curves?
JIM: Well, in general, a flat or inverted yield curve in a country should be underweighted in an investment portfolio. Also, I think an inverted yield curve tends to favor growth stocks over value stocks, because debt becomes more expensive. But at the moment, as long as the global yield curve is upward shaped we don’t have to worry about a recession quite yet. [29:43]
Emails and Q-Calls
JOHN: Time to take some Q-Line calls as we always do every single week. Our Q-Line is active 24 hours a day, it is 1-800 794-6480. It is toll-free from the US and Canada. It does work from the entire world including the South Pole if you have phone service there, but you have to pay for it � the only place it’s toll-free is the US and Canada. We ask that you keep your questions short and also tell us your first name and where you’re from, and then what you’re enquiring about.
Hi, this is Jared from Long Beach, I had a question regarding your assessment, Jim, of the impact of peak oil and whether you sort of believe the coming economic collapse by Stephen Leeb, or you’re a bit more optimistic that we started late but we could still get into alternatives in time, or whether you subscribe to the more dramatic Kunstler long emergency scenario of a complete breakdown of our current society. And based on your assessment how are you preparing yourself? Also, another question was what do you feel the impact would be of 401K automatic drawdowns that would begin with the baby boomers starting in 2008?
JIM: Jared, I’m more in the camp that we’re heading into a crisis. If you listen to some of the interviews with Matt Simmons there are things that we should have been doing here in this country that we have not done. In the last energy crisis of the 70s, you had Europe concentrate and build their light rail system, they used taxes to keep the cost of gasoline up so people drove more economical cars; you had France converting to nuclear power, so today they have 75 to 80% of their power comes from nuclear, so they’re less dependent on foreign energy sources. We in the United States have been stuck on stupid; and we really got lucky with the coming onstream of the North Sea and the North Slopes in Alaska at the end of the 70s, and the price of oil coming down. We went back from driving economical cars, a good example is Mercedes quit making diesels in the United States, they went to gasoline because the cost of gasoline was so much cheaper; people eventually went to bigger cars � just take a look at a parking lot today in the US, take a look at the big trucks, the SUVs; and the other thing is while we went to bigger cars we’ve done nothing because of the environmental movement. I just watched a piece on the news the other day where there are farmers who lease out their land to the utility companies to put in wind towers, and the utility companies pay them $12,000 a year for each wind tower. And this one particular farmer � I forget what he had, maybe 100 wind turbines on his property � and residents in the local area were suing him because they don’t like the sight of them. You had Donald Trump trying to stop wind turbines being put up in Scotland in a resort; you had Ted Kennedy fighting wind turbines off Hyannis Port. So we say we’re for alternative energy, we don’t want fossil fuels, we’re stopping the drilling for oil whenever we can, we’ve stopped refineries from being built; it’s very difficult to get wind turbines put up; we’ve put down our grid system.
I’m not quite in the Kunstler camp. I think Kunstler is more and more to an extreme outcome. I still think that if put into a crisis we can rise up to the occasion and move quickly to start maybe remedying the situation. But unfortunately, I think it’s going to take a crisis. And what am I doing to prepare? I like Southern California because we live in a climate where I have very little need for air-conditioning or heating. Basically during the Summer I can open the windows at night, turn on some fans, and sleep comfortably � during the day as well. During the Winter, if you have good thermal pane windows, and good insulation through drapes around the windows � we don’t have to turn the heat on. So there’s less demand for that. I also subscribe to the concept of live, work and play where I can walk to my office from my house, I can literally walk to the shopping center that’s near my house. So I’m within 3 to 5 minutes (car distance) from shopping and my office, and so that’s one thing that we’re doing. Then we’re looking at putting solar power to power our house. And I’m looking to get a diesel vehicle, as soon as California allows diesel into this state. It’s very difficult to bring a diesel automobile right now but to me diesel engines are much more efficient where you can get 30 to 45 miles per gallon in a car, and even more if you get a lighter weight car. So these are some of the things that I’m doing.
In terms of the 401K drawdown I think you’re going to see a movement to larger cap stocks, dividend stocks, and bonds in the future as retirees need to draw on their 401K or IRA rollovers as they retire, but I believe interest rates would be heading higher because of the age of inflation and that could be a double whammy. In other words, people could be putting their money in bonds, getting a higher interest rate, only to find 1 or 2 years from now interest rates are much higher and the value of their bond portfolio has gone down considerably. So it’s going to be a tough time as we look in the years ahead. [35:22]
JOHN: Meir is listening in Massachusetts and she says she is an avid listener to your show:
I’m interested in hearing if it strikes you as odd with the reporting of huge profits and bonuses within the large brokerage firms this week, there has not been an announcement of the disbursing of any of this money to the shareholders. I notice that Goldman and Morgan Stanley have twice the profit margin of say Exxon and yet which industry would you say is more capital intensive. I don’t own these brokerage stocks but if I did I would feel like one of the sheeple who just got fleeced, or am I seeing this wrong?
JIM: No, you see it pretty accurately. Well said.
JOHN: Baa, Baa.
This is Jeremy from North Carolina, and I was wondering how to visualize a hyperinflationary depression with Moore’s law of consumer electronics and computers? Because as computers keep getting better and better and the price of the computer keeps getting lower and lower how does that fit with a hyperinflationary depression, and the fact that you can buy things a lot cheaper now than they were a couple of months ago?
JIM: When you take a look at manufactured goods, as you increase manufacturing in other words, more plants come on line � you increase production, your overhead costs get amortized over a larger number of widgets or units manufactured, so the price of those goods come down. That’s not deflation, that’s just productivity. But what you can’t do is if you take a look at the things that you need � basic necessities, commodities, that’s where you first see the real signs of inflation and also services. Take a look at what your medical fees are now or your insurance premiums your trips to the dentist, your trips to the doctor, what all these things are costing you today. The fact that a computer keeps coming down in price, eventually however I don’t think that’s going to be the case, because eventually even computer manufacturers are going to have to pay higher cost for raw materials. And as we get to peak oil this concept of globalized manufacturing where you buy raw materials from Brazil, ship them to South Korea, Taiwan; they’re manufactured into certain assembly parts then they’re shipped off to China, in China the box is put together then put on a boat and sent across the Pacific Ocean and the boat lands in Long Beach, the merchandise is taken off, put on a tractor rig and shipped across the country or put on rail � that works now, but when you start getting to $200 oil, or eventually $250 or $300 oil I think you’re going to see all of that backfire. [38:01]
JOHN: Mark says:
With the recent comments by the IMF and some central banks to sell gold to raise capital in order to meet budgetary shortfalls and which gold will probably not be sold, when do you think the IMF and central banks will revalue upwards their �current on the books’ value of gold ever. I realize that such a revaluation of gold by the IMF and central banks would be tantamount to admitting fraud through inflation of the world’s currency and credit supplies, but do they really have any other choice as currencies throughout the globe continue to weaken?
Eventually, they’re going to be forced to do that, but I think when that happens is when the whole present currency system � the dollar standard collapses, and we go to some kind of universal currency. It’ll be done in stages through currency blocs as you’re starting to see now with the euro; also in Asia you will see a global currency, probably anchored to the Chinese currency. And then hear in the US you will see the �amigo’ where you see the Canadian dollar, the US dollar and the Mexican peso merge as one currency. [39:04]
Other Voices: Bill Murphy, GATA
JIM: Well, one of the big stories this week capturing the financial headlines is Secretary of the Treasury Hank Paulson and Ben Bernanke to China. And to comment is Bill Murphy.
Bill, let’s assume Paulson and Bernanke are in China and they’re not doing sight-seeing. What’s going on here?
BILL MURPHY: Well, people talk about from a planet Wall Street standpoint, Mr. Bernanke and Paulson are going over there to read the riot act by the United States to China, and you know this better than I do Jim that they hold the real cards here having a trillion dollars just sitting there and can pretty much pull the plug on us any time they want in so many different ways. Both societies don’t want their things to go bad, but for us to go there to dictate terms to them right now, at least that’s what many Americans think it is, I’m sure it’s not the way behind the scenes. [40:55]
JIM: One of the things that we’re starting to see and China is kind of spearheading this, they have vast amounts of foreign currency reserves, primarily dollars, but Bill, what we’ve seen China do over the past couple of years, they’re in Latin America trying to buy base metals, they’re in Canada trying to buy oil, they did try to buy oil here from the US, so if you look at it from a subtle point of view they’re trading some of their paper dollars for tangible goods.
BILL: That’s a good point, and I think some of my old colleagues have been fooled thinking its hedge funds doing the buying. We’ve actually been reporting on that in Le Metropole Café for years that the Chinese have been quietly been building up their gold reserves � they’ve been doing it through intermediaries. As you say, they’ve been buying up base metals, and people think a lot of this is hedge funds, and it’s not � and they’re very clever and that’s how they disguise their buying. And yes � what they’re doing is they’re monetizing these metals. I also heard they’ve also been buying silver of late � I know that for a fact. [41:35]
JIM: When you see the gold market get hit, and you’ll hear these stories that are published out in the press � “well, central banks are selling” � you and I know it takes 2 parties to make a trade, so if central banks are selling, they never focus on the more appropriate question: “who’s buying?”
BILL: Another good point. Of course, we know the Indians are doing all sorts of buying, the Turkish imports are way up. It was reported yesterday the Iranian central bank was buying. And these people are just biding their time and they know what the gold cartel does � this group that’s manipulating the gold price at various times � they just sit back and wait, they wait for them to go into action and they get their buckets out and scoop it all up. [42:35]
JIM: One of the problems I think the Fed has is if you go back to the last recession in 2001, they raised interest rates in 1999 and 2000 � the result was we got a 3 year bear market in stocks; we got a recession in 2001. But in response to that recession the Fed was able to slash interest rates from 6% down to 1%. And I believe the way they were able to do that is gold was at 250 something back then, you had oil under $20 a barrel. Fast forward to today, you’ve gold over $600 an ounce, you have oil over 60, you have base metals (copper over $3) � I think they’re having a more difficult time, if the US economy weakens, for them to go in there and start slashing interest rates. So you almost have the feeling that they’re going to try to orchestrate something like they did in 2003, where they jiggered the CPI � they substituted owners’ equivalent rent for real estate prices, and used car prices for new car prices � and said, “oh my God, we’ve got deflation.”
BILL: Well, that’s the way it is and that’s the American way nowadays. It’s a real tragedy because at some point it’s building up things that are completely out of sync � disequilibriums � and it’s going to create great problems down the road. A nd the average American is going to get hit over the head and won’t know what hit them. It’ll just come out of nowhere. Between the credit problems and everything else that’s building � and there’s big problems and we can get in to it all day long � when it comes to housing, I just talked to my brother in Phoenix, it’s falling apart there; we know on the coasts it’s bad; and they’ve got a problem with the interest rates and the dollar and dealing with other countries, and it’s liable to come to a head early next year. [44:22]
JIM: And you also hear that we would like the Chinese to revalue their currency, and we say we’re for a strong dollar � that’s for public consumption. But they want to devalue the dollar. Well, Bill, if you take a look at our current account deficit (it’ll be almost $900 billion this year), if we devalue the dollar, you’re talking about inflation, because that means everything we import into this country we’re going to have to pay more for.
BILL: Exactly right. It’s between a rock and a hard place, and that’s probably what they’re doing over there with the Chinese, is to try to work out some sort of way, as you said, to engineer this thing and to do the best they can to make it so that it doesn’t get out of control. But I think they’re going to have a very difficult time. [45:03]
JIM: You and your folks, especially at GATA � which is the Gold Anti-Trust Action Committee � have done monumental work documenting central bank intervention in the gold market. We know they did it in the 60s, we know they’re doing it now. And yet if you were to talk to somebody on Wall Street, or talk to an investor and say, “you know, the government goes in and manipulates the financial markets,” they look at you like you just arrived from a spaceship. And yet we do know when the Fed plays around with interest rates, when they do coupon passes the things that they do for example, Goldman Sachs changing the weight of their commodity index in August � there are just obvious examples they’re doing this but most people believe that we have free markets here.
BILL: Yes they do, and it’s a huge misconception. And I have to say, there are no people in the world as naive as Americans, when it comes to specifically the gold market. And I mean the Bank for International Settlements has admitted they manipulate the gold price; the IMF has admitted the central banks are double counting their gold reserves which means there’s nowhere near the gold in the vaults of the central banks that they say they have. I mean a lot of this stuff is just public record, and it’s so obvious, it’s blatant, they attack after the fixes, they attack on Friday afternoons � it’s always the same people in the markets, you can go to [inaudible] bull market, you can on the Tokum [ph.], the Japanese Futures Market it has Goldman Sachs short 31,000 contracts in gold. I mean it never changes. It’s just so obvious. [46:43]
JIM: We get this question often enough, and that is, if central banks and governments are this big and powerful, they can just keep this thing going on forever. My response usually to those kinds of comments, well, if they could, gold would be back at 250, not at $600. So it’s like they’re fighting a losing battle to me, because gold is 600 today, it’s not 255.
BILL: You’ve got it nailed, that’s exactly right. And the reason for that is what GATA’s gone into all these years, and we hope to get some more clarification from the IMF next year: they’re running out of physical gold. There’s a 1500 tonne demand supply deficit � they’ve gone through an extra 10-15,000 tonnes of gold over the past half decade to decade, they have [inaudible] they can get here and there but because that deficit is eating into their supply what banks will part with their gold? They’re running out so they’re fighting a rearguard action. So they can bomb the market like they do today, and it starts to go right back up again. And at some point, they’re just going to hit the wall and we’re not going up 10 or $15, you’ll see this thing at 1300 bid. [47:50]
JIM: One thing that they’ve done that I thought was rather clever, we have these exchange traded ETFs for gold and silver � there’s something about that, I mean they’re great trading vehicles if you’re a hedge fund, you can trade in and out of them, but essentially what they’re doing is creating a paper asset.
BILL: Yes, and it’s a little complicated, and I’m not sure really how it’s actually working and playing out � supposedly it’s creating all this demand for physical gold, but I’m very suspicious about the whole thing just by the nature of the way it’s done and the people that are involved in it, and it’s not my cup of tea.
JIM: You know I’m suspicious in one sense that when you think of the amount of gold that backs the gold ETF, and the amount of silver that backs the silver ETF, if you were a government and you had to confiscate gold, as our government did in 1933 to expand the money supply and create some confidence in the currency, I don’t think that with the internet and the access to information that people have they’re going to tell people: “Hey Bill, you have gold coins, please turn them in at your local bank and we’ll give you some paper money.” I think they’re going to have a greater difficulty doing that in the future. What’s your take on that?
BILL: Same as yours Jim. First of all, the rest of the world would just laugh at us. They would say why would you even care? I mean that to me would be their opinion. They would say with the internet and the information what’s going on, “Why would you being doing that? It doesn’t make any sense. Who cares about gold?” [49:18]
JIM: And if the government were to confiscate gold, it seems to me the primary and easy target would be the gold held by the ETFs.
BILL: Well, that would be a shocker, and if they needed to slow things down for a while if they had a crisis I suppose this kind of thing could happen. But again, the rest of the world would say, “well, thank you very much, we’ll take it all.” Now, I think it would be a disaster for the dollar as time went by when people realize why would they even be doing that? First of all, most Americans can’t spell �gold’. They would look at them cross-eyed. [49:23]
JIM: Yes, I had to laugh, what was it, about a month ago or two months ago, while there were a lot of prominent stories coming out saying we’re in a commodity bubble which I thought was hilarious � gold was in a bubble, silver was in a bubble because of the price increase. But if you go back to the last bull market when gold started off at $35 an ounce � and I forget what silver was, 250, or somewhere around there � take a look at the heights both metals climbed before that bull market was over.
BILL: Yes, and this one’s got a long, long way to go as you know � at least we think so. I’m looking for 3 to $5,000 an ounce gold by the time this thing’s run its course. Who knows, it could be much higher but right now that’s just a telephone book number. But this is just beginning because there is no interest in the West right now for gold at all, because real estate markets have been good even though they’re a little weak right now, they’ve been fine, people aren’t nervous there, the stock market’s is at an all time high � everything is fine for planet Wall Street, and people in the West, in the United States can’t see any reason to own gold. And of course, the gold bull the past 5 years and silver has dwarfed anything the stock market has done for a long time, so the excitement is still to come. [51:03]
JIM: But you know, one thing that I think we need to warn our listeners, Bill, and of course you’ve been around these markets for a long time so you know how they work is that, yes, we’ve had a great movement in the price of gold, we’ve had a great movement in the price of silver � same thing with the precious metal equities but when we get these corrections and pull backs they tend to be more violent than let’s say what goes on in the stock market, because there’s nobody in there trying to prop up the gold market in the way that they’re trying to do the stock market.
BILL: Yes, that’s exactly right. And I have to laugh, the stock market never corrects it just goes up everyday, and we haven’t had a more than a 2% correction since 9/11 � the Plunge Protection Team just won’t allow it. And them, and the Working Group on Financial Markets and the whole group � the Exchange Stabilization Fund � they’re just in there at the right times working the markets over. I mean Goldman Sachs has stunned people with the billions and billions of dollars in profits they’re making, and a lot of this is from �quote � proprietary trading. Well, yeah, it’s not hard to make money when you’re an agency of the United States government, you know what the markets are going to do beforehand. [52:13]
JIM: You know it’s absolutely amazing though, and here is in my estimation how it works out for the average person, because we know that they’re trying to artificially hold down the price of gold, silver and also they move against the precious metal equities. But whenever they do that, all you have to do is look at a price chart of gold, a price chart of silver, a price chart of the AMEX Gold Index, or the Philadelphia Silver and Gold Index and it’s very clear the direction it’s been going the last 4 or 5 years. So, Bill, what would you tell somebody that gets a little skittish when these prices pull back? I think they’re great opportunities.
BILL: Well, I’m with you Jim. Of course, I’ve been in this thing for many years now and I’m not going to think about selling anything until I see the public starting to get involved. We’re not even close yet. So I have every penny in these shares in gold and silver as it is, but for people who are nervous, or who have extra funds or who are more diversified, absolutely, these pull backs are great opportunities. And a lot of these little junior stocks have done nothing now for years, they were actually priced higher when gold was priced at $300 lower. It’s a tremendous opportunity, it’s an historic one � it’s the opportunity of a lifetime, things could happen overnight. I mean things could go absolutely berserk and something that nobody expected, and that’s likely to happen at some point in the future. [53:36]
JIM: You know, one thing that strikes me � and you were around in the commodity pits in the last bull market � but this bull market is different in the sense that number one, we’re already running a gold and silver deficit � we can’t produce as much as there is demand, so we’re going off stock piles. That’s number one. Number two is the gold companies that exist today as a result of consolidation � the Newmont’s the Barrick’s, the Harmony’s, the Gold Field’s � they’re not replacing their reserves. If you go back to the 70s, Homestake and Placer, they might have produced � million ounces, 250,000 ounces, that was considered a major company. Today, I just don’t see how if you’re a company like Barrick, how you’re going to replace 8 million ounces of production this year with new gold discoveries. It’s harder to find this stuff and they’re simply not replacing it, which to me spells a lot of opportunity for a lot of the up and coming small junior producers and development companies.
BILL: Exactly right, mine supply is liable to go down the next 3 or 4 years. It’s a little over 2500 tonnes now, and that’s liable to go down for years to come, no matter what happens. It takes anywhere � I don’t know � from 5 to 6 years to 10 years to find gold, and fully permit the mine, and get into production and then you’ve got to fight the local people a lot of times to make sure the environmental stuff is right and so on. And then there’s country risk and so on. So it’s a lot of challenges. And the ones in the right place and doing the right things are just�their share prices are just going to go nuts. The gold market � this tiny little sector � and the general public, again, can’t even spell it yet. When they all try to get in to some of these stocks when it becomes fashionable � and right now it’s not on the radar screens � these things are going to go nuts. [55:26]
JIM: The thing that also strikes me too, and I think we could even see this is the government had stockpiles of silver, we weren’t running deficits in the gold market. What happens when the public comes into the market and all of a sudden John Q decides he wants to own bullion or bullion stocks � you know, good luck trying to get it.
BILL: Yeah, that was the point I just made, I couldn’t agree more. And even right now even though there’s veterans in these shares, they can’t wait to sell rallies and that’s why a lot of them haven’t gone any place. Some of the bigger names have. Just at a time when everybody wants to buy all of a sudden there will be nothing for sale. There’s going to be quantum leaps in the share prices. I mean there will be double and triples in a very short period of time. [56:14]
JIM: Bill, if you were looking out in the next 12 months and you were taking out your crystal ball, if we were talking this same time next year, where do you think the price of gold could be?
BILL: Well, short term I haven’t been too good in predicting some prices. I would have thought this year it would have been much, much higher than it is now. So I think at some point in this coming year it’s going to take off and we could see it easily over $1000 this year. [56:41]
JIM: You know, it’s interesting because Bank Credit Analysts did a study of oil prices, gold prices and they were looking at in the next couple of years the price of gold crossing over $1000 an ounce. So when you’ve got Bank Credit Analysts talking about similar type figures, you’ve got James Turk saying the same thing. So who knows? Maybe it’s a currency crisis that triggers it, financial event, or maybe the fact people wake up and don’t believe the core rate of inflation anymore.
BILL: Also, they’re just running out of available central bank gold to meet this demand. I can’t stress this enough. The fact that they just don’t have the supply anymore is important. Just a couple of months ago I think it was, the Bundesbank reported that central banks were going then looking to swap gold for some reason, they were looking specifically for gold swaps � you know it was an extraordinary statement. That means for some reason other central banks are going around looking to get quality gold at different deliverable prices for various reasons. We don’t have time to get into that, but it means that they’re starting to hit the bottom of the barrel. [57:48]
JIM: Well, perhaps one day they’ll wake up and get frightened and go in the opposite direction and start scrambling and start trying to buy it. Certainly you have to look at the Bank of England that dumped a good majority of its gold in the low 200s as, you know, what a dumb move that was.
BILL: Sure was, and just about as dumb was the Swiss selling half of their gold, I don’t know, some 1200 tonnes at not too much better of a price � and they’re supposed to be so smart financially. So they got conned into it for some reason and I’m not sure why it was done but I’m sure it was nefarious and you know it was a lousy trade and it’s going to get a lot worse as the price continues to go up. [58:23]
JIM: Well, Bill, as we close why don’t you tell our listeners about Le Metropole Café, your website, what they can find there, and how they could do so?
BILL: Thanks, it’s www.lemetropolecafe.com, and you can sign up for a 2 week free trial � it’s a lot about the gold market and other commentary and the smartest people I ever met in my life are around it. This will be our ninth year and it’s a lot of fun. [58:46]
JIM: Alright, Bill, as always it’s a pleasure to have you on the Financial Sense Newshour, all the best to you, happy holidays, and come back and talk to us again.
BILL: Thanks, Merry Christmas, Jim. [58:55]
Time to Shift to Large Cap Growth Stocks
JOHN: Well, much earlier in the year, James, shaken not stirred every time I say James I think of James Bond, you know that James you made a very strong case for large cap growth stocks. You did this on the May 20th show if you remember, and that was a time when the markets were correcting. The Fed’s Open Mouth Committee was scaring the markets as a matter of fact at that time, and you still proclaimed the Dow was going to go to a new record and it was time to get into those large cap growth stocks. Now, hand on the Bible, do you still believe that the day after the Dow has risen substantially I would remind you here you are under oath.
JIM: I solemnly swear, No, I still do. I think you should get new records in the Dow and the S&P next year along with a few financial mishaps. I’m still sticking to my theory, John, of first the gain then the pain, although they managed to delay the pain for a lot longer than I originally anticipated. For many Americans, although I think they are feeling the pain, I think that’s why people are going deeper into debt, their wages haven’t kept up with inflation; and we’re seeing a few signs of the pain in terms of what’s going on in the subprime lending market and also with industrial companies such as Ford. For the first time in Ford’s history, Ford is burning through $8 billion of cash a year, and their present cash balances they would run out of cash within the next 3 years. So they needed to go out into the bond markets and raise about $18 billion, and in order to get that $18 billion they had to pledge everything that Ford owned. For the first time in its 103 year history as a company, it had to pledge its factories, its equipment and Ford Motor Credit as collateral to get that $18 billion. And so all they’re doing now in my opinion is buying some time. [1:01:12]
JOHN: Ok, why then the large cap growth stocks?
JIM: First of all, when an economy begins to slow down, as ours is doing now, when interest rates rise, growth companies tend to do better than what I call value companies and small cap companies. Growth companies can raise their capital through the issuance of stock versus let’s say smaller cap companies, or value companies which tend to use more debt. When the yield curve flattens or inverts as it is now here, there is less of an incentive for banks to lend because their margins get skinnier; and they may be more risk adverse to lend to a company with a lot of debt. In contrast to growth companies, who can raise capital usually through stock issuance, if you think about equity you have to think in terms of lets say earnings yield, which gets a little complicated, but it’s the reciprocal of the PE ratio. It means what are you earning on that stock. So if you have a growth company that’s selling at 20 to 25 times earnings that equates to an earnings yield of 4 to 5%. Raising capital at 4 and 5% is certainly cheaper than what a company would have to pay through the issuance of debt. [1:02:26]
JOHN: What about the issue of an economic slowdown, how does that impact growth companies versus value companies?
JIM: Large cap growth companies � the kind I’m talking about � are usually international companies. Many of these companies get a good portion of their sales overseas where economic growth rates, for example, in the developing world are much higher than what’s going on in the West. They aren’t as dependent on the domestic economy as let’s say a small cap or certain categories of value company. Another advantage is that as the dollar falls they can get an extra boost in their earnings through currency appreciation � that isn’t available to a domestic small cap company. The currency appreciation provides an extra earnings kick. And if we think back, John, we saw a lot of this with large cap stocks between 2001 and 2003, when the dollar lost about 30% of its value. [1:03:22]
JOHN: It seems size would be more important too as the economy slows, especially if their business is diverse and global.
JIM: That is one aspect of large cap growth stocks today. Another redeeming feature right now is that they are still relatively cheap. Now, in a world where we have central bankers inflating it’s pretty hard to find anything that is dirt cheap anymore outside of the energy sector which in my opinion remains a screaming bargain to this day. However, outside of energy, the large cap sector remains underowned and underappreciated. These are the same companies that everyone wanted to own had to own in the 90s. Today, they’ve been largely ignored by investors, and eventually I think you’re going to see a reversion to the mean: just as they have underperformed the major indices small cap stocks over the last 5 years, I can’t help but believe that that situation is about to change. In fact, as we look at the major stock indices, for example, the Dow, the S&P 500, the NASDAQ in terms of performance, I think you’re already seeing that take place. So I believe that transition is taking place now where you have basically if we take a look: the Dow is up over 16% this year, the S&P up over 14, and the NASDAQ is up over 11. [1:04:43]
JOHN: Well, I know you look at companies in terms of what do I pay in terms of their earnings present and future.
JIM: If you look at what goes on in Wall Street, if you’re looking at some guy who’s a Harvard MBA, or if you’ve got your CFA, what analysts try to do on Wall Street is come up with what you call intrinsic value of a company. In other words, if I’m going to buy a stock, I want to look at that stock as a business � what is the business worth. And then you’re going to try to determine the value of that business and then compare it to the current stock price and ask is it cheap, is it properly evaluated, or is it very expensive? And of course, what you’re really trying to find here is a good growth story that the markets are ignoring for whatever reason. And a good example right now that I would throw out there would be energy. People think that the energy cycle has peaked because the economy is weakening and that’s so myopic in the way that Wall Street thinks � they don’t think globally in how the price of energy is impacted by not only what goes on here (because we have had no demand destruction) but also what’s going on elsewhere in the world.
You know the amazing thing about this is analysts look at coming up with this intrinsic value � this is something that people like Warren Buffett do all the time, and that’s what he does very well. And intrinsic value is determining what are the earnings going to be over the next 5-10 years; what are the dividends going to be over the next 5-10 years � and then applying a discount to those earnings to try to arrive at a present value of the stock comparing it to where the stock is selling. And there are different ways of looking at companies, you have dividend discount models, you have residual income, you have earnings multiplier models � every CFA and analyst on the Street goes through these valuation methods trying to determine if a stock is cheap or expensive.
The problem, John as you have pointed out, is it has not worked in let’s say the last couple of years, instead investors have jumped into the momentum stocks, small cap companies since 2003 � companies that are losing money in fact. If you look at the great comeback in the stock market of 2003, most of the companies that did well that year were actually losing money. So the growth companies of the 90s have been ignored by investors, and if you’re analyzing those companies and trying to arrive at what the business was worth, those values have not been realized through the market performance in the price of the stock. So many of these stocks once again I use the word are relatively cheap. [1:07:16]
JOHN: You know some stock examples would help here.
JIM: We don’t like to give out recommendations but I’m just going to throw out a stock out as an example, and one that comes to mind is General Electric. GE’s revenues and earnings have grown by double digits over the last 8 quarters, yet the stock has gone virtually nowhere, except for as you and I are talking GE finally broke out. But yet the stock is one of the dogs of the Dow, it’ll probably be one of the dogs of the Dow next year because of its high dividend yield � and speaking of yield the company just raised their dividend by 12%, so it’s a great dividend grower. In fact, in addition to raising its dividend 12% here recently, over the last 5 years GE has raised its dividend at over 9 �%.
And the other thing too is GE is an international company today, they’re going to get about $30 billion in revenues from developing companies. Immelt in my opinion has done a good job of moving the company into some very promising growth areas, for example, they’re going to dominate renewable energy. When you think of renewable energy you don’t think of GE, but it dominates that area from wind turbines to solar to nuclear power plants, to efficient locomotives, to efficient jet engines. Another area that they dominate: energy efficiency; nanotechnology; they’re also big in water; and they’re also big in security � all great businesses in my opinion for this new century. [1:08:45]
JOHN: Given the economic background that you’ve talked about earlier, where will this ultimately lead us now?
JIM: I think we’re seeing central banks beginning with the Fed, in the Summer of 2004, raising interest rates � and now we’re at 5 �%, and things are starting to hurt: we’re seeing housing slowdown; we’re seeing many things in the economy start to slowdown; we’re seeing currencies outside the United States start to appreciate and that’s starting to hurt. You’re hearing for example central bank officials and government officials saying hey, there’s been enough appreciation of the euro;” you’re seeing the dollar � it’s begun a gradual decline but I don’t think, as many of the doomsters do, that we’re going to see a meltdown yet. We’re not there yet and I think that’s a couple of years off. But I also think as we’ve seen the Dow outperform the other major indices there’s a shift that’s taking place right now more into the defensive sectors and the large cap growth stocks. And in other words, if the economy is going to slow down the implications are that earnings will also slow down. Well, if earnings are going to slow down then where can I invest where I’m not going to be impacted as much by the earnings slowdown?
The other factor that I think is very important here is you’ve got central banks inflating. So they’re creating an ocean of money and as I’ve pointed out in the past when you create money and print it, there are only 2 forms of inflation. It can take place in the real economy with the rise in prices of goods and services, or in the financial economy, like the United States, where inflation can take place in asset bubbles whether it’s stocks in the 90s, real estate and bonds in this Century. But I think that is what is happening because when central banks create money and credit they can’t always control where that money goes. In previous programs this year, we’ve talked about how it takes almost $4 of debt to get $1 of GDP, and for every dollar of debt that goes into GDP, you get another dollar that goes into imports (which is why we’re running record trade deficits), and another couple of dollars that goes into the financial markets. So one of the reasons I’ve been bullish on the Dow this year and why I’ve predicted the Dow in the 12 to 13,000 level back in May, is all of that money creation that we’re seeing globally, when you create that money it has to go somewhere, it just doesn’t disappear or evaporate. [1:11:26]
JOHN: We hear a lot today about gloom and doom, but what are your reasons � especially, by the way, of the imminent collapse of the dollar, there were articles appearing this week in some of the publications. But what are your reasons for thinking that we’re really not going to see a dollar collapse, at least not right now?
JIM: Well, I think first of all, it’s not in the best interests of other countries to see the dollar collapse or the US economy collapse, because if we go down we take them with us. And the other thing is what I’m seeing globally is reflation everywhere � all central banks are inflating. They may be talking tough by raising interest rates and making it a little bit more expensive, but I’ll tell you, they’re cranking up the printing presses. To give you an example, you often hear me talk about the money supply growth in Europe, it’s over 10%; in the United States, it’s around 10%; and who knows, it maybe even higher. I’ve seen reconstructed measures of M3 and that they’re showing 10% growth rates right now. And you take a look, the money creation is starting to spill over into M2 here in the US. Japan’s money growth is 5%; Denmark is in the double digits. So if we look at what central banks are doing, they are inflating. And if necessary I believe they will intervene in the exchange markets to keep the dollar from an outright collapse. Who knows what this China trip is going to bring? It’s interesting to see that the Chinese yuan is assuming parity with the Hong Kong dollar, so we’re already seeing revaluation of the Chinese currency. And I also assume Helicopter Commander didn’t go to China with Paulson to look at the Great Wall. [1:12:52]
JOHN: Ya think?
JIM: Let’s do a little sightseeing around Christmas time�No, I think they’re up to something and the question is: what is it? Is it a dollar devaluation? All central banks are inflating, so is it a question of how to manage this without a major financial mishap? I don’t believe they can avoid one. However, if one occurs, you can bet on an ocean of money flooding into the system, and [when] that ocean hits the financial markets it’s going to go in my opinion into large cap growth stocks. [1:13:23]
JOHN: Assuming that we’re in that situation right now, where should we be directing our focus?
JIM: I would look at defensive issues, once again, businesses that are not as subject to the whims of the economy. One area that stands out are big cap growth stocks, healthcare is one � let’s face it, if you get sick or have to take a pill you’re not going to say to your doctor, “I don’t know if I’m going to renew the prescription, Bernanke and the Fed will be meeting next month, I’m going to hold off buying any medication.” No, you don’t do that. If you have to have an operation that needs to be done you know, you’re not going to say, “why don’t we wait until the FOMC meeting is over, and then we’ll go ahead and make that decision.”
Another area I like are consumer staples, things that people have to have: food, detergent, soap. I also think you’re going to see the big box retail stores do well, because as the middle class gets squeezed because of low wage growth because of rising consumer prices, and as income lags the rate of inflation, they’re going to have to make up for it somewhere, so they’re going to have to go and become better shoppers. In other words, just like my friend that I’ve talked about that got the 3% raise, and after taxes it was about 2%, where does he go with a 6 to 8% inflation rate? You’ve got to cut back and become a smarter shopper. So what we’re seeing is historically during periods of economic slowdown and recessions, or also pull backs in the economy, you see people start to tighten their budgets somewhat and you also see them going to more of the big box stores which they do very well.
And then another thing I believe are commodities. You hear this commodity glut � if you take a look at zinc stockpiles, they are the lowest that they’ve been in decades. And so we are far away from seeing a commodity bubble at this point. So commodities are another area I like. You also have to have food, you have to have energy, you have to have water. Those are the kinds of things that I think are going to do very well. [1:15:22]
JOHN: Let’s see if we can make this a little bit more practical and break it down for everybody. We want to look at what investors can do, I know you can’t make specific recommendations, but at least you can probably point people in the right areas � let’s make this a real hands-on type of thing.
JIM: Well, as I mentioned, looking at defensive, healthcare, consumer staples, big box retail, commodities, energy, base metals, things that people have to have. And John, you can do this in two ways, you can invest in individual stocks, and if you’re going to do that I would highly recommend that you for example Value Line which is available at most public libraries, so you can look and understand the business, the economics, take a look at the return on investment, cash flow profit margins, and also take a look at the trend, as well as what it’s looking like that they’re projecting in the future. Then maybe look at where the stock is selling today, so you can do your own investing in individual stocks. If you don’t like that, if you don’t want to go into individual stocks, if you’re not confident, you can look at the big blue chip growth funds, because that I believe is going to pick up in the future, we’re seeing it already reflected in the Dow, and that’s where I think money flows are going to go. So if you’re in mutual funds, look at the big cap growth funds. [1:16:35]
More Emails and Q-Calls
JOHN: time to go back to the Q-Line:
Hey Jim, this is Tim in North Carolina, I was wondering what type of investment would be the best return given higher crude oil prices that I see coming in the future. I already own shares in some US oil companies, and also some Canadian energy trusts but are there any investments that will give me the investor higher returns given the same increase in the price of oil? I love the show, and thanks.
JIM: I would add some additional oil companies or what I call national oil companies, because that’s who owns most of the oil. So I would look at some national oil companies that I would want to own, and then also I would add to that an oil service [company], because if you take a look at where we have to go to find oil today, a lot of the big oil companies are going to need that expertise and not only that, the national oil companies in these countries, and OPEC, are using these international oil service companies for their expertise to get more oil out of the ground. So definitely I would be adding oil service companies to your mix, along with national oil companies. [1:18:06]
JOHN: Well, speaking of this and investment in energy, if we look at the infrastructure here in this country, if we look at the power infrastructure, you’re having more in the Southwest than we’re having it in the Northwest I know, because we’re more hydroelectric, and it’s cheaper and it’s more in abundance, but California is not investing in its infrastructure. Back East and also even in California, we find the infrastructure of the highways and freeways are breaking down. The funny thing is if you noticed, every time you go to solicit a state benefit now whether it’s a driver’s license or you name it you’re paying taxes, you pay more. So the question is what are my taxes going for, if every time I go to do something I have to pay money and at the same time remember the highway taxes at the pump?
JOHN: The highways [have] chuck holes big enough to run semis through in some places. So you have to ask yourself, we’re paying more and more and more and getting less and less and less back. And we even hear concepts now when we talk about cutting taxes, politicians saying how that penalizes the government, or something like that, as if there’s an inveterate right they have to all of this money, and yet in reality the provision for us is far less.
JIM: One of the big investment themes is infrastructure (and that’s what we’re calling this segment here). And there are two things that are going to drive infrastructure. Number one, our energy infrastructure is decaying in this country, and yet politicians are constantly raising gasoline taxes. And now there’s a new proposal to tax even the oil companies, which is just dumb, it’s just stupid. And we’ve allowed our freeways to go into disrepair, we have not expanded them; we have allowed our rail system to go into disrepair in this country; our airports need to be expanded. Just take a look at some of the things that we have seen. You mention, John, the power-outs that we’ve had here in California this year with the heat wave that we got during the Summer; you also saw it in the break down in the Midwest last year; you saw it recently in the Midwest with storms; you’ve seen it with the hurricanes and the levee system. So government is using more of the money that it raises from taxes to pay for entitlements and for bureaucracy. And you’re right, less and less of the money that’s raised each year is being used to pay for and improve infrastructure. It’s like Ok, if we need infrastructure improvements, we need to assess another special tax to pay for that � well, what happened to all the taxes that were raised and levied before that?
But one of the big themes going forward is going to be infrastructure, because our infrastructure in this country is decaying, it’s in neglect. And that’s what you’re seeing in the Western world. On the other side, in the developing world, their economies are growing so they are building their infrastructure: China is building power plants, freeways, roads, telecommunication systems � all of the things that make a modern industrial society work today. They’re going to spend literally hundreds of billions of dollars on cleaning up their water system. So a lot of this infrastructure spending � whether it’s on communications, roads, railroads, bridges, tunnels, aviation, shipping, waste, recycling, the power grid � all of that is going to be one big investment theme. It’s been ignored here in the United States for almost 3 decades now, unlike the 50s and 60s and early part of the 70s, when we were building infrastructure in this country. We’ve gone away from that, we’ve spent very little money. You’ve heard Matt Simmons here on the program talk about the energy infrastructure of this country is very much in decay today. [1:22:12]
JOHN: It’s worked too well for too long here in this country. If you go to the supermarket, food always seems to be there magically; if you turn on the light switch, the power is usually there although that’s getting a little less frequent now giving some of the issues we’ve been talking about. And it’s really hard to bring that to the consciousness of people that this might be in trouble, that there might be a problem with this.
JIM: You know I heard a story from my brother-in-law. My brother-in-law owns his trucking rig, and he’s getting another one where he’s going to be hauling gasoline. And he was telling me a situation where there’s a pipeline that goes from El Paso to Tucson, and I’m not sure if they have a pipeline that goes then into Phoenix, or they truck the gas to Tucson. But it was either the Summer of 2005, where this pipeline broke, and they had gas lines in Phoenix because a good source of supply of gasoline was cut off. And they haven’t built the pipelines from El Paso to feed into other major metropolitan areas, because of environmentalism you just can’t build a pipeline today, just as it’s very difficult to put in wind towers. And so he’s got a new opportunity here to supply gasoline, because the metropolitan area of Phoenix is growing tremendously in terms of growth rates but that city needs to be supplied. He was telling me that the city of Phoenix has only a 7 day supply of gasoline.
And this is something that’s incredible when you think about the infrastructure in this country � we’re almost operating on just in time inventories and if any crisis erupts in the case of Phoenix a pipeline breaks between El Paso and Tucson; or for example something I experienced here in North San Diego county is we had an E. Coli breakout close to our neighborhood (and I can remember taking the month of August off, I had come up North,) and I had gone into a grocery store, and the supermarket shelves of water were completely wiped out because of this E. Coli outbreak. So you see it in traffic jams, you see it in power outages, you can see it sometimes in the supply of food, or water, when some kind of event breaks out, and this is just something that we have ignored for so long, our politicians have allowed all of this to go into disrepair because more of your tax money today goes for bureaucracy and entitlements than it does for supplying essential goods, and maintaining the infrastructure of this country. [1:25:00]
JOHN: I’m wondering how long the entitlement thing is going to fly as the middle class continues to get squeezed. Do you think they’re going to put up with this, at some point they’re basically saying I’m shucking out all this money and I’m getting nothing back for it, and you see other groups of people who are collecting on the entitlements � I don’t think this is going to fly forever.
JIM: I think you’re going to have, if they keep raising taxes in order to pay for it, there are a couple of proposals out there, and keep your eyes on this one, there’s one to lift the caps on Social Security earnings � right now, as everybody knows, you pay Social Security taxes up to a certain level, I think it is like 95 or 96,000 � I forget what the number is � and that figure goes up each year. Then after you reach that level you pay Medicare taxes on all your earned income, there is no cap. Clinton lifted the cap with his 93 tax increases. Now what they’re talking about is lifting the cap on Social Security taxes, so you would pay Social Security and Medicare tax on all of your earned income. So in effect, we would go to 50 and 60% tax rates as a result � that’s something to keep your eyes out for.
And another one is just as we are consuming more and more energy, as the economy grows, as we drive bigger vehicles that consume more gasoline with less gas mileage, and as we import more and more of our energy from overseas sources, we are importing right now over 60% of our raw oil and natural gas needs, and then you add another 10% on that that we’re importing in finished petroleum products, whether it’s gasoline fuel, jet fuel, or diesel fuel, because we don’t have enough refineries. We haven’t built a refinery here � about the only thing you can do is (though it may take many, many years) they’re allowing existing refineries to maybe expand, but in terms of going out somewhere and building a new refinery � good luck. They’ve been trying to do that in Arizona and elsewhere for well over a decade, it’s just not going to happen.
So all of this is going to catch up with us, and when it does there’s going to be hell to pay for it, because there’s going to be a severe economic contraction as a result of it. When you start having more power outs, and as the power and energy system in this country comes under increasing strains from not only increased use, larger population, more cars on the road, larger economic growth. You know something is going to give here and when that happens there’s going to be an effort that is going to have to focus because people will get tired. And until you become inconvenienced often enough that’s what it takes to wake up Americans and voters from their slumber. Much in the same way as the gas lines in the 70s, and the high fuel costs of the 70s through higher prices prompted market action. Detroit was forced to make more fuel efficient cars because Americans were buying fuel efficient cars from overseas, so the great inroads of foreign car makers in the United States occurred in the last energy crisis. We also began to insulate our homes. There were all these steps that we took but then energy got cheap again for a two decade period, and so we’ve allowed everything to go into disrepair, and our habits went in the wrong direction. We traded in the fuel efficient car for a gas guzzling SUV. So a big, big theme here for investing is going to be infrastructure, and it’s a global phenomenon. Disrepair, for example in the United States, and expanding and building industrial societies in Asia, and to me that is a theme you can stick with for the next 10 years. [1:29:06]
JOHN: I think you and I were talking off the air about some of our impressions as we were watching this, some of the new proposals for the new Congress as a matter of fact, and the one thing that you just can’t help but observe is that all of the issues they think to be hot items for the new Congress, or even the that the previous Congress talked about, we’re not really dealing with where it is we’re really going. We have this bottleneck coming simply because of that day of reckoning you were talking about when all of a sudden everybody wakes up and realizes something is wrong. Ok, that’s nice, but now you’re in the crisis and you have nothing to deal with it. It’s going to take time to react and to get in place the structures that you need to deal with that, rather than putting them in place now to avert this crisis, they’re running in the exact opposite direction. You see this at State legislature levels, you also see it in Congress. Here was a comment this week, by the way, by Nancy Pelosi, at a time when we should be encouraging the development of new energies, encouraging new exploration to keep this down, here’s what we heard:
Democrats believe and we think we can get some Republican support for the idea, and it has passed this house, it came out of the Resources Committee, passed on the floor of the house, that when the oil reaches $40 a barrel, that oil companies should be paying a royalty to the Federal government. That again has passed the House two times. That is one of the initiatives that brings tens of billions of dollars to the Congress. So that is the most, shall we say, useful to us in terms of the money that it produces.
Now, Jim, in that far coming day which we know is far off in the distance when oil hits $40 a barrel (as if that was something in the future), this starts to penalize the oil companies and what happens when we see oil hitting $100 and so on and so forth. The concern here is revenue to the Federal government not growth to the economy. Do you hear that?
JIM: Sure. I mean what we ought to be doing is opening up drilling for oil, opening up drilling for natural gas because we live in a petroleum based society. And we’re going to be that way for the next couple of decades, because like I say, yes everybody is for alternative fuels, but just try to put up a wind turbine in your backyard, or go out and try to put one on your farm. Like I mentioned earlier there are lawsuits going on to try to stop this. So we don’t have alternatives, and then what you’re trying to do is tax the oil companies as a result of this. And what happens is oil companies will go elsewhere. There was a Congressional study that was done as a result of the windfall profits tax they leveled against oil companies, and they did this study at the end of the 80s, and what they found was production went down in the United States, our imports went up and we were worse off as a result of this. And everybody knows that taxes do not encourage anything � tax incentives do. And so here, what they’re talking about, is punishing the oil companies which should be considered national treasures. So we have no energy policy in this country and these are the things that we need to be focused on. [1:32:00]
JOHN: Well, one way or another they’re going to discover it, it’s just whether or not it’s in time and how much pain results from it.
JIM: You know it’s funny, I got in this business in the late 70s, and I started out as a Certified Financial Planner, and the two topics in financial planning when I got in this business were taxes and inflation. We had 70% tax rates, we had confiscatory estate tax rates. And it was really bad because what would happen is when one spouse would pass away, there would be estate taxes due, often leaving the surviving spouse creating a lot of hardships. A lot of the family farms that we had in this country were lost during that period � let’s say the husband passed away, the farm had to be sold to pay his estate taxes. And also, we were going through that period of double digit inflation rates. You know, here we are full circle again, another 26 or 27 years later, and people aren’t talking about taxes and inflation. You’ve got nonsense out there like we’ve got deflation, we have no inflation, we have the core rate of inflation. And you know doggone well, anybody that goes into a supermarket, sends their kids to school, or has to pay the bills is not experiencing�can you tell me anything in your life, John, where you’re paying the core rate? [1:33:55]
JOHN: Nothing. I do ask the people at the supermarket, “can I pay the core rate?” And it’s a great conversation starter to explain what’s happening. But the average American doesn’t understand it. You could even walk into your bank and ask the teller there � I’ve done this like I hold a $5 bill up and ask, “why does this have any value?” And it’s like, “huh?” And one time I tried to cash a Kennedy $5 Treasury bill, and the person wouldn’t take it, “it’s not real money.”
JIM: It’s amazing but we’ve been talking about inflation, the other one is taxation, and if you look at the tax rates today, the highest income tax rate is about 35%. Then on top of that you have to add a Medicare tax rate if you’re working as an employee that’s an additional 1.45%, if you’re self-employed it’s 2.9. Here in California, everybody pays and hits the maximum tax rate of 9.3%, and if you do real well you’re bumped up into the 10.3%. And now they’re talking about lifting the caps on Social Security, and there’s also a new plan by Ron Wyden out of Oregon to make a universal healthcare that would be paid for by employers and employees. In other words, they would slap another Social Security type tax, employees and employers would pay for this, and at a time when Americans are being taxed to death, they’re experiencing inflation, they’re having to go into debt because wages aren’t keeping up with inflation, they’re talking about raising even more taxes. [1:35:34]
JOHN: We have one State now, Massachusetts, which requires everybody to have health insurance. It’s the law now, and Maryland is looking at that, so the question is if you put that type of tax in there again, does that mean that self-employed people are going to be double taxed in that program as well?
JIM: That’s exactly where they’re going. They’re going to have some kind of special tax to take care of healthcare, and what we’re going to do is you’re going to see tax burdens go over 50 or 60%. In other words, the majority of what you earn will go to the government, it won’t go to you. And my sense of things, and especially as the government reneges on promises as they have on Social Security already, and other kinds of social programs especially going forward, because the government is basically bankrupt at this time. If you look at the annual government report that comes out each year when they account for government expenses on an accrual basis in other words, future contingent liabilities the government is basically bankrupt, because those future liabilities now make up over � I think it is over 54 or $55 trillion. There’s no way the government is going to be able to pay for that, so they’re going to have to renege on promises, they’re going to have to increase the rate of inflation, and they’re also going to increase the rate of taxation. [1:36:00]
JOHN: If you go back to the earlier topic though, the way off of this thing would be just to say, “Ok, guys, we’re bust, we’re responsible, this is a new system that we’re putting in place,” and go to something a little more responsible. That would solve the problem. The only reason we’re playing this game now is to avoid ultimate responsibility, isn’t that it?
JIM: That’s basically it, and there’s not one politician, Democratic or Republican; there’s not one governor, Democrat or Republican, or any President Democrat or Republican, that’s going to do anything different. We run an inflation oriented society where government increasingly is occupying a greater percentage of the economy. As it does, we will get stagflation: you will get higher taxes, higher inflation and a more stagnating economy. And about the only thing the central bank could do to remedy this is just to create asset bubbles which create further problems down the road, making the eventual day of reckoning worse than what it would have been had we just paid the piper and taken our medicine much earlier. [1:37:58]
JOHN: Yes, but politically now if you look at the struggle going on for the control of Congress, the struggle is so intense no party can afford on either side to yield any point. So that’s not going to happen.
JIM: No, what politician is going to run for office and tell you they’re going to raise your taxes and cut your benefits. What you usually hear is they’re going to raise your benefits but they’re going to tax somebody else to pay for them, or they’re just basically going to pay for it with a bond issue, which is going to indenture a future generation with debt. So this is the route that we’re going, and we know ultimately that this system will not hold up. And so eventually, that day of reckoning is coming but they’re going to try and postpone it, as we talked about earlier, in this segment of the program, through inflating it. And unfortunately, it’s not going to turn out. [1:38:55]
JOHN: But you know I like the way you put it Jim, I was reading one of your pieces again: there will come a day unlike any other day, on which you will wake up, and just like on 9/11 flip on the tube, and there will be chaos everywhere. And the President will take to the airwaves to assure us that financially we’re just as strong as we’ve ever been. You can see this one coming, do you know that?
JIM: Yeah, and that day will come. But the reason that they can get away with postponing it today is all central banks are inflating, so it’s just a matter of which currency is debasing itself at a faster speed, and that’s what investors play the markets for. Well, I think I’ll be in the euro because they’re inflating at a slower pace than we are, or I may be in the Chinese yuan, or I may be in the Japanese yen it doesn’t matter, they’re all inflating, and as a result that’s why gold is where it is today. And the fact that they’re hammering gold as they are right now tells me that there is a dollar devaluation coming. And you can see this with the Japanese currency rising to parity with the Hong Kong dollar. They’ll probably just merge the two. [1:40:09]
JOHN: Well, Jim, that concludes our last Big Picture of the year boy, that does sound dramatic doesn’t it, when we do that? And what we’re going to do in the next couple of weeks here as we take a little time off we’ll still provide you a lot of material to listen to we’re going to examine a lot of the predictions that were made on this program by guests, Jim, and others and play clips that we think are pertinent, and see how well they actually played out as we roam through the year. We’ll have that and some other guest interviews that you’ll find interesting.
JIM: Well, in the meantime, on behalf of John Loeffler and myself, we’d like to thank you for tuning in to the Financial Sense Newshour. Until you and I talk again, we hope you have a pleasant weekend.