Friday, September 16, 2011

How Does The Machine Work?

People are always asking us, "What will happen next?"  This is part of their desperate search for safety in a non-linear, non-correlated financial world.  The reason we get this question has been covered at length.  People desire an unattainable certainty that they will be safe.  They will almost pay anything to believe this promise.  Unfortunately that is not how things work and certain losses await if this attitude persists.

In a fantastic Bloomberg interview Ray Dalio baffles A-Student, award winning, overpaid journalist Erik Schatzker as he literally gives away his secrets to success.  Ray says that everything is a machine and the key to his success is, "Understanding how the machine works."  He is a smart man and realizes that he can freely give this secret away because the audience is too inept to emulate his style.

Most people asking for direction are looking for a silver bullet.  The true path to profits is a journey and they are not willing to embark on such a quest.  At the risk of boring long-term readers we will again suggest the fundamental traits needed to make money in markets.

In 1993 Steven Landsburg wrote an amazing book titled The Armchair Economist: Economics & Everyday Life.  This text is available in used condition for as little as $2.50 a copy on  Landsburg breaks down how economics is only the study of people making choices based on conditions.  He posits, a sharp metal spike installed in the center of the car steering wheel would eliminate the need for seat belts.  Most readers think this is a stupid suggestion while Landsburg is trying to illustrate that the driver would be so focused on avoiding an accident that the roads would be safer.  Today we have such high safety standards that people are free to send text messages and focus on other distractions while the auto manufacturer provides safety. 

When the study of economics is taken seriously you begin to see it literally everywhere you turn.  It is driving behavior in all aspects of life.  Natural instincts and created incentives drive workers, managers, companies, governments and the direction of our entire society.  Dalio points out that people are baffled as each new detail of the European debt crisis unfolds.  Talking heads like Schatzker make their living by keeping people shocked at each detail while a simple, objective study of the situation would eliminate all surprise.  These countries are broke, there is no possible spin that can be applied.  They simply spent more money than they received in revenue and without the ability to print currency they are stuck.  So, there is a funding gap and who will fill it?  Someone has to purchase the debt required to continue funding these nations.  Go ahead and extrapolate this thought.  Once you take the derivative of this problem into consideration there should be no more confusion as to the nature of and outcome awaiting these debt issues.

This journey is yours and should be unique if you want to really learn how things work.  There are so many dislocated markets around us today that economic study can be practiced outside of universities.  Take for example the true money supply.  M1, M2 and M3 are metrics that today can not be accurately used in market study for several reasons.  The true money supply is a much more accurate measure of currency in the system as it includes:

  • The Currency Component of M1
  • Total Checkable Deposits
  • Savings Deposits
  • US Government Demand Deposits
  • Note Balances
  • Demand Deposits Due to Foreign Commercial Banks
  • Demand Deposits Due to Foreign Official Institutions
Here is a chart of the true money supply courtesy of The Mises Institute:
We know that the average US citizen is watching everything he owns decline in value while everything he buys is rising in price.  The true money supply metric shows us that recklessly created cash benefits only the first owner and has been creeping out into the system.  The average citizen has no ability to benefit from this windfall printing but is subject to its consequences.  Readers should be curious about what this means and how to allocate capital in light of it.  

During a time when the above mentioned challenges are faced and much of the world is bankrupt you should attempt to remove capital from situations that make it subject to the liabilities of others.  Precious metals held in physical form are one of the only choices that average people have if capital preservation is sought.  We concede to Warren Buffett that gold is an awful investment.  

Mr Buffett, we are not worried about investing we are only trying to survive the conditions that you and your friends have forced upon us.

Only you control the direction of your journey in markets.  The best course is to let go of all notions of how things "should" be and let objective thought lead you.  Ray Dalio developed a set of principals that guide him.  Most people are guided by what others think of them and then when they end up in a ditch covered in capital losses they look around for someone to blame.  Mr. Dalio is an independent thinker and a man of intellectual courage.  If we could conceive of two more respectful adjectives to describe him we would use them.  Do not be surprised by the continued success of a man who seeks to objectively trade what is.

Sunday, September 11, 2011

Silver Prices

Before we can give a proper update on the price of silver, two issues must be addressed.

First, if you are invested in a sector mired in a bear market you just cannot make money.  No matter how glossy the presentation or how popular the fund manager, gravity will win every time. As an example we will examine the common motive of the already-wealthy investor: "Not losing money". It is shocking how, time after time, this quest for certainty and safe harbor paradoxically yields the opposite results.

Our observation is this: Investors trade in their objectivity for perceived safety in the care of popular managers. A sharp dresser explaining yesterday's market can be tempting; he oozes certainty as he lays out what happened in history. But try and ask what he sees coming tomorrow.  Ask about the economic factors facing major demographic groups.  How about an opinion on the way capital flows will be affected by these groups as they respond to their newly-realized conditions?

The trick to making money in markets is attaining, if only for a split second, that aforementioned "total objectivity".  The market does not care about glossy presentations or the popularity of managers. This market is an adversary that must be taken seriously.  After all, it is the only enemy of which we are aware that at times has sent bright men jumping from tall buildings when they could not face defeat.

Once pure objectivity has been obtained in a state of true humility you will be in a position to see where capital is likely to flow.  The reason that this state must be obtained is because all other states are driven by the desire to be more secure, wealthier, safer or smarter.  Every time these desires drive a trade your risk of losing increases dramatically.

The second issue we need to cover is the difference between nominal and real prices.  We will keep this section short as this topic has been covered several times already on this site.  New readers are encouraged to use the search box at the top right of the screen to catch up.

Nominal prices are totally and completely irrelevant in making investment decisions.  We are exclusively concerned with real prices.  As we will explain, silver is a screaming buy right now and could be cheaper today than when we were discussing it at $9/oz.  Novice traders embrace total and complete ignorance when they make statements such as, "I will buy silver when it comes down in price a little, it is too high."  While it could come down in price the logic is flawed as a metric for making investment decisions.  These investors are headed for eventual losses; economic discussions in their company should be politely avoided.

Consider the following silver chart covering the past 18 months:
The rise to $50/oz represented an excessive spike and made a pullback likely. Notice that after briefly crossing $50 the price fell relentlessly for days.  The COMEX raised margin requirements 5 times in an effort to force liquidation of paper silver long positions.

When you purchase a futures contract to hold 5,000oz of silver only $21,600 in cash is required for the initial contract.  This provides roughly 9x leverage in that particular market.  If you have $21,600 in your account and the exchange raised the initial margin requirement to $25,000 per contract you have to either post $3,400 to your account or sell the contract.  Imagine if they do that 5 times in 8 days.  What effectively happens is all weak hands are forced from the market.

Here is a 5 month chart of silver:
Silver remains in a major long-term uptrend.  The price of this tracking stock could retreat to roughly $23/oz without disturbing the trend that is in place.  Within that trend we see a strong bullish pennant formation.  This occurs when a trading range develops and becomes tighter and tighter until it breaks either higher or lower into a new short term trend.  Silver is currently trying to break that pennant and at this time it appears to desire higher ground.

Remember our example of how the exchange raises margin requirements to manipulate the price of commodities.  Silver has begun to test its old highs with half of the leveraged removed from the trade.  As they continue tightening silver requirements consider that eventually they will achieve a 1:1 ratio with cash and we will effectively be dealing with a physical market.  

Silver mining stocks are perhaps even more compelling at this time.  Due to the byproducts found in silver mining some producers are operating with a negative cost of production per ounce.  We have covered how to buy metals so many times that you should know what to do.  You can also ask your highly compensated stock broker or wealth adviser what to do in the sector.  If he suffers from denial and continues to persuade you to consider bear market sectors try our search box at the top right of this page.