Friday, March 2, 2012

What Happens Next?

We are constantly getting the question, "What happens next?" Unfortunately, most market participants are unable to objectively understand what is happening now. We have consistently tried to help our readers see that we do not possess a crystal ball. A persistent, rigorous, and ego-free quest for objectivity drives our work in markets. This is the key to profiting from what the masses are unable or unwilling to notice.

As we have detailed in previous posts, the privately owned US central bank has fully implemented a policy of privatizing profits and socializing losses. The privatization of profits exclusively benefits the Fed's owning shareholders, the primary dealers. The socialization of losses affects anyone using dollars as a means of saving or transacting business, i.e., you.

The following image depicts a battle which is currently raging in the public's mind. Ironically, only objectivists can see that a winner has already been declared. It will take the public some time to notice the outcome and this is often the case when you seek to drink upstream from the herd.
Market participation in bond funds is at record high levels. Savings accounts and certificates of deposits are stuffed with excess cash as investors fear deflating asset values. A basic understanding of economics would suggest that near 0% yields would curb interest in debt instruments and deposit products. People have chosen return of their capital over return on their capital.

So What's The Problem?

The problem is that we are not in a traditional market-driven deflation. A select few market participants, primary dealer banks, have been allowed excess liquidity via treasury churning as a means to repair their damaged balance sheets. Remember that the damage was caused by their manipulation of traditional market activity. While you are dealing with the hangover from the past excesses, they are having a Monday morning Bloody Mary party and you are not invited.


This is not a problem until excess liquidity begins to seep into the economy. As long as the public perceives liquidity to be scarce, there is no problem.

What to Watch

We are beginning to see the effects of this central bank behavior in markets. While the government uses Soviet-era tactics to assure the public there is no problem, astute market participants see otherwise. Remember that government inflation numbers do not include food, energy or anything that has risen in price.


With the average savings account returning less than 1% per annum, before taxes, savers are losing more than 7% on their money. We continue to wonder how they can be unaware of this reality but, so far, the Fed's mission has been accomplished. Once the herd is awakened to this, we urge you to pay attention in order to avoid being trampled as they rush towards speculative investments in a cloudy, panic-filled haze.

When bonds are sold at the margin, we expect sheer panic to ripple through the ranks of owners. Today's bond buyer is effectively last to the party and, as we know, most likely to get slaughtered. He likely has no idea that bonds trade on price not yield and can go down in value creating a loss for the owner. We have heard them say they don't care because holding to maturity is an option. Let's see if they are calmly holding that 2% treasury coupon 9 years from now.

The consequences related to a reduction in savings account balances is more dire. Banks have used excess deposits to repair their capital ratios and boost lending in what has been the best yield curve imaginable. Paying depositors 0.50% and being selective about loaning to only the best borrowers at 5-8% has been a business that only a gangster could dream of. Throughout this era, holders of bank stocks have been hanging on hoping for valuations to rebound while being totally unaware of increasing costs associated with banking. The Dodd Frank Consumer Protection act has increased the cost of a free checking account to over $400 per annum. Combine this with the worlds most tedious anti-terror documentation and operating a retail bank becomes expensive.

As soon as depositors begin to connect the dots discussed above, we expect severe tremors to be felt in the banking sector. At the start of this downturn, there were more than 8,000 banks in the US. We expect that number to shrink by at least 1,500. That leaves another roughly 1,100 as only 421 have failed since the beginning of 2008. Holders of bank stocks are totally unaware that the central bank is privately owned and will always act in the best interest of its shareholders, the primary dealers. Only a fool would expect otherwise.

Once banks have to compete for depositors the game changes. Being forced to pay competitive rates on savings products will end the yield curve advantage which they have only as a result of the massive levels of fear present in markets today. The costs associated with banking today will act as a death knell for smaller banks forcing them to merge or fold under the pressure of a weight they refuse to notice. Bankers are notorious for using the rear view mirror to predict the future. They do not see what is coming which would require looking through the windshield.

What To Do

We suggest you spend some time thinking about the concepts that we have discussed above. Notice the behavior of the public. Remove yourself from any attachment to a specific outcome you might desire. Try to objectively see the circumstances and catalysts present in the market today.

We suspect there will be a rush to speculative assets once the public wakes up. Volatile shares with promising upside are a likely home for "hurry up" capital being deployed by unskilled savers. Gold remains a core holding in our management strategy. Rarely do you see a product that rises 20% per annum in price while demand remains pegged at 100%. In this case, we suspect speculative mining shares will attract significant quantities of hot money.

You must make up your own mind as to the likely course this issue will follow. Read, study, learn, and question everything in your efforts to protect and grow your own balance sheet.




How Did We Get Here?

The title of this article could be used to illustrate the primary delineation between Austrian and Keynesian schools of economic thinking. Austrian proponents believe that any credit driven economic expansion must be followed by a natural period of contraction. Misallocated capital creates excesses in the system (malinvestments) that must be purged in order for the system to function properly. Keynesian proponents believe strongly that increasing liquidity during a contraction period will lessen the pain associated with natural processes. We hope to show you that the Austrians are right and the actions of the Keynesians controlling your banking system have consequences, the effects of which you will be borne by you.

The behaviors which caused our current condition trace back to 1998. Like much of the cancer which has taken over our economic system, the perpetrators originated from Solomon Brothers. A group of former "Solly" traders formed Long Term Capital Management (LTCM) in 1994. Ironically, there was nothing long term about their investment intentions. The firm used excessive leverage to exploit small differences in the net present value of sovereign fixed income obligations. Ultimately, a collapse of the Russian ruble caused the firm's demise. LTCM had been funded by powerful, connected interests in New York and around the world. When the firm collapsed suddenly, certain stakeholders felt they should not bear the full consequences of their investment decisions. A meeting of the privately owned Federal Reserve Bank of New York was summoned and a quasi bailout was arranged. The public was told that this action was essential to protect the stability of the entire financial system. In reality, a new era had begun. Connected New York firms could now use excessive leverage to maximize profits with the assurance that losses would be pushed onto the public.

Within 12 months, we were in the midst of a speculative bubble which concentrated capital in the burgeoning technology sector. By the first quarter of 2000, this bubble was exploding. Hot money flows had pushed equity valuations to levels possible only when excessive credit floods a system. After September 11th, the system was again flooded with excess credit. This time the hot money flooded into housing. Buyers with marginal credit were encouraged to speculate in illiquid housing markets with down payments as low as 0%. Connected banks had created this situation by providing the credit needed to fuel the boom. They garnered transaction fees from every part of the loan process. Once the loans were issued, they generated fee income for packaging the loans into large investment products. They profited from the sale of these products at inflated prices. Finally, knowing that the underlying credit quality was poor, they bought insurance against a loss in value of these products even though they did not own them.

When Lehman Brothers was frozen out of overnight credit markets in 2008, the over-leveraged system hit a wall. Banks balance sheets were badly damaged and a natural bankruptcy process was in order. Again, the privately held central bank pushed responsibility onto the public. We remain in a period of stagnation caused by the favorable treatment of connected banks at the expense of the citizenry.

We write this so that you may begin to understand the pattern of these events. Please research what we have discussed and learn the truth behind history for yourself. There is no conspiracy at work in the financial markets; this happens in plain sight. The conspiracy is in how the information is delivered to you. Their playbook involves convincing you that the actions were required to insure your safety.

Learning to think for yourself and make up your own mind could be what saves your balance sheet from the next round of privatizing profits and publicizing losses.

Wednesday, February 29, 2012

US Pension Liabilities

It is nearly impossible to locate a major media story documenting the problems facing the US pension system. Public and private funds alike are patently insolvent. What is more alarming is the public perception related to this condition. Take your own poll on the issue as we have done. Notice that you are brushed off as crazy for even asking the question, "Who is going to pick up this tab?" Polling participants feel confident that the government will take care of this. As always, we will attempt to properly communicate the facts so that you can apply logic and reason in predicting the likely outcome.

We have done our best to locate proper facts surrounding this issue and welcome reader submissions. The condition of state pension systems is especially alarming. A 2011 study by Bryan Leonard of State Budget Solutions found that using conventional private sector calculation methods, states faced an unfunded liability of $2.5 trillion. State and local governments have historically promised large future benefit packages to their workers.

Alabama faces an unfunded liability of roughly $10,000 for every man, woman and child in the state! How will they pay for that? JP Morgan already enslaved Birmingham with what may be the worlds most expensive water works project. The state has only so much to offer in the way of incentives to industry. Where will the revenue come from to meet these promises?


We are not picking on Alabama. The same problem exists in Yankee states. New Jersey made only 14% of the contribution suggested by actuaries this year. Where will the the remaining 86% come from?


Notice there is some key language in here which we will reference below. The funds have all reported liabilities based on their modeled return estimates. In the event that they exceed these returns, liabilities will be reduced. If the opposite occurs, liabilities will increase and further deepen the hole that they fail to acknowledge is already caving in around them.

States are not alone in their struggle. Private companies face similar issues. Mercer estimated that S&P 1500 company pensions were collectively underfunded by 25% at the end of 2011. They cite a yield-starved environment as the possible culprit. The privately owned US Federal Reserve has by decree set interest rates at 0% for the foreseeable future. How will these funds meet their 8-9% return objectives that have been used to estimate their liabilities?



How To Profit From This

As longtime readers will attest, our mission is to help you clearly see the facts and use your own ability to think in order to protect your balance sheet. We are staunchly objective and bound by a personal code that requires logic and reason be applied to every set of facts we encounter. We see a limited number of outcomes in our analysis of this particular situation.

  • Returns Exceed Expectations: This is the most desirable outcome by a long-shot. When returns exceed expectations the liabilities of the pension fund are drastically reduced. Surplus gains are allowed to count towards annual contributions reducing the cash obligations of the sponsor. Where will these returns come from? Towers Watson says that 37% of pension assets are deployed in the bond market where rates are in zero territory, far south of their 9% target return. The Dow Jones Industrial Average advanced 5.53% in 2011 again leaving a gap between desired return and actual performance. This puts a great deal of pressure on the 2% cash and 20% other holdings.



  • Government Assumes Liabilities: This is the expected outcome. US citizens believe that their government is a superhero which can defy the laws of economics, physics, and 6,000 years of behavioral human history. US government payments already account for more than 20% of incomes. That number has continued to grow while the nation finances its largess with sub-2% bond issuance. The US is already spending nearly $1.5 trillion more than it receives in annual tax revenue. The bond market has not raised any concern about this so maybe they will be able to raise that gap even higher in order to assume bankrupt pension plans?
  • A Cheaper Dollar Allows Plans To Meet Obligations: We feel this is the likely outcome. Some plans will be allowed to fail. Those of private companies outside the sphere of government influence are the key suspects. Also in jeopardy would be an insolvent state with political leadership differing from that of Washington. Remember, the playbook calls for a shock event to create the need for a public solution. If there is no need for a solution, there is no need for a modern politician. We feel that a continuing controlled devaluation of the dollar is what the leadership desires. They hope that this will increase returns in some sectors with the difference being made up by freshly printed excess currency. This currency will come from a bailout of the Pension Benefit Guarantee Corporation. This way the citizens get the nominal dollar amount promised while the real cost is reduced. Since government educated voters have been shielded from any monetary history lessons or the definition of "real" vs. "nominal", it should take them at least an election cycle to realize what has actually happened.

We genuinely believe that our assessment of the problem is accurate. Also, we feel that one of the three solutions outlined above will be utilized as an answer to the problem once it surfaces. As a fiduciary, our task is to shield capital from the fallout created by such events. In this case we would first seek assets that are not the liability of another party. Precious metals meet our criteria. When ongoing reckless currency creation is likely, we are compelled to position ourselves first in gold and to a lesser extent silver. Other options are available in the form of commonly defined hard assets. We would caution readers that assets fixed to one area carry risk. Also, hard assets that spoil or require a consumer buyer could be a problem.

If you stay aware and objective and think for yourself you will be able to shield wealth from the fallout these events will surely create.

How Government Names Laws

Some are disheartened by our assertion that any law passed by a collectivist government can be understood only by replacing the action word with its antonym. For example:
  • 2011 Food Safety Modernization Act. This law drastically reduced the competitive landscape in food production. Small farmers are unable to compete legally with agribusiness interests. Consumers are compelled to ingest genetically modified foods produced by a select few corporations in the name of supply chain safety.
  • 2011 National Defense Authorization Act. This cleverly named edict sailed through a late night signing ceremony while US citizens were fixated on Ryan Seacrest's Times Square ball drop. Ironically, the bill destroyed 250 years of human struggle in the name of liberty. It paved the way for indefinite detention of civilians in the name of fighting terrorism. Considering the implications of the law should it be remained the 2011 National Attack Authorization Act?
  • 2011 Dodd Frank Consumer Protection Act. Where do we begin? Consumers are no safer. It is nearly impossible to start a hedge fund highlighting an overall reduction in choice for the investor. You are breaking laws even uttering certain words in the finance business if you work outside of the NY banks.
  • The Patriot Act. This one is amazing. What is so patriotic about it? You have to prove that you are not a Jihad warrior to open a savings account that pays 0.50% in interest. We assume when a patriot wants to board an airliner he must be strip-searched by 75 uniformed, formerly unemployed government mules that now constitute the largest federal union.
This list could go on indefinitely but we are only trying to make one point to you the reader. Please, think for yourself. The next time the government proposes action to protect you, give some thought to the consequences of their proposed law. Remember, they live in a totally different reality. They don't share your health care system. They have their own private pension plan. They remain separated from you and are not subject to the laws that they write.

You have a God given ability to use logic and reason in decision making. Consider salvaging this before it is too late.