At the Edge of the Cliff

In my first posting on this blog-site – To Buy or Not to Buy (May 2012), I stated that I was expecting another 2008 global financial crisis type event which would lead to a collapse in financial markets. This would trigger a ‘flight to safety’ with Investment Funds ditching ‘risky’ assets and re-investing that money into US Treasury bonds, which would push up the value of the US dollar.

 

However I also stated that at that time, many financial markets were already oversold and I therefore anticipated a rally to occur before we entered the serious collapse.

 

Three months have now passed, and during this time many markets have indeed rallied, some by over 20%. This rally has been fuelled by three main elements.

 

Firstly there has been a lull in the bad news haemorrhaging out of the Eurozone, and with last weeks announcement by ECB president Mario Draghi of a new mechanism called Outright Monetary Transactions (OMT) designed to buy unlimited amounts of the bonds of crisis-hit Eurozone countries so helping to keep their interest rates down, allied to   this weeks positive ruling by the German Supreme Court on the legality of the EU’s 500bn euro bailout fund, it has allowed sentiment to improve and once again give hope that a long term solution has been found.

The bad news is that it hasn’t! This new scheme will only help their short term liquidity problems and does nothing to solve the real issues. Although we must give the EU authorities credit for their amazing ability to keep the plates spinning whilst doing absolutely nothing to solve the underlying issues. It really is politics at its very best.

 

Secondly, the US Federal Reserve has confirmed that the stimulus will continue with its recent announcement of more quantitative easing, or QE3. This has also reinforced investor’s belief that there will be a constant stream of cheap money to fuel the increase in asset prices and get us all out of jail.

This addiction to more and more stimulus to levitate prices whilst the underlying health of the financial system deteriorates seems strikingly similar to the downward spiral of a heroin addict, taking ever increasing amounts to achieve the same hit until their system can’t take anymore. Our financial system will likely go the same way.

 

Lastly and most importantly, prices rallied because they were very oversold. This may sound simplistic but it is at the core of how all asset prices move. Basically whilst all asset prices are in a trend (either up or down), they do not move in a straight line. They oscillate around the trend, with investors at times getting over optimistic and pushing prices up too high, and at other times getting too pessimistic and selling prices down too low, swinging like the pendulum on a clock from one extreme to the other.

In May we were at one end of that extreme and so a rally was pretty easy to predict, but where do we stand currently? Do we still have blue skies ahead or are the storm clouds gathering?

 

Well, there are a few things that are cause for concern:

 ·        The strength and duration of the move.

The chart below is of the S&P 500 Index (a broad-based index of US companies) and shows how the index has moved from 1998 to the present day.

 We can see that both the major peaks in 2000 and 2007 occurred around the mid 1500 level, and that this has become a zone of resistance (It’s important to realise though that this is an area of resistance not a distinct price level, and that therefore prices can push through this level or fail to reach it entirely before ‘topping out’).

 

 

 

We also know from looking at previous cyclical bull market rallies (these are shorter term ‘multi-month’ rallies within a longer term ‘multi-year’ bear market) that on average they run for almost three years before topping out, whereafter the bear market resumes.

We are currently at 36 months and counting so this rally is wearing very thin.

 ·         The extent to which technical analysis indicators are overbought or oversold.

I use a number of technical indicators to help me gauge things such as investor sentiment, momentum and relative strength. Almost all of them are either already into overbought territory or well on their way, meaning that conditions are ripe for a correction, and although there is nothing to stop these indicators becoming even more overbought in the short term, it does tell us that we are getting close to a peak.

 ·        Seasonal Factors

Many financial markets tend to be weaker from May to August, but the September/October timeframe is often the worst time of the year for stock markets.

 ·        Commitment of Traders (COT) data.

This information gives a breakdown of investors in the Traded Options market and classifies them according to certain categories - small speculator, large speculator or commercial, for our purposes we can think of the speculators as ‘mug punters’ and the commercials as ‘the professionals’.

What tends to happen is that as a rally matures and prices rise, more and more speculators get sucked in and join the bandwagon, buying traded options that profit if the price continues to rise (known as going ‘long’) - the more the price rises, the more bullish they become and the more options they want to buy. Meanwhile the professionals, knowing that the price is overextended (see the earlier pendulum analogy) and will shortly correct, are happy to keep on selling options to the speculators knowing that once the trend changes and prices fall, they will make money (known as going ‘short’).

 Therefore as the rally continues, the ‘mugs’ get longer and the ‘pros’ get shorter, and by monitoring this dynamic, and comparing these extremes with previous examples we get a useful indicator as to when a rally has run its course.

The chart below is of the current COT data for Silver, and shows the weekly change in the open positions of the speculators and commercials.

 

 

 As the price of silver has risen, the ‘mug punters’ (represented by the combined grey and yellow bars) have become increasingly bullish and have continued to add to their long positions. If we focus on the red bars we can see the corresponding increase in the ‘pros’ short position over the same period.

Previously when we have reached these kinds of extremes the rally has been near its end, and then when prices collapse the commercials clean up by buying back their ‘short’ positions for a profit whilst the speculators panic out of their ‘long’ positions at a loss. Once again losing their shirts, crawling away to lick their wounds until the next time.

It’s not called a suckers rally for nothing!

 

So when we look at the bigger picture there are a number of warning signs.

• The rally from the 2009 lows has already gone on longer than average.
• We are nearing an area of resistance where previous rallies have terminated. 
• Many technical indicators are in overbought territory suggesting a top is near.
• We are entering the most dangerous time of the year for stock markets.
• The professionals are getting very short in a number of markets including gold and silver, in anticipation of price falls.

 We are seeing increasingly linked financial markets, with investors selling out of US Treasury bonds, selling the US dollar, and putting this cash to work in stock, commodity and currency markets. All fuelled by a diet of endless stimulus.

Unfortunately when this kind of woolly, simplistic thinking takes root, it normally means that nobody is actually thinking at all, with a very predictable result.

 The markets may trend higher for a little longer whilst investors chase the rally, basking in the warm glow of cheap money. But the fat lady is warming up.

It should be quite a show.

 

Interest Rates: Where Are They Heading?

If you ask most people what they know about interest rates, they might just about be able to tell you what their current mortgage rate is. If you ask them about the ‘yield curve’ and where rates are likely heading, you will almost certainly get a blank stare and a swift change of subject!

The point being that most of us know virtually nothing about what interest rates are, why they move and where they might be going, and yet we are seemingly quite happy to take on large debts, either for a mortgage or business loan, with the view that as rates are currently low it’s a good time to borrow more and ‘she’ll be right’.

This attitude has prevailed in many places around the world, and because of the resulting debt that has been amassed, our debt servicing costs will become crippling should interest rates start to rise.

We will discuss what the future for rates holds in a moment, but firstly let’s look a bit closer at how interest rates are generated.

 In most Western societies the process is pretty similar in that the Central Bank sets the rate at which banks lend to each other overnight (In NZ this is known as the Official Cash Rate or ‘OCR’).

 Under normal circumstances this is the only rate over which the Central Bank has direct control. There are then a range of Government bills or bonds of various durations, ranging from one month to thirty years depending on the particular country.

These bonds pay a fixed dividend or ‘coupon’, but the price you buy or sell the bond at can move up or down and is decided by the marketplace, as a result of this relationship the interest rate of the bond moves inversely to the price of the bond.

 For example:

At Issue

 Price of Bond  $100    Coupon $10     Interest Rate  10%

Bond Price moves up                              Rate goes down

 Price of Bond  $125    Coupon  $10    Interest Rate  8%

Bond price moves down                         Rate goes up

 Price of Bond  $ 75      Coupon $10    Interest Rate  13.33%

It is worth noting therefore, that Central Banks the world over cannot control the yield curve, only the ‘overnight rate’, unless they directly intervene by buying bonds of longer duration, as many are now doing via Quantitative Easing.

In a ‘normal’ market, the interest rate increases as you move out along the ‘yield curve’, meaning that 10 year bonds will have a higher interest rate than 5 year bonds, which will in turn have a higher rate than 2 year bonds, etc.

This can be illustrated in the chart below of a stylized ‘Normal Yield Curve”

This intuitively makes sense. As a lender you would justifiably expect to earn more in interest the longer your money was tied up.

 However, there are numerous factors that can affect the yield curve, including – economic growth and inflation expectations, perceived investment risks, changes to taxation regimes, political uncertainty, comparisons to alternative investments, changes in the liquidity within the financial system, and as already mentioned direct Central Bank intervention, often making the reality anything but ‘normal’.

Interest Rates though are like most other things in that they follow a long term trend. So where in that trend do we currently stand?

Well, New Zealand is currently enjoying some of its lowest interest rates for decades. The same can be said for the majority of developed countries, as globally rates have been trending down for over thirty years, caused by a combination of low inflation, relatively high returns on investments and a seemingly inexhaustible supply of easy credit.

The chart below shows the US 30 year mortgage rate (an excellent proxy for global interest rates), and the extent and duration of the move is quite apparent.

We can see that although there have been periods of rising rates, sometimes lasting for a few years; the long-term trend has clearly been down.

If we now look at a longer term chart of the US Federal Funds Rate (the ‘overnight rate’) we can see that prior to the collapse from the highs of 1980, interest rates actually staged a thirty year rally!

So putting the information from these charts together, we can confirm that interest rates do move in predictable long –term cycles, with rallies and corrections along the way, and that with rates at their current generational lows and factoring in the number of years that they have been falling, it would appear that the downtrend in place since 1980 should shortly come to an end.

However, things may not be quite that simple.

Remember I said earlier that the period since the 80’s was driven by easy credit, good investment returns and low inflation? Well whilst that may have been the case in the early years, it slowly morphed into a low investment return, high inflation environment where more and more credit was used to paper over the cracks.

 As we now know, the collapse of this house of cards ultimately lead to the 2008 global financial crisis, and it is the actions taken by Central Banks around the world to try and stimulate growth that has pushed rates to these historic lows in the years since.

Unfortunately, once interest rates are down at these very low levels, the action of cutting them even further to stimulate the economy tends to have very little impact (the so called ‘pushing on a string’ effect).

And irrespective of low rates, the unwinding of the excessive debt burden will lead to numerous countries defaulting. There is no way to stop it.

So with these repercussions rolling on for the next few years, Central Banks will likely keep rates low for some considerable time, and that is precisely what I expect them to do.

But as we now know, they do not control the entire yield curve (at least not without creating other major problems – there is no free lunch!), and as we can see from what is unfolding in Europe with Greece, Spain, Portugal, Italy etc, even with low ‘overnight rates’ once the marketplace senses that a country is in trouble and might not repay it’s debts, its bonds are sold aggressively and interest rates rise dramatically compounding the problem and making default even more likely.

This is what we are currently witnessing. Like a giant queue of naughty schoolboys lined up to take their punishment, ranked in order of how bad they’ve been, with the Greek kid at the front. And once he’s had his six of the best, it’s the Spanish kids turn and so on.

So we in New Zealand may currently be basking in the warm glow of low interest rates, but as the sovereign debt crisis unfolds and builds, moving from Europe through Japan and finally the US, at some stage we will be number one in the queue, and as we have seen from the charts above, when the trend finally changes interest rates have a hell of a long way to climb.

So is now a good time to take on debt because of historic low interest rates?

Well, if you can weather a substantial rise in rates and still be ok, or if you intend on paying down the debt over the next 2 to 3 years then the answer may be yes. But if you are relying on rates staying where they currently are over the long term, the future will likely be very painful indeed.

Just ask the Greeks.

Gold: Why and How to own it

In my last post, 'Don't be a Rabbit in the Headlights' I stated the following:

'Turning to investments it becomes slightly easier. Basically the majority of things will do badly, including stock markets and property. Stock markets typically halve during these periods, and property, as I have already alluded to, is seriously overvalued.

The one ray of light is the precious metals. They will continue to act as a hedge against the global crisis, and the more the crisis unfolds the better they will do.'

 In this post I intend to firstly show you that the precious metals sector still has a long way to go before it peaks, and then look at the various ways you can gain exposure to it, depending on your individual appetite for risk.

Before we get started I want to point out that for simplicitys sake I will be talking mainly about gold. However, silver will also benefit and will loosely follow gold's moves although not exactly (gold tends to lead the PM's sector moves, whilst silver often lags initially and then catches up explosively).

Gold has had a tremendous move since the $255 low in 2001, reaching an all time high of $1918 in August of last year. At first glance this seems extreme and would suggest that the top has been set, however to help get a better understanding we need to look at both  what preceded this move, and how normal bull market cycles climax. Once we get this perspective we will be able to see whether what we have witnessed thus far tallies with what we should be seeing.

So, to help put the move from 2001 into perspective, what happened in the years prior?

The last cyclical gold bull market ran from January 1970 to January 1980,This was the most recent period of severe financial strain to occur since the Great Depression of the 1930's. During this time, gold rallied 2429% higher.

From this peak it then began a cyclical bear market, and proceeded to fall for the next 20 years down to the 2001 low of $255, a fall of 70% over the two decade period. During this  exact same period  stock markets, bond markets, housing and other asset prices were benefiting from the explosion of cheap credit and enjoyed some of their greatest rallies ever.

By contrast, our current gold bull market move is a more modest 752% to the August 2011 peak. So we can see that although it feels like we have had a large rally thus far, by historical standards we are barely off the starting blocks.

Next, I want to look at the form that a regular bull market takes.

Lets take a look at the chart below:

 It shows the price movement in the Nasdaq Composite Index ( US based index of Technology companies), from its bull market beginnings in 1980,  its peak in 2000 and its subsequent collapse.  A few things immediately  become  apparent when you look at the chart. Firstly, the speed at which prices increase accelerates as the bull market wears on, with the price increases becoming parabolic as we near the end point. And secondly, the transistions between phases 1,2 and 3 are seperated by sizable corrections, which at the time feel very much like the whole bull market rally is over.

This upward sloping curve, or parabola, is the typical shape and style of a fully-fledged bull market. It stays roughly the same irrrespective of whether the underlying investment is an index, commodity, stock, bond or anything else, and the reason for this is that it is a reflection of human nature and how we react to greed.  The nature of the actual investment itself is irrelevant, the common theme is the way in which greed manifests itself, which fortunately for us helps to make it predictable.

If we now look at a chart of the current bull market in gold, we can see that we are nowhere near the 'blow-off' top that has been witnessed in prior bull markets, in fact it looks much more likely we are at the correction seperating phase 2 from phase 3. Also, at the peak we should be expecting almost everybody to be invested in it, talking about it and unable to see an end to the rally (the most recent example of this being the property boom that peaked in 2007). This is clearly not the case as the overwhelming majority of people don't even consider gold an investment let alone actually own some.

 

Having looked at the reasons why I feel the PM's sector has a long way to go, let us now turn our attention to how you can invest in it.

There are a number of ways to gain exposure to the sector depending upon an individuals attitude to risk. Lets start at the safest end of the spectrum.

You can buy physical gold or silver coins( or bullion) from your National Mint. They will normally offer you a range of options, the absolute safest being to have them in your possession, in case of an armageddon type scenario, alternatively you can have the mint store the physical coins or bullion on your behalf, or lastly you can own unallocated bullion at the mint, which means that you are one of a pool of people that own an amount of bullion stored at the mint on your behalf, but you do not have the right to a specific piece of bullion i.e. you cannot rock up to the mint and ask to see your bullion, unlike the second option where you do have some specific coins or bullion that you can see.

I would advise everybody to have some exposure to physical gold or silver, between 5-10% of your net worth. The manner of your holding really comes down to your own comfort zone, with some people only happy with the metal in their hands and others a bit more relaxed.

Next, you can buy shares in the companies that mine the gold and silver. Historically, the mining shares tend to leverage the price movements of the underlying metal, over the lifetime of the bull market, however they can be extremely volatile and at times can substantially underperform. It is for this reason that unless you are someone that is relaxed about the volatility and doesn't check how your portfolio is doing every day, they are probably best avoided if you want to have a long, happy life. If you do invest in them I would recommend taking possesssion of the share certificates and not owning them through the nominee account of your broker, and exposing yourself should your broker default over the coming months and years (and many will).

Lastly, there are financial instruments called Exchange Traded Funds ( ETF's) that trade on Stock Exchanges all over the world. They have exploded in popularity over the last few years and they allow investors to gain exposure to all manner of investments that were historicaly quite hard to trade. As a consequence it is now quite easy to gain exposure to gold or silver through these instruments. However, the problem is that although the price of the ETF mirrors that of gold or silver, you do not have any direct ownership of the gold or silver. The ETF merely trades in line with it. Also you are exposed to the creditworthiness of whoever sponsors the ETF, so if they default you may lose your money.

I currently feel that these ETF's offer decent exposure to the sector for many people, however there will come a point in the cycle when they will become too risky and money should be redistributed into physical gold or silver.

There are other ways to gain exposure, but I believe they are unsuitable to mainstream investors.

To conclude, looking at both historical precedent and general bull market dynamics I believe we have a long way to run before this current precious metals bull market has run its course.

That being said, we are currently in a consolidation that I believe will take both gold and silver lower before we reach bottom. I think gold will likely reach $1300, but it is possible that it could go as low as 1150 before the correction is finally complete, as a result there is no need to rush in at the moment, simply organise yourself so that when the bottom is reached you can pull the trigger. As I have stated previously I expect to see gold at $5000 and silver at $100 an ounce over the next few years, but at the moment patience is the key.

If you do want to own some shares but are unsure as to which ones to go for, simply post a comment at kiwiblackers.blogspot.co.nz and I will add your email to my specific precious metals bulletin that goes out whenever there is something of note in the sector, and contains what I consider to be some of the better buys.

 

Don’t be a Rabbit in the Headlights

As we struggle to come to terms with the enormity of the impacts from the ongoing financial crisis, the most common reactions are to deny it, ignore it or just hope that something will come along and make it all better. Unfortunately, the cost of doing nothing will likely be very high indeed.

In the my last post, I outlined both the reasons behind our current situation and the likely outcome (http://kiwiblackers.blogspot.co.nz/ ‘What Lies Ahead’ ). So for those of you that would rather be proactive, and not stuck in the headlights here are some of the things that individuals and businesses can do to insulate themselves from the worst that may come.

The first step is to take a long hard look at your personal financial situation.

Let us start with potentially the biggest problem of all, how much debt do you have? If the answer is very little or none, great, you are already in a far better position than most. Unfortunately this is unlikely to be the case for many of us.

If this debt is related to a mortgage, how are you coping with the interest payments? Could you still cope with interest rates 3 to 4% higher than they are currently? If the answer is no then you are likely over-leveraged and may struggle over the next few years. .(There will likely come a time through this financial crisis when global interest rates will head much higher).

How much equity do you have in your home? If the answer is not much then you could also find yourselves in trouble when house prices drop – and yes, that’s ‘when’, not ‘if’ - I believe prices in new Zealand will drop at least 25% in real terms but they have the potential for a far more serious fall ( I intend to talk about the housing market in a future post).

In short, most people’s debt issues will be housing related and here are the three most obvious ways to resolve the situation in order of preference:

1.     If you own a property portfolio, consider selling enough to be able to reduce the leverage on your main residence. This will not only reduce your exposure to the property market in total, it will also increase the degree of financial pain you will be able to weather before your main property comes under threat.

2.     Without the buffer of a property portfolio you should consider downsizing to a smaller property. It will also have the effect of reducing your property exposure and increasing your overall financial resilience.

3.     If you have a sum of money available you could consider using it to pay down some of your mortgage to reduce your overall exposure.

4.     Lastly, consider selling your property and renting whilst the storm unfolds.

Having looked at the main cost part of people’s financial equation, let’s now look at the security of their income stream. Whether employer or employee, the same kind of questions will need to be asked to try and establish how both you, and the company you own or work for are likely to fare in the years ahead.

It is pretty clear to most that if the next few years play out as expected, there will be a surge in business closures, bankruptcies and job losses. Whilst this will not be pretty, it will not affect all of us equally. There will be many firms that struggle, a few that do ok and some that do spectacularly well, as is always the case during these periods.

It is worth noting that during previous periods such as this, it is the middle classes that get wiped out. This is because the poor have very little to start with and the seriously rich are ‘bomb-proof’(so what if their net worth goes from $10m to $5m, they are hardly on the bread line), so it’s largely the middle classes that have the debt to match their aspirations.

As a consequence, if your business is not positioned at either the absolute top end of the market place or at the absolute bottom, you will need to be extremely fleet footed - the middle ground can be a dangerous place.
Some of the big picture questions to consider are:

·         Is the business reliant on discretionary spending? People will have less and less money in their pocket as we move forward.

·         How profitable is the business currently? Is there room for the business to cope with a downturn?

·         How much is the business leveraged to the fortunes of other companies?

·         How indebted is the company? How will it cope with a substantial increase in interest rates?

·         Is the business tourist focused? There will likely be a severe drop-off in visitor numbers.

·         How wide spread is the company’s revenue stream? Will the failure of one supplier/customer put your company in jeopardy?

·         How reliant is it upon Central or Local Government funding. This will be progressively squeezed at the process wears on?

·         Foreign exchange rates will likely see huge volatility making life very hard for both importers and exporters. Although initially we should see a substantial weakening of the NZD against the USD, hedging policies for the majority of businesses will be very challenging.

There are many more questions one could ask, but if after assessing the long term potential for your employment, you realise that it looks rather precarious then start doing something about it sooner rather than later. Can you move to a more robust company in the same sector? Can you move into a business field that will do better than the one you are currently in? Can you tailor your finances so that your income is not essential, or at least if you were to lose your job it would not be as painful? There are few easy solutions, but forewarned is forearmed.

Lastly, let’s look at those people that have some savings or investments and see what their best course of action might be.

In New Zealand, the Retail Deposit Guarantee Scheme that was introduced during the depths of the 2008 crisis has now been wound down. It was brought in out of necessity because Australia had already done the same thing and if NZ had not followed suit there would have been a mass exodus of funds across the ditch.

The sole reason the schemes were rushed into being around the globe, was to restore investor confidence and prevent a ‘bank run’. Were a serious bank run to occur and the banking system collapse, neither the NZ Government nor many other Governments have the necessary financial muscle to actually guarantee the deposits in their banking systems, it would effectively bankrupt the country. The banking sector is simply too large.

As a consequence we have to be extremely careful where we put our money. In NZ a large portion of the banking sector is owned by Australian banks. If the parent banks in Australia come into financial distress they will need all the funds they can get their hands on, that includes the money that is currently deployed in NZ. Despite protestations, they will repatriate as much money as they can, and this has the potential to violently disrupt the NZ banking system.

Therefore, my advice is to consider the following:

·         Do not have large sums of money on deposit at the Australian owned banks.

·         As a general rule, bigger is better and therefore having an account at HSBC may be wise. I would also recommend RABOBANK, it was until recently one of the few AAA rated banks in the world and is still one of the safest.

·         For large sums of money, consider cutting the banks out of the equation completely and investing directly in short term treasury bills. There will be a time when this also becomes risky, but for the time being it is safe for NZ investors. Clearly in other parts of the world it is already high risk e.g. Greece, Spain, Italy etc.

·         There will be exceptions to the ‘bigger is better’ rule, unfortunately you will need to do your own homework as to the lending profile and leverage of each candidate.

·         Credit Unions offer an opportunity as they are only allowed to lend against their deposits, and so do not use leverage.

·         Try to keep some money available as a ‘float’ so that should the system dry up you are not left with nothing to tide you over.

Turning to investments it becomes slightly easier. Basically the majority of things will do badly, including stock markets and property. Stock markets typically halve during these periods, and property, as I have already alluded to, is seriously overvalued.

The one ray of light is the precious metals. They will continue to act as a hedge against the global crisis, and the more the crisis unfolds the better they will do.(I have mentioned in a previous post about my upside targets for gold and silver, and in a future post will elaborate on both the ways and the reasons for holding it).

As the precious metals are one of very few investments that will act as a hedge, you should consider holding between 5-10% of your net worth in them. This may seem extreme, but it is only in western culture that owning gold or silver as a store of value has died out. It is still the norm in the rest of the world, where they have seen currencies and governments come and go.

It may help to think of it in terms of house insurance. Nobody likes paying for it, but if the worst happens and your house burns down you will glad you had it!

In conclusion, it’s about shining the harsh light of reality on your personal circumstances and asking lots of what ifs, even if the answers are unpleasant. There are clearly many other things you can do to help yourself, but most of them will likely revolve around spending less, saving more and lowering your exposure to financial collapse. Once you have done what you can do, go about enjoying your friends and family..... the really important things in life.

i will leave you with a few quotes that say it more eloquently than I ever could.

Worrying is like a rocking chair, it gives you something to do, but it gets you nowhere. ~Glenn Turner

You can't wring your hands and roll up your sleeves at the same time. ~Pat Schroeder

and lastly,

If you have fear of some pain or suffering, you should examine whether there is anything you can do about it. If you can, there is no need to worry about it; if you cannot do anything, then there is also no need to worry. ~Dalai Lama


Hope this helps to point you in the right direction.



This post obviously has a New Zealand focus, but the same principles apply the world over. For readers in the UK I suggest looking at http://www.marketoracle.co.uk/Article31124.html entitled ‘Savers protect your deposits from Bankrupting Banks and Quantitative Inflation. This has some good advice that is particularly relevant to the UK.

What Lies Ahead?

In life we are surrounded by cycles of varying degrees. From the orbit of the planets to the pendulum of a clock and everything in between, almost everything has its own tempo and rhythm. Nothing is static.

Unfortunately, despite the cyclical nature of things touching every aspect of our lives, we have a strong predisposition to think in linear, straight-line terms. This displays itself in all manner of things from economists forecasting booms that will never end to real estate agents forecasting ever increasing house prices.

This extrapolation of what we have recently witnessed, projecting more of the same into the future is the single best reason why most experts are consistently useless at predicting recessions or depressions in the economy.

One of the earliest discoveries of economic cycle theory was made by the Russian economist Nikolai Kondratiev in 1925. He found that there was a general business cycle lasting between sixty to seventy years with three key phases being expansion, stagnation and recession. Unfortunately for Nikolai, Stalin did not like his conclusion and had him sent to a gulag for eight years before having him executed in 1938.

Since his death, Kondratiev’s theory has been refined, and numerous cycles of different durations have been discovered and added to the mix, however the basis of his theory remains the same. In simple terms it is a story of boom to bust.

In the early stages credit flows into the productive areas of the economy, leading to a huge amount of economic activity bringing growth and prosperity.

As the cycle wears on, this explosive growth results in the economy becoming saturated and stagnating, leading to a reduction of investment opportunities and a gradual lowering of credit standards.

Faced with this lack of opportunity, this ‘easy money’ starts to move away from productive industry and head towards other areas of the economy e.g. housing, stock markets etc, thus starting an ‘asset price bubble’ - the more these assets go up in price, the more money flows into them, which pushes them up even higher, which sucks in even more money etc etc.

Towards the end of the cycle, credit is expanding at an incredible rate and flowing solely into speculative assets; people are overcome with speculative fervour -nothing and nobody is going to convince them that the party is going to end! Debt levels expand to massive proportions and finally the inevitable happens…… markets crash and a financial crisis follows.

Once all the excesses have been squeezed out of the system by bankruptcy, default and inflation, and debt levels have returned to normal (think 1930’s depression), the economy is ready to start the cycle all over again.

So, you might ask, having weathered the financial crisis of 2008 are we ready to embark on a new cycle once again? The answer unfortunately is no.

After studying hundreds of debt bubbles, Reinhart and Rogoff (two economists that do know what they are talking about!) found that not only has excessive debt repeatedly led to financial crises in almost all countries over the last two centuries, but that these high debt levels take years to work off, and this deleveraging creates a prolonged slump whilst Governments, businesses and consumers rebuild their finances.

In other words, it is not just one short financial crisis and then off we go again, a short, sharp, shock is quickly forgotten. We seem to require pain over a prolonged period in order to engender behavioural change, and that is precisely what we get during the deleveraging process.

It is important though to understand that we do not face a period of unrelenting financial crisis, there will be periods where we experience cyclical recoveries similar to what we have had since 2009. Unfortunately these periods of recovery will feel more like mini-recessions than booms, and once they have run their course we will once again feel the effects of the deleveraging process as the next crisis hits.

And so although the 2008 crisis was the first, it will be followed over the next few months and years by credit crises in the Euro Zone, Japan and others until finally it comes home to roost, in the USA.

It would appear that we have at least another five years of the process before we can even consider an endgame, and the financial pressure will continue to build every time we get another crisis.

Anyone believing that we will quickly return to the ‘normal’ days of pre 2008 is sadly mistaken. However, better to be informed as to what we face than shove your head in the sand (or anywhere else that feels comfortable) and hope for the best.

If by this stage you are starting to feel depressed, don’t worry. There are courses of action to take to help protect yourself and your family, and to insulate yourselves from what is coming, and I will go into more detail on them in a future post.

To Buy or Not to Buy

The precious metals have been undergoing a correction since hitting their all-time highs in 2011. This is standard behaviour in long term ‘bull’ markets, where the price has a substantial rise followed by a period of consolidation, before commencing the next phase of the rally.

Silver started its correction a few months earlier than Gold’s, but both the metals have now been correcting for some time and are looking deeply oversold. The mining shares have been hit even harder with some brutal price movements and heavy volume, suggesting there has been a capitulation, where all the loose holders of stock get washed out in a flurry of selling, setting the stage for a powerful rally.

  Everything seems to be indicating that we have reached a major low point and should be buying, so should we dive in?

 Well unfortunately there is a rather large fly in the ointment, namely a pending 2008 style financial collapse, which will have major repercussions.

 When the financial crisis of 2008 arrived it did not just come out of thin air. It occurred as a result of the credit fuelled boom we had experienced for the preceding twenty-five plus years and was an entirely predictable event, despite what you may have heard in the media.

 The credit crisis was bad enough, however that event only signalled the start of a process that will eventually unwind the excesses of those prior years. This process normally takes the pattern of a series of cyclical economic collapses and recoveries, gradually squeezing the excess debt out of the system and returning asset valuations to normal.

The global financial crisis of 2008 signified the first of these collapses, the recovery we have seen since is now getting long in the tooth by historical standards and the next collapse will likely begin soon, if it hasn’t already started.

When this collapse starts in earnest it will likely trigger falls in global stock markets and a stampede to ‘safe-haven’ assets, namely US Treasury bonds, which will drive up the value of the US Dollar against its counterparts, all of which will initially put pressure on the precious metals and the mining shares.

I knew that we were facing a major correction in the precious metals sector and assumed it would coincide with the next collapse, but I believed that we would have another rally before we reached this point, intending to exit the sector during this period. I also believed that we would have another rally in global stock markets that would also help the precious metals sector.

 In short, the pieces suggesting we had reached the top just didn’t seem to fit together.

Unfortunately over the last couple of months, instead of staging a rally, global stock markets have gone lower, and the normal correction in the precious metals has morphed into a serious one, with the sector showing technical analysis readings not seen since the depths of the crisis in 2008. All this before the next collapse has even truly begun!

 It is the way the markets have reacted over the last couple of months that has now raised the probability of the collapse being just around the corner.

It is this imminent risk of collapse that is forcing me to hold fire on the precious metals at the moment.

In the short term I expect to see a rally in global stock markets, gold, silver and the mining shares as the conditions are ripe for a rebound, but I think this rally will most likely run out of steam and when the crisis starts to bite they will all succumb and go to new lows.

In conclusion, the precious metals realm is very oversold currently, but it is hard (though not impossible) to see them being able to mount a sustainable rally in the face of another 2008 type crisis. Those currently invested in gold and silver may want to sell some during the course of this coming rally in order to re-deploy their cash at the better entry levels that will likely present themselves over the next few months, or they may just choose to buckle up and enjoy the ride.

Be in no doubt, the fundamentals for the precious metals are amazingly bullish and the upside potential is huge. My expectation is that once the downdraft from another global crisis passes, the sector should not only recover quickly, but will also begin the longest and most powerful rally of its bull market to date. I fully expect to see gold over $5000 an ounce and silver over $100 an ounce, with the mining shares leveraging those gains.

This is the first of my comments on the financial markets. Over the coming weeks I intend to cover a range of financial subjects, both local and global, as well as elaborating on some of the themes discussed here.