monday morning with bill

There has been an endless amount of chatter about the price of gold being too high (it’s not) and perhaps representing a bubble. It also seems that fair amounts of ink and windage have been wasted on worries about the gold trade being “too crowded.”

Why is gold so valuable?
In my daily column on my own Web site, on Sept. 17, I noted a remark by Dennis Gartman of The Gartman Letter that the gold market was “terribly, egregiously, preposterously, shockingly overpopulated.”

That day, gold closed at $1,014 an ounce. Here we are, about two months later, and gold is more than 10% higher.

In a bull market, worrying about an idea being too crowded with like-minded investors is not very productive. More likely than not, it will help to eliminate you from a winning position.

At some point, when the gold market is finally reaching a top, it will, in fact, be too crowded. But we’re almost nine years into this bull market in gold, and to me it seems that there are more people of the mind that “the trade” is too crowded than there are who say it isn’t.

We’ll know gold is overcrowded when . . .
For the long-gold trade to really become too crowded, certain events will need to occur:

Goldman Sachs (GS, news, msgs) will have had “bus tours” to a bunch of mines, like the tours it and other companies have arranged for different industries, particularly technology.

The public will have to be involved in a major way, and we’ll see ads on Bubblevision encouraging people to buy gold instead of prodding them to sell their jewelry, as is the case these days.

Banks will need to find a way to put money into gold — because no modern mania has ever ended without the banks finding a way to lose money in it.

We will most likely need to see a frenzy of mergers and acquisitions, and a leveraged buyout or two.

Last, BusinessWeek will have to put gold on the cover, telling us how it’s the wave of the future, or some variation of that theme.

I put this list together somewhat tongue-in-cheek, but over the past couple of decades, most of these events have occurred before a big mania has ended — be it energy in the late 1970s and early ’80s, stocks in the late 1990s or real estate in the middle of this decade.

So it seems to me that what’s crowded is not the long-gold trade but more likely the camp of folks who think it’s too crowded.

At the intersection of yellow dog and greenback, it’s worth noting that the tiny island of Mauritius became the third central bank to buy gold in the past month — specifically, 2 metric tons worth $71.7 million from the International Monetary Fund (following in the footsteps of India and Sri Lanka).

I don’t know what the fourth central bank will be, but I’m pretty sure there will be one.

Meanwhile, the Buttonwood column in last week’s Economist, “Paper promises, golden hordes,” cited the small quantity of gold that actually exists: “Two hundred metric tonnes of gold” — that’s what India bought — “would occupy a cube of a little more than two metres on a side; it would fit into a small bedroom.”

(For folks who might not know, all the gold that’s ever been found would fit into two Olympic-size swimming pools!)

The column noted the psychological sea change that appears to be taking place at the central-bank level: “For bullion bulls, the implication is clear: central banks no longer trust the creditworthiness of other governments. And if they have lost confidence, private investors should do the same.”

I think that pretty much sums up how the groupthink process gets started. Of course, that idea will have cut a wide swath through all levels of asset managers (witness my scenario above) before gold finally becomes too crowded and tops out.

Gold sky at morning, bonds take warning
The corollary of folks wanting to buy gold — i.e., having no faith in dollars and other colored paper — also has implications for the bond market. It’s what I have alluded to with my shorthand nickname “the funding crisis.”

That the Buttonwood column took this up for discussion is potentially an early sign that the concept of a funding crisis may now be going mainstream (at least sophisticatedly so):

“Developed-country governments have attempted to control bond yields through quantitative easing and to support stock markets through ultra-low interest rates. But they cannot support their currencies as well without risking problems in the bond and equity markets. Gold’s surge may indicate that investors fear the next stage of the crisis will occur in the foreign-exchange markets.”

That is a succinct warning of what I believe will likely be next year’s serious problem for the xera, where weakness is no longer described as just excess volatility but a genuine cause for concern.

Why is gold so valuable?
We’ll know that it’s time to start paying close attention to a potential funding crisis when the bond market trades lower in lock step with the dollar trading lower. That will be an indication that the foreign-exchange market is calling the tune — the implications being higher interest rates and, I would think, lower price-to-earnings ratios and, ultimately, a weaker economy.

Dollar weakness is so widespread lately that even the Icelandic króna and the Latvian lats have been rallying against it, which suggests to me that the belief in our green paper as the world’s reserve currency is being questioned seriously everywhere.


By Bill Fleckenstein
MSN Money
This week’s column is going to be a little different, as I’d like to discuss human nature and the paper we call money from a slightly different perspective.

How Nixon closed ‘the gold window’
I was recently thinking about what has transpired in this country in the past decade: first the equity bubble, then the real estate/credit bubble and the steady debasement of the dollar (where a trickle of trouble threatens to turn into a flood).

I have been struck by how few people seem to understand how all these events are related — in that, at the root, they each have the irresponsible printing of money as the cause. (The sociological and psychological phenomena that go with that — e.g., the regulators not doing their job — are just part of the process.)

Each problem led to the next, and one year ago the financial system was bailed out at the risk of the country ultimately enduring a funding crisis.

One fact that strikes me is how few people seem to have been able to protect themselves from the first two (even though they were so obvious) and how so few will be able to save themselves from this third, huge problem.

In my own little world, I wrote until I was blue in the face about the risks inherent to each of those bubbles — and others did, too — but still only a small subset of folks avoided calamity.

Similarly, I have droned on forever about the weakness in the dollar and the necessity for folks to protect themselves via precious metals or some other idea. (I don’t know what that idea is, or I would say, but there will turn out to have been other options.)

Let’s face it. Dollars — the things we call money — are simply pieces of green paper. They are just a state of mind. They have no intrinsic value and are just wampum. Thus, they’re not worth anything. Furthermore, all paper currencies historically have lost all of their value.

On the other hand, gold — which has been in an eight-year bull market but still receives far more derision than praise — has been money for literally thousands of years.

In fact, the green paper has lost 97% of its value compared with gold since President Richard Nixon closed “the gold window” in 1971. (He ended the promise that dollars could be exchanged for gold.) Yet people seem to be more terrified of owning gold than dollars.

Gold nail-biting
For the past month or so, as gold has traded around $1,000 an ounce, I have seen no euphoria — only a tremendous amount of angst on the part of gold holders who fear an imminent collapse in the price.

But the point of this column is to encourage people to think about what’s liable to happen to the green piece of paper I’ve nicknamed the “xera” (a combination of Xerox, zero and dollar).

Federal Reserve money printing in the past year — to create its own bailout from the problems it created, and to finance other government bailouts — is the functional equivalent of the government saying that you can take the Monopoly game out of the closet, grab all the colored pieces of paper, put three or four zeros on the end of each bill, and then go out and spend it.

Go directly to bailout
However, the way this game has been played, some folks got multiple sets of Monopoly money, some financial institutions got thousands of them and yet a lot of individuals got no Monopoly money. But the outcome is still the same: The value of the money in circulation has to be worth less once this turbocharged Monopoly money is introduced into the system. That means inflation.

Folks will ask me, “How can we have any inflation, given what’s going on today?” Well, we may not have inflation immediately. But it is not debatable what would happen to the purchasing power of your green pieces of paper when you think about the Monopoly example.

The likely outcome as we proceed down the road is liable to be more and more fear about what a dollar is actually worth (i.e., nothing). When Main Street psychology turns against the faith-based currency we call the dollar, it will be nearly impossible to get that genie back in the bottle. Of course, this is part and parcel of the funding crisis, though the dollar’s meltdown could start before all of this dawns on Main Street, as it appears already to be dawning on America’s creditors.

So, if you’re not in the habit of thinking about the dollar and the effect its depreciation is having (and will have) on you, consider this: Basically, you are the frog that’s slowly being boiled in water, and at some point you’re liable to face a similar demise, financially.

Hedge fund manager John Paulson (speaking at the recent Grant’s Interest Rate Observer conference in New York) succinctly summed up his views about how to protect himself:

“What I’m looking at is not where gold is going to be tomorrow, one week from now, one month from now, three months from now. What I’m looking at is where is gold going to be vis-à-vis the dollar one year from now, three years from now, five years from now. And I think, with a high probability at each of those points, gold will be higher than it is relative to the dollar today. That probability increases the further out you go. So when I look at what the risk is, the risk to me is far more staying in dollars than it is in gold at this point.”


From Bill Fleckenstein

The debate over health care has captured everyone’s attention, but it appears the next big government program that needs to be addressed will be Social Security. That’s the focus of the July 30 article “The next great bailout: Social Security” by Allan Sloan, Fortune’s senior editor at large.

History of Social Security
Those who’ve been paying attention have long known there is no money in the Social Security Trust Fund — it’s all been spent. Thus, former Vice President Al Gore’s famous assessment that Social Security receipts should be placed in a “lockbox” was actually correct.

Given that so few people really understand the Ponzi nature of the current Social Security financing scheme — created in 1983 by a commission chaired by none other than the world’s greatest serial blower of bubbles, Alan Greenspan — I decided to reprise Sloan’s article. (The Social Security problem is especially important because it likely will put additional pressure on the dollar and on bonds, and exacerbate the funding crisis down the road.)

The story begins: “In Washington these days, the only topics of discussion seem to be how many trillions to throw at health care and the recession, and whom on Wall Street to pillory next. But watch out. Lurking just below the surface is a bailout candidate that may soon emerge like the great white shark in ‘Jaws’: Social Security.

“Perhaps as early as this year, Social Security, at $680 billion the nation’s biggest social program, will be transformed from an operation that’s helped finance the rest of the government for 25 years into a cash drain that will need money from the Treasury. In other words, a bailout.”

As I’ve already noted, there is no money in the Social Security Trust Fund — just IOUs from the government to itself. What is liable to spark debate and grab headlines is that instead of producing its biggest surplus ever in 2009-10, the trust fund could start running deficits in the next year, primarily because the weak economy is generating less tax revenue.

That’s years earlier than expected. Social Security wasn’t supposed to go into the red until around 2015.

Past projections were for a cash-flow surplus of about $87 billion this year and $88 billion next year. But new projections show those figures may drop to around $18 billion or $19 billion, which could easily go negative. And once the red ink starts spilling (a temporary bounce into the black in the next couple of years notwithstanding), that deficit will grow for the next 20 or so years unless something is done to halt it.

In order to better illuminate what has transpired and how misleading government accounting is, I would like to use the example from Sloan’s article to explain what has happened: “The cash that Social Security has collected from my wife and me and our employers isn’t sitting at Social Security. It’s gone. Some went to pay benefits, some to fund the rest of the government. Since 1983, when it suffered a cash crisis, Social Security has been collecting more in taxes each year than it has paid out in benefits. It has used the excess to buy the Treasury securities that go into the trust fund, reducing the Treasury’s need to raise money from investors.”

In other words, the government spent it. Throughout all those years in the 1980s and 1990s, when folks worried about the budget deficit, it was reported to be lower than it would have been had the Social Security Trust Fund’s money not been going into government coffers, thereby reducing the size of the deficit. Also untenable is the projected worker-to-retiree ratio, which will jump from 30 Social Security recipients per 100 workers in 1990 to 46 per 100 in the next 20 years.

And Social Security funding isn’t the only time bomb. Sloan notes that “when it comes to problems, Medicare makes Social Security look like a walk in the park, even though at about $510 billion this year, it’s far smaller. Not only are Medicare’s financial woes much larger than Social Security’s, but they’re also much more complicated. . . . Medicare is more convoluted, because the health-care system is much more complex than Social Security. Which, when you think about it, involves only money.”

(I’ve discussed some of the health care proposals, by the way, in my daily column on my Web site; a subscription is required.)

Summing up, Sloan cautions: “Social Security may not make it onto the agenda until next year. But it’s going to show up sooner or later, and probably sooner, because the numbers are so bad that something’s got to be done.”

All of these future funding issues will come under scrutiny in the next couple of years as the budget deficit explodes and worries about how it will all be financed take center stage.

Turning to last week’s main event, the Federal Reserve’s Open Market Committee meeting, here’s what I wrote ahead of the release: “There is just too much pressure on the Fed (not the least of which is Bernanke’s view of the 1930s) for it to do anything that even remotely resembles tightening.”

The Fed did not contradict me, as it chose to continue pursuing the policies it had previously articulated. That must have put a smile on the face of Paul McCulley of Pimco, who recently stated in an interview on Bubblevision that he wanted the Fed to avoid raising interest rates too soon and that the economy needed to see more inflation.

That, ladies and gentlemen, coming from the country’s largest holder of bonds. In the old days, bondholders were thought to be inflation vigilantes. But as we can see from McCulley’s statements, they are now really just liquidity hogs.

As for the ramifications of all the money printing the feds are doing and the recent growth spurt in China, it’s worth passing along the conclusions reached by “Government Sachs” in a report headlined “Commodities in the Crosshairs” (not available online to the public). That report described the moves we’ve seen so far this year in commodity prices as “just the beginning” of a new bull market that “ultimately would likely be even more extreme” than what we saw in prior commodity rallies.

Goldman Sachs (GS, news, msgs) noted: “The reality is that the commodity problem is one of supply shortage due to years of under-investment. . . . This chronic problem has been exacerbated during the financial crisis by tight credit conditions and large price declines, which impact producers.”

Goldman says that when the global economy recovers, we’re likely to see severe price constraints and some wild action, just as we did in mid-2008.

I pass that along as food for thought, and it jibes with the view of a friend of mine that I find intriguing: that as crazy as commodity prices seemed to be last year, they could get even crazier, just as tech stocks’ wild ride from 1995 to 1998 paled in comparison to what occurred in 1999-2000. I’m not saying that’s going to happen, but given the amount of money printing that has gone on (and will go on), anything is possible.


From Bill Fleckenstein

Sometimes it is just amazing how wrong the market (and thus most professional investors) can be. It seems that an obvious outcome is not so obvious if its onset is delayed long enough.

One year ago, as I explained in my June 23 and June 30 columns, it appeared to me that the die had been cast for the economic disaster we’ve since experienced. Rereading those columns last week, it’s hard to believe the Dow Jones industrials ($INDU) were still flirting with 12,000 back then.

I bring this up because, as regular readers know, the winner in the inflation-versus-deflation battle seems clear to me (though the timing of that “victory” certainly isn’t). However, the battle continues to inspire much debate on Wall Street and in the financial news media. And I continue to get tons of questions in the Q&A section of my daily Web site.

I feel compelled to revisit the subject yet again, with a little help from my friend Jim Grant — who, in the latest issue of Grant’s Interest Rate Observer, makes important points that I find mandatory to pass along.

Not your father’s, mother’s . . .
Grant starts off by quoting the Bureau of Labor Statistics regarding the fact that May’s 1.3% drop in the Consumer Price Index was the largest decline since April 1950:

“It’s a funny deflation, though. Deflation, to us, is too much debt chasing too little income. One symptom of deflation is falling prices. In a proper deflation, prices fall broadly, not narrowly. Seventeen months into the Great Depression, the CPI had fallen by a cumulative 8.1%. This time around, December 2000 to date, it’s risen by 1.8%.”

Grant then notes that although the steel industry is operating at a capacity utilization rate of below 50%, AK Steel (AKS, news, msgs) was raising prices for the second time since May. “If deflation it be, it’s deflation light,” he says.

As Grant’s colleague Ian McCulley points out, “If we are truly in a sustained deflation, price decreases will eventually spread.” And Jim notes: “It hasn’t happened yet. Core CPI, which includes food and energy, is 1.8% higher than it was last year. Though its rate of rise has slowed (a year ago, it was rising at an annual pace of 2.3%), it continues to hold above the level to which it sunk during the great deflation scare of 2002-2003.”

McCulley proceeds to observe that the Cleveland Fed has its own alternative measure of CPI and that by virtue of its calculation methodology, “it is thus a less volatile price index than headline CPI, and is currently rising by 2.4% year-over-year.”

That’s not all. Many folks believe that with the economy operating so far below its potential output and with high levels of unemployment, inflation can’t possibly happen.

Grant says that would be “a perfect theory, if not for the existence of so many countervailing facts. Bolivia recorded a monthly inflation rate as high as 120% in 1984-86 with unemployment rates in the mid- to upper teens. Bulgaria recorded a monthly inflation rate as high as 242.7% in 1997 with unemployment rates ranging between 12.5% and 13.7%. The greatest hyperinflation of them all was not the 1920-23 German affair but the Hungarian calamity of 1945-46, which occurred in a war-ravaged economy operating well below pre-1939 levels of resource utilization.”

Grant sums up his thoughts on the inflation front as follows: “What strikes us is what small effect a mighty debt collapse has had. It makes you fear — almost — for prosperity.”

Let’s hope all of those salient points will assist folks in deciding whether they think we will see deflation or inflation in the future.


By Bill Fleckenstein

FedEx (FDX, news, msgs) last Wednesday tempered the enthusiasm of folks on “green shoot” watch. While stating its belief that the economy had hit bottom, the company also said it had no “visibility” to predict future earnings or any expectations of a real uptick in business.

Much of this economic green shoot talk has centered on slight improvements in still-weak/sloppy business conditions. But a lot of that has been a function of companies restocking inventory after the collapse in business at the end of last year and the start of this one.

That, coupled with money printing and the stock market rally, fed on itself and caused a lot of people to get excited about economic prospects improving drastically by the year-end.

But now that the market rally has stalled, negative macroeconomic and corporate news could easily precipitate a reassessment of this whole green-shoots-growing-into-a-beanstalk idea that a recovery has begun.

This means the Federal Reserve’s predicament will become even clearer. Given the path it has chosen, the Fed will have to print even more money. That’s likely to mean upping its quantitative easing at some point, as Treasury yields have ratcheted up and mortgage rates have followed suit.

Weighing in on the subject, a knowledgeable source I often refer to as the “Lord of the Dark Matter” told me: “Make no mistake, it is a total disaster, with most banks now offering 30-year fixed (mortgages) in the mid- to high-5% range, and then only for the best FICOs. Then again, it was tremendously naive or, more likely, arrogant in the first place to assume that you could indefinitely run a public sector borrowing requirement of 13% of GDP and keep mortgage rates down at a level that induces a massive, permanent refi boom.”

In any case, due to the ramifications (both present and future) of the Fed’s money printing, it has now resorted to the jawbone policy. The Fed thinks that by talking tough enough, it can boost its credibility and get bonds to rally (lowering rates), thus wriggling itself out of the box. But given the damage wrought by its own hands, that will be hard to do.

Thus, somewhere in the not-too-distant future, the Fed is liable to find itself back in the position of needing to create more stimulus. (To the extent that stocks are weak, you can be sure that the Fed’s tough talk will evaporate.)

On the subject of putting the green shoots story into proper perspective, there was a terrific article in the June 16 edition of USA Today headlined “For Boomers, recession is redefining retirement.” It says:

“The 77 million Americans in the Baby Boom generation face an economic storm: The Wall Street meltdown trampled their retirement nest eggs more than any other group. After losing jobs during what they thought would be some of their peak earning years, many are struggling to get back into the workforce. Health care costs are rising, and declining home values mean they might not be able to count on home equity to guarantee an easier retirement.”

That pretty well sums up the problem that’s faced not just by baby boomers but by many others.

The article makes a point that echoes what I have said many times in the past: You need not have acted in any way irresponsibly (though many did) to find yourself in trouble.

Among the unemployed workers interviewed for the article — described by the reporter as having “planned perfectly and saved enough for their retirement” — was an individual who offered this picture of himself: “I was the poster boy for what American middle-aged people should be doing.” But he lost a pretty good job at AT&T and now relies on his wife’s income.

This gets to the root of the problems we face going forward: the inability to create good jobs.

The twin bubbles spawned by former Fed chief Alan Greenspan, in technology and then in housing, marked an era in which capital was misallocated. Many jobs that were created then and subsequently lost will not be returning. (To say that these twin bubbles ruined many lives is probably an overstatement, but to say that Greenspan altered many lives in a very unfavorable way is not.)

The No. 1 priority, if our country is to get back on its feet, is to figure out ways to create real jobs. Of course, what comes before that is having businesses that can create the profits to create those jobs.


By Bill Fleckenstein

For every action there is an equal and opposite reaction. It’s what Sir Isaac Newton postulated in his Third Law of Motion. Here is a tweaked version for the times in which we live:

When money printing goes to excess, as it almost always does, speculation follows. (This is not to say that speculation requires money printing. It doesn’t.) However, one can never know in advance exactly where the speculative juices will flow and what assets or markets will be kited wildly higher.

Lifetime member of the pressmen’s union
Look at what happened when then-Federal Reserve chief Alan Greenspan printed too much money (and that was kid stuff compared with what we see today). In the mid- to late 1990s, stocks went on a tear, culminating in the sheer lunacy of the yearlong-plus dot-com craze. Lust (greed) sent the market caps of Web sites into the multibillion-dollar stratosphere, based on nothing more than targeting “eyeballs.”

Subsequently, the money printing that was used to mitigate the ill effects of that bubble caused real-estate prices to go insane — or, more precisely, it made real-estate-financing terms insane. During that period, stocks also went wild, with some of the zaniest action occurring in the leveraged buyout arena

Modern day” wisdom (of the past 20 years or so) has it that this money printing will fix things and not lead to excesses or inflation. But that is a silly notion. It’s not as though quantitative easing, which sends money right to banks, is a precision instrument that targets only bank balance sheets. The money flows where it will, and it can go anywhere.

What excessive money printing always leads to, in addition to speculation, is inflation, a weaker currency and higher interest rates. The latter two — components of the nascent funding crisis I’ve written about before — are what we have seen recently. (On that score, more saber-rattling occurred Wednesday when Alexei Ulyukayev, the first deputy chairman of Russia’s central bank, said his bank might convert some Treasury reserves into International Monetary Fund debt.)

No inflation? Not really
Nonetheless, folks are of the opinion that there can be no inflation of any consequence — because wages aren’t galloping higher (as they were in the 1970s, led by strong union activity).

That argument simply isn’t true. Inflation has supposedly been tame over the past 10 to 15 years — due, in part, to the fact that it’s been substituted and “hedonicized” away. (For an explanation of those terms and how this works, read “How the government manufactures low inflation” and “Why all roads lead to inflation.”)

Throughout those two bubbles, even though there was no generalized wage pressure because the majority of the money flowed elsewhere, wages were driven higher as the unemployment rate bottomed out at the top of the bubble. In other words, even without a rampant upward spiral in wages, we still experienced real inflation.

The other presumed barrier is the so-called output gap, which holds that slack production capacity will keep inflation at bay. Although that theory sounds appealing, it has not been effective at warding off inflation.

So, for the time being, worldwide money printing has spawned a healing process in the financial system. The world economy has bounced from an overly depressed state, causing financial markets to lift — which has engendered a feeling that the worst is behind us. (Home Depot (HD, news, msgs) said just that on Wednesday when it issued a slightly more optimistic earnings forecast.)

For the unemployed, a hollow recovery
Many industries may have seen their worst, but that does not mean the sum total of businesses — i.e., the economy — will be strong anytime soon. When I say strong, I mean capable of generating lots of good jobs, which at the end of the day is what’s required.

To sum up: Money printing has bought us another round of speculation. And, while we don’t know what other unintended consequences will follow, it looks increasingly likely that this latest round has also “bought” a funding crisis.

What it almost surely has not created is a self-sustaining recovery.


By Bill Fleckenstein

This week . . . a rant.

First of all, let me say that I almost never read Paul Krugman’s New York Times column, as I noticed several years ago that he has an uncanny ability to understand a problem but totally misdiagnose the cause.

During the “W.” years, Krugman would frequently outline an economic problem, then go out of his way to blame the president. A lot of poor decisions did flow from George W. Bush, as he was basically in over his head. But this Nobel Prize-winning economist was a Johnny-one-note when it came to W.

But I did read Krugman’s May 31 column because of its headline: “Reagan did it” (registration required). I thought, wow, I need to see what this is all about. Here goes:

The devil in deregulation
Krugman wants us to believe that all of our financial ills can be traced directly back to the presidency of Ronald Reagan and deregulation. As usual, he finds the source of trouble — almost. He identifies a specific piece of legislation that he claims started us on the path to so much financial trouble: the deregulatory Garn-St. Germain Depository Institutions Act of 1982.

Close but no cigar. The actual offending cancerous legislation that kicked off the move toward extra reckless lending did involve then-Rep. Fernand St. Germain, a Rhode Island Democrat. But the problem legislation was the Depository Institutions Deregulation and Monetary Control Act of March 31, 1980.

It’s important to note that the law was enacted two years before the act Krugman cites — and nearly a year before Reagan took office. The earlier legislation contained a provision that increased the limit for deposit insurance from $40,000 to $100,000 at a time when $100,000 was a lot more money than it is today.

Tracing the roots of reckless lending
Believe it or not, I felt in 1980 that it was a bad law that would lead to recklessness. That’s because the excessive increase became an incentive for depositors to be less disciplined regarding the health of their depository institutions.

I made this very point at the height of the tech mania in a speech titled “Spinning Financial Illusions: The Story of Bubblenomics,” which I gave at the Contrary Opinion Forum on Oct. 1, 1999:

The seeds of this bubble were sown way back in 1980 when Congress passed the Depository Institutions Deregulation and Monetary Control Act, calling for the phasing out of Regulation Q, which allowed financial institutions to compete with money market funds. A piece of that legislation was financial cancer: raising the insured deposit maximum to $100,000.

That seemingly innocuous change (thank you, Fernand St. Germain) spawned “brokered deposits,” the primary driver of the reckless lending practices of the 1980s. Money sought out the highest bidder with no regard as to how it might be used.

As a result, we witnessed the funding of overleveraged LBOs and the overbuilding of real estate long after the 1986 Tax Act made it uneconomical to speculate in property. It is hard to overstate the significance of this legislation in creating the excesses of the 1980s, which set the stage for the even greater excesses of the 1990s.

Back to Krugman’s column: He wraps up his indictment with a statement that demonstrates his utter lack of understanding about what has transpired over the past quarter-century: “There’s plenty of blame to go around these days. But the prime (my emphasis) villains behind the mess we’re in were Reagan and his circle of advisers — men who forgot the lessons of America’s last great financial crisis, and condemned the rest of us to repeat it.”

That is just nonsense. The person to blame for the increase in deposit insurance was none other than St. Germain, who saw to it that the deposit insurance increase was put into place.

Besides, does anyone really think Reagan is more culpable than former Federal Reserve chief Alan Greenspan? Greenspan deserves the lion’s share of the blame, and Reagan had essentially nothing to do with it (other than having had the bad judgment to appoint Greenspan).

It’s ironic that Krugman doesn’t even understand the fallacy of his own argument.

Boosting the cap by 150% took away market discipline as depositors dropped their guard about what the wild men running the savings and loans were doing with their money. In fact, that change of regulation — i.e., fiddling with the deposit insurance limit in the deregulation legislation — is precisely what started the lax-lending-standards problem that ballooned into “too big to fail” and ultimately morphed into “too big to bail out” in 2008.

If the remote cause of our current troubles was an unwarranted increase in deposit insurance, the immediate cause was Greenspan’s incompetence — in the form of monetary policy and “leading” the Fed’s own inept effort at regulation, the twin drivers of this debacle.

Greenspan personally helped give deregulation a bad name through his wrongheaded cheerleading — an example of this being his advocating (in 1999) that the remnants of the Glass-Steagall banking regulations be repealed in the wake of the collapse of Long-Term Capital Management in 1998!

(Although I happen to be generally in favor of deregulation, that doesn’t mean I favor deregulation always and everywhere.)

However, even that poorly thought-out idea would not have been as disastrous as it has been had the Securities and Exchange Commission possessed the common sense not to allow financial companies to essentially leverage themselves to infinity.

Also culpable are other “government-sponsored” bodies, such as ratings agencies and the Financial Accounting Standards Board. They helped perpetrate the illusion of safety while the country attempted to speculate its way to prosperity, from whence we blew up.

Deregulation didn’t cause this disaster. Incompetence and greed did. The implication from Krugman’s article, that regulation or re-regulation would solve the problem, is nonsense. What must happen is for people in positions of regulatory authority to do their jobs.

But the Fed, the Office of the Comptroller of the Currency, the Office of Thrift Supervision and some congressional committees — aka the “regulators” that Congress entrusted with powers of oversight — did nothing as our financial problems built and built in plain sight. (All along the way, as these excesses built, many of us pointed them out in real time.)

New rules won’t solve anything and will cost businesses and individuals more money, which they can ill afford to spend. A classic example: the Sarbanes-Oxley accounting reforms of 2002, which caused a huge increase in paperwork and costs but did nothing to help prevent the financial system from nearly vaporizing.

No, Mr. Krugman, Reagan didn’t do it. Greenspan did it, aided and abetted by almost everyone in the regulatory apparatus who abdicated their responsibility.


This week I’d like to update readers on the funding crisis. That’s the third in the three-baseball-game analogy that I dreamed up last fall (read “Economy sinks as we save bankers”) as a way to think through the enormous problems we faced.

The first and second games (crises) — the credit meltdown and the economic downturn — have been pretty easy for folks to understand, as they were front and center in the news.

The view from the dugout
Essentially, the financial crisis now lies behind us (with the economic crisis in full bloom, the recent economic “bounce” notwithstanding). That’s due to all the moves put together by former Treasury Secretary Hank Paulson and other government officials. Those actions stopped the vaporization of the financial system, essentially giving everyone a do-over.

But therein lay the seeds for the funding crisis — which, as I noted in my daily column at on May 21, appears to have started.

This is a much more subtle but pernicious crisis in some ways, as it’s not so apparent but is disastrous in the long term.

My reason for saying so? Because if the dollar is called into question (as now appears to have begun) and if the Federal Reserve’s monetization cannot lower interest rates (and in fact causes them to rise, due to the consequences of printing so much money), then the Fed is trapped. The more it tries to solve the problem by printing more money, the worse it all becomes.

How that will play out exactly, how long it will take and what the road map along the way might look like is difficult to say, due to the many permutations of how events might interact.

But the ultimate outcome will be a weaker currency, more inflation and higher rates until such time as the printing press is finally taken away from the Fed.

Away from the nuance that is the funding crisis, the action in recent stock trading cannot lay claim to subtlety. Indeed, there’s no mistaking the bizarre behavior on display, wherein so-called low-quality stocks outperform so-called high-quality stocks. To explain this disconnect, let me first reprise remarks from my Oct. 8, 2007, column:

“At a recent New York conference, investor Jim Chanos noted a couple of anomalies that, in all likelihood, are a direct function of quant trading. They highlight a disconnect between stocks and their underlying fundamentals that only a computer could love.

“It turns out there are two — and for all I know, more — closed-end mutual funds that own mundane large-cap S&P-oriented stocks: the Cornerstone Total Return Fund (CRF) and the Cornerstone Strategic Value Fund (CLM). Inexplicably, these funds trade at premiums of better than 50% to net asset value. . . .

“The connection to the quant universe is that Renaissance Technologies, among the biggest quant hedge funds and certainly a very successful one, is the fourth-largest shareholder in both Cornerstone funds.

“You have to scratch your head and ask: What is a quant fund doing paying a huge premium for an easily replicated portfolio?

“The only logical answer would be that the stock-price characteristics have behaved in a way that makes Renaissance’s computer — obviously programmed by someone — think these funds are a good thing to buy, regardless of the fact that their valuation is beyond absurd. . . .

“That’s what the computer-driven models at quantitative funds do, setting aside the fundamental questions of what a company actually makes or does and what that business is really worth.”

Fast-forward to now: Most of the people I speak to who are knowledgeable about the minutiae of trading point to problems with various quantitative and market-neutral computer-driven strategies.

To wit, after having worked well for so long, many of these models have recently stopped working, thereby inflicting considerable pain on many of the funds that have used them — the aforementioned Renaissance Technologies in particular. Referring to the fund managers who are now witnessing the failure of their models to accurately track, a knowledgeable friend I’ve dubbed the “Lord of the Dark Matter” describes them as “people chasing tracking error.”

The preponderance of quantitative funds rectifying their errors — i.e., cutting their losses — might account for a decent portion of the seemingly nutty action in the stock market these days.

I say “seemingly” because oftentimes the market can appear nutty. Then you find out six months later that it wasn’t. Rather, there was some reason only identifiable in the aftermath. However, in this instance, I don’t think that will turn out to be the case.


By Bill Fleckenstein

We have now seen a string of data points that indicate an improvement in the economy, with potentially more such data to come — which is certainly refreshing news.

But after two quarters of gross domestic production contracting at a rate of 6%, if the economy shrinks only 2%, that will look like strength from a data standpoint. After a couple of quarters like we’ve just experienced (which are quite rare), just restocking depleted inventories could easily produce a positive GDP number in the short run.

Thus one cannot examine any of these reports in isolation. One has to take a step back and look at the whole mosaic. We don’t want to become overly bearish about certain problems. But neither do we want to become overly bullish about a couple of positive bits of news.

Anything but clear
The bursting of the housing bubble and the attendant collapse of the financial system, and the money-printing/government stimuli aimed at mitigating those disasters, are creating enormous crosscurrents that will make divining the market action (as well as the news) particularly tricky.

If one wants to talk about a legitimate “green shoot” (the new favorite buzzword for signs of a recovery), I would point to a recent Wall Street Journal article in which the CEO of Caterpillar (CAT, news, msgs) noted that demand for excavators in China is at a record level.

Again, that is just one nugget. But I continue to believe that the large economy most likely to recover first will be China. That leads to one of my areas of interest: commodity-oriented businesses.

I’ve been a fan of precious metals for reasons related to currency debasement, but lots of other companies will benefit from what transpires in China as well as from worldwide stimulus.

Small is beautiful
If stagflation is the most probable outcome (my view at this juncture), we are liable to see coming out of this period sort of a replay of the 1970s, but on steroids.

Small companies, which are usually nimbler than large companies and can grow more quickly, are likely to be the biggest beneficiaries. If we are to experience inflation/stagflation over the next several years, companies that can grow rapidly — i.e., unit growers — will be sought after, and small may become beautiful.

Conventional wisdom has it that, as a result of the financial system’s collapse, bigger is better. But I think bigger is slower and less flexible and therefore less adaptable. I’m especially interested in small companies that are uniquely positioned or are in sectors that have the wind at their back.

That’s sort of the prism through which I am viewing the landscape. I’ve been thinking about this for some time and wanted to pass it along for readers to chew on.

As for the current stock market rally, color me skeptical that the lows for the bear market have been seen. However, given the money printing that has taken place and will take place, folks must give any expectation that they hold a wide degree of latitude.

(All that stimuli and money printing seem poised to take their toll on the dollar — which, if the case, and if the bond market has indeed seen its lows, will add another level of complication for equities down the road.)

Lastly, part of the reason for my skepticism comes by way of market observer Justin Mamis.

In March, as I detailed in “Bear’s end? Wishing won’t make it so,” he cited somewhat of an ending sequence that has yet to fully unfold:

An intervening rally from a significant low. (That rally is now under way.)

Eventually, a real surrender, which will set the final low.

In all likelihood, a test of that final low.

Now, it is not written in stone that this sequence must occur. But it’s certainly worth thinking about.


From Bill Fleckenstein

To judge by the green on my stock screens last Monday, you’d have thought Lam Research (LRCX, news, msgs), Research In Motion (RIMM, news, msgs), IBM (IBM, news, msgs) or perhaps a few other companies had some solution to the swine flu outbreak.

As a friend commented with tongue in cheek: “Buy some RIMM. People will lose jobs, stay home and e-mail nonstop from RIMM-a-phones.”

In that way, I guess RIMM would be a “play” on both swine flu and unemployment.

Certainly, there is nothing to commend the travel/tourism sector, as companies such as Royal Caribbean Cruises (RCL, news, msgs) and Carnival (CCL, news, msgs) will clearly be hurt by the flu outbreak (not that their businesses weren’t already in trouble, thanks to the recession).

There was logic behind the slide in those companies’ shares. But in other areas of the market, the action was far less logical.

Swine flu concerns? Go out to dinner!
Dot-connecting was certainly MIA the next day, when many restaurant stocks (already the beneficiaries of huge rallies in the past month or so) finished higher. It was somewhat incongruous to witness world markets like our own panic over swine flu (to the point of pounding the price of hogs, etc.) while speculators partied in restaurant stocks, even though the flu’s spread might keep many cautious diners at home.

I can’t tell whether that means the fears of swine flu are overblown and it was just an excuse for traders to lower the stock market, or whether restaurant stocks are caught up in some weird orbit of their own.

In any case, I found it striking that the consequences of swine flu would apparently matter to everything except for one particular group that would definitely be affected by a flu pandemic.

Tilting at inflection points
Now to turn from infection to inflection points:

For someone with a bias like mine, Tuesday’s action in the bond market, combined with Wednesday’s macro data and action in foreign-exchange trading, made it possible to conjure up the notion that we are nearing a major inflection point: the funding crisis I’ve written about before, the consequence of all the monetary and fiscal stimulus the U.S. is using.

On Tuesday, long bonds cracked a potentially important level around 3.85%. One could make the case that the low is in for yields and that they are on a slow, steady march higher. Of course, the Federal Reserve is not going to accept that at face value and will become more aggressive by monetizing long (30-year) bonds.

What ought to happen to the dollar — as I have felt for some time — is that it should be pressured by that monetization. On Tuesday and Wednesday, the dollar was very weak. It looks like it could be beginning to break down on the charts.

But charts have a way of repairing themselves, and I may be jumping the gun (which I have been known to do on more than one occasion).

There are myriad reasons — not least of which are the trillions of dollars of supply — why one would expect interest rates to rise and the dollar to decline. But an environment where we saw weaker growth and more inflation would be especially bond-unfriendly.

Weaker growth would prompt the Fed and the government to keep applying stimuli. The inflationary consequences would pressure interest rates higher, which the Fed would try to suppress. That action would exacerbate the problem, and the vicious cycle would continue.

Though I hesitate to make too much out of one report on the gross domestic product (or government statistics in general), Wednesday’s first-quarter GDP data — which showed a contraction of 6.1%, versus expectations of 4.7% — make for a wonderful example of what the future holds: essentially a replay of the 1970s, only far worse.

It’s not that I find the results terribly surprising or especially alarming. I do not. What’s more interesting is that the GDP price index, which measures the prices of goods and services included in GDP calculations, was expected to be 1.8% but registered 2.9%, and that the and that prices of core personal consumption expenditures (a measure of inflation that master of disaster Alan Greenspan particularly focused on) rose 1.5% quarter to quarter, versus expectations of just 1%.

To stare at those numbers for a second, what you see is that while GDP was contracting at a rate rarely seen in this country, there was no deflation but rather inflation. That is because the reaction to anything that looks and smells like an “unauthorized” decline in asset markets is met by the stimulus that we have seen.

(We will likely transition from two quarters of minus 6% GDP growth to a rate less severe, like, say, 0%. If that happens, it may look like an economic revival when in fact it’s just a deceleration in the rate of collapse.)

I have been waiting for signs of an inflection point that signals a sea change in psychology. As inflection points occur, it’s quite difficult to actually determine that things are changing. (Inflection points are always obvious in hindsight — the greater the distance, the better.)

Nevertheless, the aforementioned data/market reactions appear tantalizing, as they hold the potential for just such a change.

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