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Real Money, Funny Money and
YOU -- Part 3.
by Professor von Braun
May 30th, 2005
"A thing long expected takes the form of the unexpected when at last it comes."
-- Mark Twain
It is estimated that currently
manufacturing comprises 10% of corporate profits, while 50% or
more, comes from shuffling money around. In the 1950's these figures
were reversed and 50% of corporate profits came from manufacturing.
Much of what is consumed today comes from China and other Asian
countries, which is where the manufacturing base now is. Should
there be a slowdown in the paper shuffling business, corporate
profits will diminish accordingly along with the ability to manufacture
tangible goods that can be sold at a profit. So, what can the
investor buy into and expect a return? Richard Russell, of
www.Dowtheoryletters.com, (ph. 858 454 0481) has been suggesting
utility companies but now concedes that they, too, are overvalued.
Companies that pay dividends are in short supply, and a return
on capital is getting harder to find.
Counter party risk is another aspect of the financial markets that needs to better understood by those wishing to preserve capital and survive any major blow up or melt down of the asset inflation game. The derivatives markets are vast, little understood, and apart from the LTCM debacle in 1998, yet to be seriously tested. The OTC markets in most cases do not report all the contracts out there and many of the derivative contracts are not publicly reported at all. Complicated black box structures hedge interest rates against currencies, commodities against commodities, and so on. But what happens next time the participants come up against a market that turns unexpectedly? As mentioned in part 2, Greenspan has already warned Congress of the potential threat to the US financial system contained within the activities of Freddie Mac and Fannie Mae, the two mortgage giants. I would find it hard to believe that a similar threat does not lie hidden within a large US corporate as well, given that most of their profits are coming from the paper shuffle.
Perhaps what Greenspan was referring to was counter party risk, since some entity must be on the other side of a derivative contract involving the Fannie Mae and Freddie Mac. And while Greenspan may not be privy to the inner workings of these behemoths, he may be privy to the contents and risk involved via the other party, one most likely close to the Fed. Speculating with tax payers money is an inherently risky business; after all, the GSE's enjoy an implicit guarantee that Washington will bail them out if things go wrong, and that is why they are able to sell so much paper to offshore buyers.
The rise in interest-only mortgages since 2001 has been dramatic, but it looks like it now has a companion, one called the 'silent second'. Apparently this involves the issuer of the first mortgage providing the deposit as a second but its not recorded on the deed. In some cases the amounts involved are as high as 125% of the value of the property. Now that is a dangerous activity if there ever was one. In some ways it seems we have the potential for a repeat performance re the Savings and Loan debacle of the 1980's, the notable difference being only one of magnitude. This one is far bigger, involving far greater amounts well in excess of a trillion dollars.
The CNBC participants refer to the term 'investor' at least 100 times per day, but this is a misnomer -- they should be using the term 'speculator' as most of the activity they are reporting is speculation. One does not invest in a hedge fund, one places a bet in the hope of obtaining a return, which is not investing. Investing, to some degree is becoming a lost art form, while speculating flourishes. Seeking capital gains is speculation, which is what we saw in the dot.com boom and is what we are now seeing in the real estate bubble currently playing in a town near you. To call this investing is very misleading.
Most mutual funds are finding it tough to generate returns at present as stocks are trading sideways, have been for several years, interest rates are low and 'hot' sectors are in short supply. The heady days of the Nasdaq being above 5000 are gone and eventually real estate will follow suit. Neither the bulls nor the bears are doing well, a situation which in and of itself can't continue. It needs to be remembered that both the bulls and the bears are booking what profits they do have in dollars and few are hedged against a dollar decline. Numerous commentators have 'warned' of the potential for this event, but few have come up with a solution. Several suggest owning gold -- buying gold coins or bullion and taking delivery -- which is wise as it's the only way to go neutral on this market. Others suggest a mix of cash, bonds, the Swiss franc, a basket of currencies, annuities and so on.
Most money managers are refusing to acknowledge the risk inherent within the US financial system; some can recognize it, but few have formulated and implemented a safe strategy. Most prefer to follow the leader, often their largest competitor, and duplicate each others portfolios with little in the way of exit strategies.
What is remarkable is how in a rising market the chatter is all about how well 'we' are doing, how great 'our' economy is and what a wonderful world it is. But in a down market the 'we' suddenly becomes 'you' and the 'our' just as quickly becomes 'my'. What is left of your portfolio will depend upon what action you took prior to a significant threat to the US financial system materializing. If you believe that the Fed can fix it, then reread Greenspan's reported comments to Congress in part 2.
Once again I refer to Richard Russell, who said in his 5/25/05 commentary: "As subscribers know, I've warned since late 1999 that the operative word in this bear market would be INCOME." And, "I've been scouring all my sources for securities that bring in attractive yield and at this point they are very hard to find."
When the asset inflation/paper shuffling game ends, then cash flow will be the investors best friend. Income will be key while this mess gets sorted out and that may take a while.
What you do between now and then will be what makes the difference to your living standard's -- standards that are likely to decline for the average maxed-out real estate owner who failed to see that this was a bubble, that even property renters need income and that houses are difficult to sell in a declining market.
Now, could the game go on indefinitely? Well, how many greater fools are there? At what point do they run out? Obviously when it came to the dot.com boom they ran out in March of 2000 and have not been seen since. A chart showing the rise in real estate looks ominously similar to the Nasdaq's pre-fall period, which was very similar to a chart of the Dow in 1929, and we all know what happened then.
The period following the 1929 stock market collapse is one that gives us a potential view of how things could unfold as the ingredients that led to that collapse, easy credit and, as a consequence, record debt levels, are present today -- although at much greater degree. There was too much money in the system and when the greater fool supply ran out a depression took place. During that period cash flow was king. Banks were closed, citizens' gold hoards seized, properties sold at significant discounts, stocks took years to recover and life in general was tough.
The financial 'mess' took several years to sort out and one of the ingredients, now that the government had the citizens' gold, was the revaluing of the price of gold to $35.00 per ounce -- an event that became official on Jan 31, 1934, some four years after the stock market peaked. Effectively this reduced the gold content of the dollar and was a devaluation of the monetary unit, something that's been happening ever since.
This revaluation was significant for companies that were producing gold, as their cashflows increased accordingly and owners of those companies did exceptionally well. However it needs to be noted that it was the action of the powers that be that created this circumstance, not the activities of the companies themselves. They just happened to be a beneficiary of a manipulation of the price of the commodity they were producing. For several years after substantial dividends were paid to shareholders and share prices increased accordingly.
The fact that the price of gold was the means used to inflate the currency and allow for more dollars to be issued is suggestive that something similar may need to occur again. Now of course individual ownership is legal, but in 1933 it no longer was. Gold ownership was outlawed, but ownership of gold mines was not interfered with until gold production itself was banned in 1942.
The Prof can be contacted by email at email@example.com
Copyright by Professor von Braun. All Rights Reserved. Reprinted at USAGOLD by permission.
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