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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, (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 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 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

Copyright by Professor von Braun. All Rights Reserved. Reprinted at USAGOLD by permission.

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The Rocket School of Economics -- The Lecture Series Index

  • 22 May 2009 -- An Often Overlooked Issue!
  • 28 Mar 2009 -- Problematic Banking Systems!
  • 14 Nov 2008 -- What Exactly is an Asset?
  • 23 Aug 2008 -- Through the Looking Glass?
  • 02 Aug 2008 -- Compounding to the Downside!
  • 26 May 2008 -- Back to Basics Again!
  • 31 Mar 2008 -- The Broken Watch -- Part 2.
  • 27 Mar 2008 -- The Broken Watch -- Part 1.
  • 06 Feb 2008 -- The Financial Equivalent of Faulty Towers.
  • 10 Dec 2007 -- Monetary Systems & Productive Assets.
  • 14 Feb 2007 -- Divorced from Reality
  • 06 Sep 2006 -- Gold, Bankers, the Trade Deficit and Unsettled Transactions
  • 19 Jun 2006 -- When is a Reserve Not a Reserve?
  • 31 May 2006 -- The significance of August 15, 1971.
  • 08 Apr 2006 -- Keep Your Eye on the Ball!
  • 30 Mar 2006 -- What came first?
  • 11 Mar 2006 -- An Unanswered Question.
  • 08 Jan 2006 -- Where have all the projects gone!
  • 11 Dec 2005 -- Gorillas, Rising Gold Prices and Depreciating Paper Currencies!
  • 23 Oct 2005 -- Custodial Risk.
  • 16 Sep 2005 -- An Inherent Flaw.
  • 08 Aug 2005 -- Central Banks and 'Reserves'.
  • 31 Jul 2005 -- Central Bankers, Actors and 'We'.
  • 17 Jul 2005 -- Unintended Consequences! -- Part 3.
  • 07 Jul 2005 -- Unintended Consequences! -- Part 2.
  • 25 Jun 2005 -- Unintended Consequences! -- Part 1.
  • 14 Jun 2005 -- The Two Greater Fools Theory.
  • 03 Jun 2005 -- Real Money, Funny Money and YOU -- Part 4.
  • 30 May 2005 -- Real Money, Funny Money and YOU -- Part 3.
  • 26 May 2005 -- Real Money, Funny Money and YOU -- Part 2.
  • 21 May 2005 -- Real Money, Funny Money and YOU -- Part 1.
  • 09 Nov 2002 -- Carrying a Big Stick.
  • 17 Sep 2002 -- Wishful Thinking!
  • 27 Jul 2002 -- Gold Bugs Beware -- part 2.
  • 10 Jun 2002 -- Gold Bugs Beware!
  • 06 Apr 2002 -- Currencies versus Gold.
  • 26 Jan 2002 -- Bear Market Strategies.
  • 01 Jan 2002 -- 2002 -- A Perspective.
  • 20 Oct 2001 -- The Storm Clouds are Gathering.
  • 30 Sep 2001 -- What to Say?
  • 01 Jul 2001 -- ...Said the Fly to the Spider.
  • 14 Jun 2001 -- Upward and Downward!
  • 28 May 2001 -- Volatility Time, Again!
  • 14 May 2001 -- The Coming Bull Market in Gold Stocks?
  • 24 Feb 2001 -- High Hopes, Wishful Thinking & The Absurd
  • 20 Feb 2001 -- Who Put the Holes in the Swiss Cheese?
  • 22 Jan 2001 -- US Dollar Admits Identity Crisis!
  • 16 Jan 2001 -- Dear George W.
  • 24 Nov 2000 -- The Bubble Has Burst
  • 11 Nov 2000 -- The Media, Bull Markets & the Gold Price
  • 02 Nov 2000 -- Gold Stocks
  • 29 Oct 2000 -- Oh The Tangled Web We Weave ...When We Set Out to Deceive
  • 24 Oct 2000 -- A Mystery!
  • 16 Oct 2000 -- A Peso Here ...and a Few Thousand Pesos There
  • 10 Oct 2000 -- The Unfolding
  • 30 Sep 2000 -- What's Wrong with THIS Picture?
  • 25 Sep 2000 -- Buy Gold Now!!
  • 23 Sep 2000 -- The Times, They Are a' Changing
  • 15 Sep 2000 -- Time WILL Tell!
  • 27 Aug 2000 -- SS "Paper Assets" Begins to Take on Water
  • 06 Aug 2000 -- The Indian Summer
  • 26 Jun 2000 -- A Yellow Brick Wall
  • 22 May 2000 -- The King IS Naked
  • 30 Apr 2000 -- Goodbye Yellow Brick Road
  • 18 Apr 2000 -- Beware the Ides of March, April and May
  • 08 Apr 2000 -- Really, Sir Aldot!
  • 25 Mar 2000 -- Where To From Here?
  • 18 Mar 2000 -- The Gnomes of Zurich
  • 12 Mar 2000 -- The "New" Economy??
  • 06 Mar 2000 -- Two Questions
  • 04 Mar 2000 -- Iceberg Dead Ahead!
  • 28 Feb 2000 -- The Wizard of Oz
  • 06 Feb 2000 -- Here We Go Again!!
  • 15 Jan 2000 -- Comments on the Gold Market
  • 29 Dec 1999 -- No Raw Ingredients Required
  • 28 Dec 1999 -- No Way Out
  • 14 Dec 1999 -- Ho, Ho, Ho!
  • 07 Dec 1999 -- Greenspan's Bubble
  • 03 Dec 1999 -- Early Warning Signs

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