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The Obvious is Obviously Wrong - Aubie Baltin

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  • The Obvious is Obviously Wrong - Aubie Baltin

    The Obvious is Obviously Wrong

    by Aubie Baltin - January 4, 2007

    Concensus Forecasts for 2007

    The S & P 500 WILL BE UP 10 to 15% IN 2007
    For the first time since 2001 all the analysts surveyed by Barron’s are in unanimous agreement that the S & P 500 will be up 10% at the very least. Well the surest bet for 2007 is that not only will the market NOT be up but it is my firm conviction that it will be down at least 10%.

    Another unanimous forecast for 2007 that everyone–and I mean everyone–is in complete agreement that the US Dollar is weak and heading sharply lower in 2007. To tell you the truth I think so too, but if there is only one truth that I have learned in fifty years of investing it’s that whenever there is this strong a consensus on anything, you can rest sure that it is wrong. The obvious is obviously wrong! So what will happen to the US dollar and why? Right now I can’t offer you a well thought out answer, but I will try to find one for my next letter. But rest assured it is not going to hell in a hand basket.

    The other side of a “weak dollar” coin should be a strong consensus for a sharply rising gold prices to new highs or at least it should be, but luckily for us it just ain’t so. To a good deal of our readers who have been believers in gold for over 20 years it may seem so, but even though gold mutual funds have been the top performing funds over the last five years–up 23% last year–nobody except the gold bugs are recommending them and whenever there is a mutual fund expert (?) on TV, they never mention gold. Don’t despair. That’s good for us gold investors. The only thing that worries me is all those gold bars on the cover of Time Magazine. To me that means there are still some unforeseen hiccups in Gold’s upward march, probably in response to the unexpected dollar strength that will surely blindside everyone this coming year. Or as I forecast in my last missive; a test of the $560 area to complete the diagonal Wave 2 triangle by the middle to end of Jan. 07 before Gold’s Wave 3 lift-off to $1000 +.


    Another sure thing is what seems to be the unanimous consensus that the FED’s next move is to lower interest rates. The question is not if, it’s when. Here is a perfect example of hearing and seeing only what they want to hear and see. In the face of all of Wall Street and the Media’s talking heads calling for a cut in rates, the world seems to have not heard the Fed’s warning that their next move is most probably up! This is exactly the kind of stupidity you get whenever (which is all the time) you isolate one and only one factor and try to base a prediction on that one factor. Question: If the assumption is that the dollar is weak and getting weaker, what if anything can the FED do about it ? Dah, raise interest rates?


    The biggest risk is the “one” that nobody perceives, that does not exist. If the Fed has to raise interest rates in an attempt to protect the dollar, what would happen to our Goldilocks Economy, Bond and Stock Markets? Dah, I hadn’t thought about that.

    Has anybody noticed that the spread between treasuries and junk bonds is near the lowest in history? Under 3%, down from a normal 7% to 10% and a high of over 15% in the 80’s. The world is now taking on risk at a higher and faster rate than ever before. I guess that’s what happens when you grow up believing in fairy tales and believing that the Government and the Fed will take care of us all, from cradle to grave: Which is only possible if there is nothing between the cradle and the grave.

    Looking for a "sure fire bet," try buying Treasuries and shorting junk bonds.


    In the past, every inverted yield curve was precipitated by the Fed sharply curtailing money supply in conjunction with rapidly rising short term rates thus eliminating all short term liquidity and precipitating a recession. The inverted yield curve did not cause the recession; it was just one of the “effects” of the Fed taking away the punch bowl.

    With the FED’s continued shoveling of money into the system faster than I used to be able to shovel coal into the boiler of the great lakes freighter I worked on some 50 years ago, restricted money supply is certainly not the cause of today’s yield curve. So what is? And why is nobody even questioning it, let alone looking for an answer. I guess it’s easier to believe in fairy tales like Goldilocks. Do you really believe that people are buying long term bonds at these rates because they believe that inflation will stay below 2% for the next 30 years? Those dummies can’t even predict next months inflation rate let alone what it will be in 30 years.
    Ever hear of Supply and Demand or is that just something you all learned about in first year university and along with the rest of our Economists, promptly forgot. Has anyone even noticed that 30 year bonds which once made up over 30% of our National Debt has now fallen to below 5%; while Short Term paper which used to be under 30% is now over 50%? Does anybody still remember what happens to price when you reduce the supply of one product and at the same time increase the supply of another competitive product? (Remember; bond prices up means interest rates down)


    I have on numerous times in past letters explained the carry trade as well as the different goals of the super rich and the desires of exporting nations like China and Japan to maintain their current monetary exchange ratio. So what this inverted yield curve is really warning us about is the extraordinary liquidity out there as well as the unbelievable levels of risk that exists in almost all forms of investment except perhaps GOLOD. It is certainly not about projecting the continuation ad infinity of the world’s fairy tale economies.

    During America’s 1970’s flirtation with hyper-inflation, wage and price increases were driven by a rapid expansion of the money supply created by the FED to fund the government’s massive “Guns & Butter” deficits. The upward spiral was finally brought under control in 1981 when Reagan appointed Fed Chairman Paul Volker, who immediately raised short-term interest rates, reduced monetary growth and brought on the 1982 recession. early on in Reagan’s term in order to wring inflation out of the economy before the next election. The challenge facing the government both then and now is how to continue to live beyond the government’s means without causing massive inflation. Volker came up with a brilliant plan to solve this problem. He decided to sell Government Bonds directly to private investors through the financial markets, instead of directly to the banks. By placing the bonds in the hands of the public, he avoided the massive increase in Bank reserves, thus limiting the banks ability to create new money out of thin air. The success of his plan becomes obvious once we examine the subsequent explosion in the size and breadth of the bond markets; gross issuances of Government Bonds grew from less than $.9 trillion in 1970 to over $23 trillion by 1997 and to over $42 trillion by 2002. The second part of Volker’s program was to reign in government deficits, but his advice like Greenspan’s and Berenanke’s was ignored. The debt began to come under control with Bush I and Clinton, mostly due to the Peace Dividend, after the fall of the USSR and especially after Gingrich and the Republicans took control of Congress in 1995. Nevertheless, the Gross Federal Debt continued to increase every single year, in spite of the phantom "surpluses" of the last two years of the Clinton administration. Since then the national debt has reached dizzying heights, especially since 9/11; which brought not only an abrupt end to any remaining Peace Dividend but precipitated a restart of a guns and butter economy. You won’t believe what the numbers will end up being for 2006 as the hurricane reconstruction and war bills come due. It is this new interaction between the explosion of debt and "the capital market’s revolution" that produced a new and highly deceptive (hidden) form of inflation.

    The Interest Rate Anomaly
    It is impossible for the tremendous volumes of bond purchases to have been funded simply out of savings. This anomaly has not attracted much attention or investigation. Instead, most analysts now find this state of affairs to be utterly normal. "Deficits don’t matter" perfectly summarizes the prevailing attitude. The massive accumulation of government and corporate debt while still maintaining a low inflation environment no longer provokes much curiosity, even among professional economists. What’s even more curious is that an ever rising bond, stock and real estate markets have become accepted as the normal state of affairs, requiring no special explanation our counter-action. Periodic bouts of inflation, the tell-tale signs of a long-standing debt addiction, have all but vanished. The central banks, as financial physicians, seem to have affected a miraculous cure. Few have ever bothered to ask how the central banks have accomplished this feat. But as long as inflation, like your wayward daughter, is out of sight, who really cares exactly what the central banks have been up to.

    The character of the 21st Century inflation is different from that of the 1970s. Since 1987, price changes following huge increases in money supply have been restricted to stocks, bonds and real estate rather than to wages and consumption goods at least so far. How can inflation sometimes affect financial assets and other times mostly consumer prices? The particulars depend on where and how the new money enters the system, and most importantly, what the initial recipients spend it on. As the initial recipients (the banks, the creators of new “out of thin air” money, the big Brokers and Hedge Funds) find themselves with a surplus of cash relative to their needs and since they don’t consume, they will bid for financial assets (Bonds) which, the sellers of those assets, the government, will supply as much of as is wanted. In this way, monetary expansion will affect some prices more than others. For example, during inflation, the relative price of apples in terms of oranges might no longer be 1:2, the apple might now cost $2 and the orange $6, a ratio of 1:3. Price ratios are not stable under inflation. However, suppose that instead of comparing apples to oranges, we compare apples to the DJII. If apples cost $1 and the DJII is 5,000, and then money is created and used by the initial recipients to buy stocks, the apple may still cost $1, while the DJII becomes 10,000. That is a financial disaster just waiting to explode.

    With financial assets absorbing most of the impact of the newly created money, the outbreak of inflation into wages and consumption goods that proved so disastrous in the 70s has been, for the time being, repressed. A large part of that can be explained by globalization and the massive capacity over investment that is associated with every massive credit expansion and low interest rate induced boom. The inflationary price adjustments rest assured will eventually leaked out of financial markets into other markets, the first was real estate. Normally, the latter recipients of the new money spend it on consumer goods and cause inflation to creep into the CPI. But the massive worldwide over capacity build up has kept prices of consumer good and wages in check so far. However, in recent years, money that has been injected in ever increasing amounts into the financial markets was either contained there or poured into real estate. The GAO’s (FMN & FRE) taking a lesson from the Banks, quickly jumped into the fray. Normally all this would have showed up in the CPI, but this time the government, in its infinite wisdom, decided to only measure rents, which were falling, instead of home prices which were skyrocketing. The mechanisms of this containment in conjunction with interest rate arbitrage geared through financial derivatives, a stronger US economy that has been attracting 80% of the worlds savings, and the government’s management of public opinion about inflation has kept the CPI at bay thus far. BUT alas, all good things must come to an end and as the Real Estate Boom begins to deflate, rental rates start increasing as the prices of homes both old and new have been inflated out of the price ranges of most Americans, “the chickens come home to roost” as inflation begins to creep up as the process is reversed: Perhaps its time to change the rules for calculating inflation again? The question remains: Not If but When will INFLATION begin to gallop?

    Entrepreneurial activity is the activity of insightful entrepreneurs who perceive profit opportunities and are willing to risk their capital to back up their ideas. The continuing rearrangement of productive activities by entrepreneurs aligns production with consumer preferences.

    The Management of Expectations
    The purchasing power of money depends on the supply and demand for money itself. The greatest determinant of the demand for money is public expectations of future prices. If prices have been stable, people will expect them to remain stable and money demand will remain about the same or actually decline.

    In spite of accelerating money supply growth, if people do not believe that prices will rise in the future, inflation expectations can remain low. On the other hand, if the people perceive a large increase in the money supply and hence future increases in prices. . In response to inflationary expectations, people buy now, drawing down their cash balances and raising prices. Their lowered demand for investments (bonds) pushes up interest rates as well as the prices of goods and services now, rather than later. The more people anticipate future price increases, the faster those increases will occur. . .

    Deflationary price expectations lower prices, and inflationary expectations raise them.

    Recent history suggests that people attribute more importance to the recent price changes of consumption goods in forming expectations about the future. Similarly, consumer's attribute more importance to price trends in financial assets in forming opinions about the future prices. Moves in asset price attract little interest from the masses until a trend has been in place for some time.

    To the extent that any money at all has leaked out of financial assets into consumption goods, the deliberate distortions in the measurement of the Consumer Price Index (CPI) has been introduced in order to create a false consensus that "there is no inflation." A variety of questionable price adjustment stratagems have been instituted in the CPI computation: The exclusion of food and energy, the use of "quality-adjusted" prices, seasonal adjustments, and the replacement of home prices with rental rates. The index incorporates only consumption goods, when most of the price increases are showing up in financial assets and the costs of health care. So successful has been the management of expectations that inflation has disappeared from public discussion. Most of the public did not view a succession of all-time highs in the stock market in any way relevant to the price they would have to pay for milk. Growth in the money supply attracted no analytical attention from the mainstream financial media. Some prominent "supply-side" economists even advanced the ludicrous idea that the US economy was in danger of falling into deflation during the late 90s and into 2003, called on the Fed to inflate even more. This successful management of inflation expectations has forestalled the eventual rejection of cash in favor of tangible goods that ultimately results from excessive money creation. The impressive reduction of inflation is a dangerous illusion; it has been obtained largely by substituting one set of serious problems for another. The public, intoxicated with the gains from real estate and stock and bond market inflation, has adopted a don’t ask, don’t tell policy toward central banks.

    The Corruption of Savings
    A peculiar feature of the social psychology of financial asset prices is their self-reinforcing character. The upward trend in stock and bond prices has served to enhance the respectability of capital markets and their perceived safety as repositories of money. Some commentators reason that inflation must now be quite low because the credit markets are patrolled by "bond vigilantes," astute traders ever alert to punish central banks for their inflationary indiscretions and always ready to dispense rough justice in the form of higher interest rates. However, this analysis assumes that inflation is reflected primarily in consumption goods and that bond yields are free to move on their own to convey meaningful information about changes in the value of the monetary unit.

    These assumptions are more or less the reverse of reality: The funneling of inflation into bonds as described above provides a floor under bond prices and hence a ceiling on bond yields. The bond vigilantes have gone on an extended vacation. Another popular argument is a stock market that is expensive, when measured by P/E ratios, is cheap because low interest rates justify higher P/E ratios. Stocks appear to be cheap in a dividend discount model that uses the current bond yields to discount present value. This view fails to take into account that the bond bull market is a symptom of high inflation, not low inflation. Inflated prices for bonds might make stocks look relatively cheap in comparison to bonds, but in the absolute sense both are inflated.

    But what does it matter if stock and bond prices rise relative to consumption goods? "It's paper gains today, paper losses tomorrow; who cares?" The problem with financial inflation is that investment decisions by entrepreneurs are based on relative prices and interest rates. When interest rates and relative prices are distorted, the entire productive structure of the economy looses it’s direction and becomes distorted. The movement of real savings into real investment is stymied and we end up with jobless growth first and then over investment into enterprises that should have not been entered into because their rate of return is too low given the risks involved. All this ends up denigrating all currency matters and distorts economic calculation. Like it or not, A GUNS and BUTTER economy must eventually produce inflation.


    The expansion of the financial sector relative to that of the economy (mining, agriculture, manufacturing, transportation, energy, transportation, and retail) is but one example of these distortions. The increasing domination of stock market activity by financial institutions and financial services companies have quietly come to dominate not only the S&P 500 but the entire economy. For example, right now financial companies make up 40 percent of the index, up from 12.8 percent 20 years ago. The current weight of financial services is almost double that of industrial company stocks and more than triple that of energy shares.

    It is also worth noting that the current weight of financial services companies in the S&P is significantly understated because the 82 financial stocks in the index do not include the likes of General Electric, General Motors, Chrysler or Ford etc., all of which have huge financial operations that last year represented more than 100% of their earnings. Financial companies now generate about 40 percent of total profits of all United States’ companies, which is up from 7 percent in 1982. In addition, profit margins at financial companies in the last quarter of 2006 stood at 51.6 percent of all corporate output, around 31 percent higher than their average since 1929.

    The economic purpose of capital markets is to provide a nexus between savers and borrowers for the financing of productive investment. Financial entrepreneurs, such as venture capitalists, traders and speculators, need a true interest rate, which is essential in forecasting the best uses of Limited available real savings and the measuring of risk in an uncertain world. But a society cannot prosper by printing ever-increasing quantities of paper tickets representing claims for real goods and drawing more of the population into trading these tickets back and forth among themselves. All of this is nothing but a financial fantasy and fraud and like all Ponzi schemes must come to a sad end. The fantasy being that central bankers have found a way to inflate without any negative consequences. While the effects of money supply growth can be confined to stocks and bonds for a time as inflation is hidden in plain sight. The inevitable adjustments cannot be postponed indefinitely and its unwinding will be neither easy nor painless and is most probably threatening both an economic as well as financial disaster.

    The Fed’s Conundrum
    The question that most analysts and especially Bernanke are asking is: Why were long term interest rates still not rising in the face of 17 consecutive point discount rate increases? The answer my friends is both simple and very worrisome. All these Banks, Hedge Funds and other financial institutions that have had it so good for so long, making all that easy money are now between a “rock and a hard place”, as they are now locked since their positions are too big to liquidate (CASH OUT). They can’t get out because there is nobody to sell to. They are all forced to continue to keep playing the game until the bitter end. The same holds true for all the Central Banks that have been buying up all the US government’s newly issued paper. They too are caught between the proverbial Rock and a Hard Place. In order to maintain employment in their countries, they must continue to export and protect the value of the US dollar. They can talk all they want about diversification of their reserves but they too, like the arbitragers have no one to sell to. They are all locked in and must continue to play the game. However, all this used to depend on both the US FED and the BOJ, but now it’s all in the hands of the BOJ and should the YEN start to appreciate especially against the Dollar and the Euro; watch out below as the easy profits turn into even easier losses on the biggest bets ever taken.

    Now I have hopefully addressed the question that heretofore nobody has bothered even asking. What’s making the stock and bond markets behave like they have never done before, if it’s not a New Paradigm? If, as I surmise, a financial and economic disaster is in our future, then the only question not yet asked is, when and how will it begin? The best answer that I can come up with is that it depends. Since I don’t have a crystal ball, I can only guess. The deadlock that will ensue this year as the Democrats take over both Houses of Congress cannot be positive. Even if there were easy solutions, all eyes are on the 2008 Presidential Elections and neither party will give the other a platform to run on; no matter how much the country needs it. “The Piper Must Be Paid” - the only question remaining is not IF, but when and by how much?

    January 4, 2007

    Aubie Baltin CFA, CTA, CFP, PhD.
    Palm Beach Gardens, FL.

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    Last edited by FRED; 01-04-07, 01:41 PM.

  • #2
    Re: The Obvious is Obviously Wrong - Aubie Baltin

    Excellent exposition; I largely agree, except I'm not quite sure that anti-consensus is enough to trump fundamentals (the very fundamentals you lay out).

    The key question I have is regarding your predictions of a stronger dollar but also higher interest rates. Don't these predictions conflict? If the dollar strengthens, the Fed can lower interest rates to provide some domestic relief. Perhaps you think the dollar will strengthen but the Fed will be stubborn and leave interest rates high?

    I honestly don't know where gold, the dollar, or interest rates will go over the next year, but I know what the fundamentals are. On a trade and deficit balance basis, the dollar must come down -- and this isn't even to begin to consider the generally-shrinking US share of the global economy. The fact that the dollar may stay up, short term, suggests that the interventions going on to prop it will snap all the more catastrophically when they finally move.