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I wish I was referring to Fannie and Freddie
in the title of this piece, but because those institutions are being
resurrected, the funeral I am waiting for is the one for our entire
fiat-based system. We are now on the brink of a collapse in confidence that
brings the whole world financial system to its knees. Each market intervening
action is becoming more extraordinary. The rallies which pull the suckers in
following the intervening actions are becoming more brief and less powerful. I
expect this one to be no different. This sequence has now become a broken
record. Markets threaten to take out technical support levels and the
government comes to the rescue. Armageddon is avoided until another day and a
relief rally ensues on the belief that the government has fixed the problem a
new bull market can begin. After all, this is how investors have been
conditioned over the last three decades.
The
problem is that the government has made the problem worse. This first began
with the surprise unprecedented 75-basis point cut in August 07, and followed
with other extraordinary actions taken in January, March, July, and September
of this year. I can’t wait to see what they have up their sleeves for
the next debacle. Ed Sullivan would say “we are in for a really big
show.” They better think up something fast because they are up against
a multi-decade extended market that is now headed down after just having
reached a major double top:
 
Look out
below. You could make the case that the S&P 500 will decline all the way
back to 500 before being rescued by technical support.
After the
moves to restructure Fannie/Freddie, it should be clear to all that there are
no limits to which the government officials will go to prevent a collapse
(and for politicians to keep their jobs). The only reasonable conclusion is
that we will one day arrive at a point where government action is not enough,
and when it does, the magnitude of the collapse will be far worse than what
it would have been if we allowed it to occur earlier. We need to let this
beast die as I wrote in "It's Always Darkest Before the Dawn...of a Depression."
We have
strayed too far off course and there will be no avoidance of catastrophe at
this point. We are just too far extended now. The decision to save Freddie
and Fannie was totally expected. The third and final leg on our path to
collapse (first initiated by the creation of the Federal Reserve in 1913) was
set in motion by our total abandonment of the gold standard in 1971 and is
now only months, if not weeks away. Nixon gets the blame, but he was merely
reflecting the collective will (or “non-will”) of the American
people to exercise a little sacrifice and discipline and pay our national and
international debts. See my piece titled,
http://www.greenfaucet.com/the-market/debt-demographics-debasement-are-destiny.
The price we will pay the piper will be catastrophic as a result. We became
the most gluttonous nation in the history of the world. The image of that fat
guy who ate so much that he exploded in that Monty Python movie comes to mind
when I look for an analogy.
Many have
written that our children will be paying for the extravagance of the
baby-boomers for the rest of their lives. I disagree. I now think that we are
close to a reckoning event that will impose austerity, economic pain and
suffering on the vast majority of Americans. This will be difficult to endure
and could last a while. The US Government and consumers will be forced to
make major adjustments. Lifestyle changes will be revolutionary. But on the
positive side, it could restore some of the bedrock principles this country
was founded, built, and thrived upon (thrift over profligacy, savings over
consumption, and discipline over excess). This will hopefully place us back
onto the path of responsibility and sustained growth. We should be able to
refresh anew after the cleansing process which expunges the huge mutli-year
debt overhang. This will be painful and most government officials will fight
it tooth and nail, pandering to the masses to prop up the current system, now
clearly doomed to failure.
This
backdrop will prove to be treacherous for investors. I think we are now
embarking in a period that will see financial convulsions between inflation
and deflation. Battling between the two and trying to position for the
correct scenario will rip most portfolios apart. If you are positioned for
one while the other occurs, it destroys your capital base, leaving an
investor with less to try to take advantage of the next swing. Since last
August (2007), the correct bet was on the inflation trade. That trade changed
on dime on July 15. Many incorrectly interpreted the dollar strengthening and
rebound in deeply oversold sectors as a return a bull market for US equities.
Wrong! This was a reversal of a very crowded trade as the winds of deflation
began to displace inflationary forces. The reversal of the long
commodities/short the dollar (and equities which benefit) was swift and
brutal and continues today.
Because
the jig is up and the end game / reckoning has now begun, the only question
that remains is will in end in fire (inflation/hyper-inflation) or ice
(deflation). I like the recent quotes from the prescient old-timer Harry
Schultz (from Peter Brimelow at CBS Marketwatch) to
explain: "Fed maneuver room approximately gone. Any $US injection big enough to avert a depression triggers runaway inflation. If not big enough:
depression. US on knife-edge. Gold helps you either way. If Bush bails them
[financial institutions] all out, the die would be cast for inflation unseen
in the West since 1923 Germany. If no bail: Hello, 1929." In order
to determine which scenario to position your portfolio for, I like to turn to
the US Dollar for clues. The “80-level”, a multi-decade support
level violated a year ago, should now offer firm resistance for any further
dollar strengthening as it rises to 80 once again. Look at the chart below:
As the
dollar rose from under 71 (the end of March) to over 79 (now) over the summer
we saw an across-the-board selloff in commodities and emerging market
equities and a mini-counter-trend rally in the stinky US sectors (tech,
financials, consumer discretionary) where investors had previously been
losing their shirts. Government bonds also rallied indicating that this was a
period in which you should have been invested for deflation. We are now
approaching an important test for the US dollar is it approaches 80 again. The
dollar has rallied up to 80 over the last couple of weeks (not quite shown on
the chart above).
If the
dollar does in fact rally above 80, then I think that the deflation trade
will accelerate further and takedown US equities this time in a major whiff
of asset deflation which takes down almost all asset classes except US
treasuries. If it continues unabated it will result in a major deflationary
depression. Gold will eventually rise in value amidst the chaos and removal
of the paper currencies, but not after first declining significantly.
If, on
the other hand, the US dollar begins to decline back below the 74-73-level, I
think that investors will need to consider repositioning for the inflation
trade. While the dollar stays in the 75-80 range we can expect big gyrations,
but little real movement or investment direction. In the inflationary
environment, your best investment choices are energy and precious metals. If
the dollar does move above 80, I view it highly likely that at some point
before a deflationary depression occurs, governments and politicians around
the world will massively debase their currencies and enact ultra-expansionary
fiscal and monetary policies in order to fight it. Therefore, anyone with a
one-way bet on deflation could be wiped out if we experience one or two
highly-inflationary periods along the way.
Planning
for the unavoidable collapse of this beast of a fiat financial system we must
now confront (the “Financial Funeral”) is thus fraught with
danger as you try to navigate between seemingly wild and capricious swings
between inflation and deflation. The only bet sure to fail is that the
government actions will succeed in preventing the Financial Funeral from ever
occurring.
Kurt Kasun
www.greenfaucet.com
A contributing writer to GreenFaucet.com, Kurt Kasun writes a
high-end investment timing service, GlobalMacro, which is focused on
identifying opportunities that produce returns in excess of market with
reasonable risk. He is strategically located in Washington, D.C., a key to
maintaining contacts and relationships which help Kurt understand global
policy and economic factors as they emerge. His investment approach has
always been macro in nature largely due to his undergraduate studies at the U.S. Military Academy at West Point (B. S. National Security, Public Affairs, 1989) and his
graduate studies at George Mason University (M.A. International Commerce and
Policy, 2006).
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