Hyperinflation or Deflationary Depression - Part 1
By John Robino - Dollar Collapse.com
News and Alerts on the coming Dollar Collapse and how you and your family can survive and prosper.
By John Robino - Dollar Collapse.com
By John Robino of Dollar Collapse .com
M3 died a controversial death this week. As for whether the Fed’s decision to stop reporting its broadest measure of money was simply a recognition that money has become too complex to quantify, or an attempt to hide the accelerating debasement of the dollar, time will tell. But one thing is certain: The best gauge of gold’s near-term direction has now become impossible to calculate. Called the “Fear Index,” it was created by GoldMoney’s James Turk in the 1980s, and since then it’s been nearly flawless (read on for its final prediction). Here’s how James and I explained it in our book, The Coming Collapse of the Dollar:
“The dollar is a balance sheet currency, which is to say an accounting fiction. Its value is derived from the assets held by the Federal Reserve and commercial banks, some of which, like gold, are real and tangible, and some, like bank loans, foreign currencies, and derivatives, are not. The Fear Index measures the relative importance of gold within the U.S. monetary system, and is calculated by multiplying the U.S. gold reserve (i.e., the weight of gold reportedly under the Treasury’s control) by gold’s exchange rate to get its total market value, and dividing this result by M3, the broadest measure of money supply.
A reading of, say, 2%, indicates that for every $100 circulating as M3, there is gold worth $2 sitting in the U.S Treasury’s vaults. Gold would thus account for 2% of the dollar’s value, with the other 98% dependent upon the financial assets of the Fed and the nation’s banks. The calculation for December 31, 2003 is as follows:
When the Fear Index is falling (that is, when the number of dollars in circulation is rising faster than the market value of the gold in U.S. reserves, or when the number of dollars is falling more slowly than the value of the gold reserves) the implication is that people are willing to hold these extra dollars because they’re optimistic about the prospects of the dollar and/or the U.S. economy. When the Fear Index is rising (which occurs when money is flowing into gold, pushing up its exchange rate and raising the market value of U.S. gold reserves), it’s usually because people are worried about the dollar or the health of the U.S. banking system, and are looking for alternative stores of value.
And when the Fear Index exceeds its 21-month moving average and the moving average rises above its level of the previous month, the result is a ‘Buy’ signal, indicating that gold is headed higher. As you can see from the chart below, there have been only five such signals in the past thirty-five years, all of which were followed by gold rallies.”
Investors who bought gold at the last Fear Index buy signal are up about 80% today. So now the question becomes, where’s the top (which is the same thing as asking where the dollar will bottom out). Without the Fear Index, this question has become a lot harder to answer. But it’s also a long way off. As James wrote in his most recent Freemarket Gold and Money Report newsletter:
“As we can see from the page-1 chart [posted below], the Fear Index has again been climbing over the past few years. There are a couple of noteworthy points to make as a result. There are two solid red downtrend lines on the page-1 chart. Look at what happened after the first downtrend line was broken. The Fear Index soared. Now look at what is happening.
The Fear Index is again soaring, and I expect it to continue climbing higher, repeating the experience of the 1970s. I’ve drawn two uptrend channels to show that I expect the Fear Index to climb within an uptrend channel just like it did through the 1970s. The second point to which I want to draw your attention on the page-1 chart is the dotted, red downtrend line.
I expect the Fear Index in time to reach and eventually break through that downtrend line. In other words, the Fear Index over the next several years is heading back to – and probably above – 10%. In fact, it is my expectation that within several years, the Fear Index will climb toward the peak reached during the Great Depression. It will do this as the problems with dollar fiat currency become more apparent, causing a flight from the dollar into the safety and security of gold. The flight out of the dollar is already underway. It’s only a matter of time before the rush for the exits turns into a torrent.
Assuming M3 grows at 8% a year over the next three years, and the Fear Index rises to 10%, implying that we’re worried as in the 1970s, the Fear Index yields a target gold price of $4,961 per ounce."
Viewed this way, Washington’s obligations actually do look pretty manageable. If we’re doing as well as Germany and better than Japan, how bad can it really be? Well, it can be very bad indeed, because the “national debt” in the above chart refers only to direct obligations of the federal government, and government doesn’t have to borrow to finance itself with debt. Consider: If the Fed lowers interest rates and liberalizes lending rules enough to convince me to build my dream house, I go out and borrow, say, $500,000, which generates taxable income for my mortgage banker and her support staff. Then I hire a contractor and crew, who spend six months earning good money and paying taxes. Then I furnish the house and landscape the yard, generating taxable income for furniture makers and gardeners. Government, by encouraging me to borrow, has pocketed tens of thousands of dollars that it doesn’t have to borrow for itself.
|Housing History: Is it 1986 or 1929?|
Housing stocks got a nice pop this week, as both Barron’s and the Wall Street Journal called luxury homebuilder Toll Brothers a buy. Interesting timing, this. Why would such usually-sensible papers talk up a cyclical industry at the peak of its cycle? Well, it seems that the big home builders have diversified into lots of different regions, and used their financial muscle to buy up all the good home sites. This makes them immune from a mild slump, which is what their fans expect. As the Wall Street Journal put it:
“That's why the bulls need this housing slowdown. They are expecting that the companies will be able to have some earnings growth, grab more market share, and throw off enough cash to buy back stock to shore up their share prices.”
So the idea that the homebuilders—and by extension, I guess, the mortgage lenders and big consumer banks—are a buy hinges on the severity of the housing slowdown. If it’s modest, as the past few have been, then the homebuilders, trading at, like, 6 times earnings, will push their weaker local competitors off the field and emerge even stronger and more valuable. And based on the behavior of housing starts since the 1980s, that doesn’t seem too farfetched. Starts have fluctuated, sure, but they haven’t fallen by very much for very long. A few years of modest decline is the worst recent history says to expect. The leading homebuilders would breeze through another 1990 or 2001 without a scratch.
Unfortunately for the homebuilders and their investors, the history on which they base their optimism has another component: Leverage. While housing has been doing its onward-and-upward thing, Americans have been borrowing like crazy, mostly to buy, you guessed it, houses. And once inside, they’ve been sucking out the remaining equity via cash-out refis and home equity loans. It’s the perfect self-reinforcing cycle: Home prices go up because we can borrow, and we can borrow because our homes are going up.
In 1985, total U.S. debt came to a not-inconsiderable $55,000 per person, or $220,000 per family of four. Two decades and 25 million new houses later, those totals have risen to $140,000 and $560,000, respectively. Our debt burden is now three times the size of the economy.
For the brief-slowdown-followed-by-another-building-spree thesis to work out, you have to assume that Americans will spend the rest of the decade borrowing two trillion more dollars each year. And for that to be possible you have to assume that America’s trading partners will buy another $700 billion of new Treasury bonds each year without demanding a higher interest rate. Who knows, maybe they will, and the housing bubble will inflate for another decade. As an economist said to me on a radio show a while back, “People have been complaining about American debt for thirty years and it hasn’t slowed us down. This economy can handle whatever amount of debt we care to take on.”
But what if this time a different bit of history is about to repeat? Since we’re borrowing like it’s 1929, maybe the housing market will start behaving that way too. Here’s what happened after that debt binge:
These days, millions of people around the world have pretty much the same problem. They see America borrowing like crazy and making a mess of one foreign adventure after another, and they suspect that U.S. markets, as a result, are headed for disaster. But they don’t know what to do about it. Five decades of growth and prosperity have trained them to look at only the long side of the market. The short side—that is, betting on things going down—is foreign territory.
So this column will be the first in a series on how to make money when the Dow and the dollar both head south. The plan is come back every few months to see how we’re doing. My guess is that we’ll be doing great.
Let’s begin with options, which are contracts to buy or sell 100 shares of stock for a given period of time at a given strike price. A call option gives its holder the right to buy (or call away) 100 shares, while a put confers the right to sell (or put the shares into someone else’s account). Said another way, calls become more valuable when the underlying stock goes up, and puts become more valuable when it goes down. If not exercised by their expiration date, options cease to exist, costing the owner their entire investment. This short lifespan was a drawback of old-style options, which ran for only nine months. But that problem was solved by the creation of Long-Term Equity Anticipation Securities, or LEAPS, which last up to two-and-a-half years.
LEAPS let you place multi-year bets for relatively little money. But they’re tricky. They come in a wide variety of expiration dates, strike prices, and underlying securities, which makes it possible to construct strategies both brilliant and incredibly stupid. Doing LEAPS right requires expert help.
So I stopped by the office of Bill Lambert, a Moscow, Idaho money manager and options guru who spends his days constructing arcane strategies with amusing names, most of which make his clients a lot of money (call him at 866-525-9194 for a free consultation). We spent an hour in front of Bill’s four 19 inch screens, him pulling up charts, running simulations and rattling off figures for volatility and delta and gamma (“the Greeks,” he calls them), and me scribbling furiously and asking the occasional really dumb question. The result: four slick ways to turn bad times into major windfalls.
Gold Price Suppression Short Squeeze Spread
In sound-money circles, it’s accepted as fact that the world’s central banks have been colluding with a handful of commercial banks (known as bullion banks) to depress the price of gold. For the full story, see Sprott Asset Management’s “Not Free, Not Fair,” at http://www.sprott.com/resources/reports.php. But for now, suffice it to say that the central banks secretly lend their gold to bullion banks, which sell it on the open market (thus depressing gold's price) and invest the proceeds. The bullion banks are obligated to return the gold to the central banks someday, which means they're short gold and stand to make a lot of money if gold goes down. But of course it hasn’t gone down. It's up big, which means:
1) The bullion banks have tens of billions of dollars of unrealized losses on their gold shorts which, when reported, will crush their stock prices.
2) At some point the bullion banks will have to buy all this gold back, which will send its price through the roof. A classic short squeeze!
So let’s buy LEAPS calls for GoldCorp, a high quality, low risk gold mining company, and LEAPS puts for Goldman Sachs, reputed to be one of the leading bullion banks. We’ll buy round lots of ten contracts (giving us exposure to 1,000 shares of stock) at their closing prices on Friday, February 17. Total cost: $13,900.
Bill’s take: “Goldman can peel off $50 easy. If it does, this put will go up 600%-700%.”
|Buy GoldCorp $30 Jan 08 call|
|Buy Goldman $130 Jan 08 put|
|Total Cost|| || |
Gold Price Suppression Short Squeeze Calendar Spread
For a less costly variation on the above spread, let’s also sell a shorter-dated Goldman Sachs put, and use the proceeds to defray the cost of the longer-dated put. Ten of the Jan 07 130s bring in $4,800, lowering the up-front cost of the strategy to $9,100. This is what’s known as a calendar spread. With it, you don’t make as much if Goldman tanks in 2006. But 2007 is when everything is due to fall apart anyway. And in the meantime, you still win big if GoldCorp goes up.
|Buy GoldCorp $30 Jan 08 call|
|Buy Goldman $130 Jan 08 put|
|Sell Goldman $130 Jan 07 put|
|Total Cost|| || |
Now let’s say you expect oil to soar in the next couple of years. $4 gas might finally convince American consumers to stop their obsessive shopping, which in turn would cause upscale retailers like Abercrombie & Fitch to implode. So we’ll go long Exxon $65 calls of 08, and short Abercrombie & Fitch via its Jan 08 $70 puts.
Bill’s take: “Exxon is a right near its ‘05 high. It’s been going sideways for a year, building a base. It’s a slam dunk to go higher. Abercrombie & Fitch was $15 in ‘02, and now it’s $65. It’s put in a beautiful double top, and could fall to $30 easy.”
|Buy Exxon Mobil $65 Jan 08 call|
|Buy Aber. & Fitch $70 Jan 08 put|
The NASDAQ Tanks in 07 Calendar Spread
One of the risks of using options on individual stocks is that any given company can do things —good and bad—that have nothing to do with the market. GoldCorp could a have mine accident or Exxon another Valdez. Or Goldman Sachs could merge with CitiGroup or some other monstrous entity, making its puts worthless.
You can eliminate this risk with options on broad indexes like the S&P 500 or the NASDAQ. Because the NASDAQ is heavy on tech and light on energy and mining companies, its options, known as QQQQs, are especially juicy shorts. The QQQQ is currently $41, so let’s buy the Jan 08 $40 puts and sell the Jan 07 $40 puts, for a net cost of only $1,075 on ten contracts.
Bill “I’m looking for the Qs to be down in the 20s…hell, you’ll be $15 in the money if the market tanks in 07.”
|Buy QQQQ $40 Jan 08 put|
|Sell QQQQ $40 Jan 07 put|