How Christmas ended starvation and enriched the West

The world was flat until 1600. Not the shape of the planet. According to the best economic history, standards of living even in 1800 AD hardly differed from those of 5000 BC. TV shows dealing with the ancient past assume a gradual slope of progress so they portray Egyptians or Abraham and Sarah in the Bible as if they were primitive South American tribes still stuck in hunting and gathering mode for food. But if economic historians are correct, Egyptians in 3000 BC lived as well as the eighteenth century French.

Famine and mass starvation were common. Nobel-Prize winner Robert Fogel wrote that in eighteenth century France 20% of the people could get only enough calories each day to fuel a short walk to the spot where they begged.

Of course, some ancient capitals did better than others by looting conquered nations but per capita wealth never increased; it just sloshed from one conqueror to another. Rome enjoyed wealth and splendor because it had stolen stuff from defeated nations for the most part.

The real economy will end the expansion, not the Fed

The Fed has done an excellent job of preparing the world for this rate hike so it was already built into market prices. Don’t expect much to happen.

Some economists expect rising interest rates to kill the “recovery” and plunge the US economy into a recession. And of course the standard Austrian business-cycle theory teaches that rises rates will cut short an expansion. But as I have written before, recessions can happen without rising rates because of the Ricardo Effect.

But the idea that tight money is the only cause of recessions, as monetarists claim, is an example of the post hoc fallacy: because recessions happen after several rate increases by central banks, people think the event that happened first caused the one that happened later. It’s similar to attributing the rising of the sun every morning to roosters crowing.

US in rut like old German socialism

Mainstream economists and the Federal Reserve are trapped in a rut, condemned to repeating the mantra that monetary policy can save us even though it hasn’t for seven years. Germany after World War I faced a similar situation and the US should heed the lessons.

Socialist ideas swept through Germany like the swine flu in the last half of the 19th century. Otto von Bismarck, the Kaiser’s prime minister, devoted his career to fighting socialists while preserving the monarch by co-opting socialist policies. He promoted unions, nationalized railroads, mines and other large industries. State regulation of industry exploded. He provided social security, healthcare and unemployment benefits. By WWI socialists could not point to a single policy of theirs that Bismarck had not already deployed. Socialists dominated parliament but they weren’t happy because the Kaiser ruled and they didn't.

That changed with the revolution after WWI that gave the German socialist parliament control of the nation. Socialists were jubilant. Now they could demonstrate to the world the superior nature of true socialism. The only problem was that Bismarck had already implemented all of their ideas. They had nothing new to offer. Ludwig Mises described their quandary in his book Omnipotent Government:

Industrial sector data scarier than retail

The sales figures for Black Friday are out and they are scary. Brick-and-mortar store sales plummeted 10.4% over the weekend from last year's levels.

Online sales increased on Black Friday by 14% over last year to $2.7 billion
and on Cyber Monday by about 16% to $3 billion, but that did not make up for the plunge in in-store sales. On-line sales were up about $750 million while in-store sales fell $1 billion.

Retail sales at Walmart and Macy’s have looked sad for a while. Retail sales point to the potential for the Grinch to steal Christmas for investors.

Japan, Europe and mainstream monetary theory are out of gas

When a sailor hits a dead spot where the wind refuses to blow he cays he is “in irons.” Japan’s economy sailed into the irons this past quarter when its GDP declined for the second quarter in a row and officially signaled a recession. GDP fell 0.8% in the third quarter after shrinking 0.7% in the second on an annualized basis. This marks the fourth recession Japan has endured since the global crisis hit in 2008.

Following so soon on the heels of massive stimulus, the recession should strike a death blow to mainstream monetary theory. Abenomics, the economic recovery plan that Prime Minister Shinzo Abe launched in 2012, was the poster child for mainstream monetary theory. Japan would wash away deflation and decline with a torrent of new money.

Debt service burden signals downturn

Investors can never have too many omens of disaster and the Bank for International Settlements has given us a new one to watch for signs of impending recessions - the corporate debt service burden.

Authors Mathias Drehmann and Mikael Juselius first wrote about it in their article "Do debt service costs affect macroeconomic and financial stability?" published in the BIS Quarterly Review September 2012. They summarized their findings this way:

"We find that the DSR prior to economic slumps is related to the size of the subsequent output losses. Moreover, the DSR provides a very accurate early warning signal of impending systemic banking crises at horizons of up to one to two years in advance."

How GDP fools economists

Economists look to GDP to determine if the US economy is in a recession. Generally, it takes two quarters of the economy shrinking (economists call it negative growth, but they’re linguistically challenged) for the National Bureau of Economic Research to declare a recession. Of course, those two quarters indicate the bottom of the recession, by definition.

The market outruns profits

I created a new model of the S&P500 that incorporates more variables and some nonlinear action. The chart at the left shows the results. The blue line represents the quarterly averages of the S&P 500 while the red shows quarterly averages produced by the model, the last three quarters of which are forecasts. The data analyzes quarterly averages because profit data is reported quarterly by the Bureau of Economic Analysis.

The model uses data back to 1948, and as the reader can see the value of the market has run ahead of where it should be in proportion to the growth in profits. Something similar happened in the dot.com bubble of 2000 but to a greater degree. Obviously, the market can deviate from valuations justified by profits for a very long time if people are confident, less risk averse, and willing to drive PE ratios higher.

The market could continue to rise through the holiday season if investors become convinced that the Fed will not raise interest rates due to poor economic data. And if the data become bad enough, investors might expect more rounds of quantitative easing in which the Fed pumps dollars into the economy by purchasing bonds from banks, or as I wrote last week, introduces the US to negative interest rates.

I don't expect profits to rise enough to justify the high valuations in the market since profits have been at record levels and are declining in the current reporting season. According the WSJ:

Profit and revenue are falling in tandem for the first time in six years, with a third of S&P 500 companies reporting so far. 

 Historically, profits continue to fall once they have climbed to record heights and start descending. The most likely scenario is that the market will fall to valuations more in line with falling profits.

Fed shuffles from ZIRP to NIRP

Inflation is fading; the economies of Asia, South America and Europe are collapsing; the people have tasked the central banks with fixing all things economic. Yet, reports by Fed economists show that the recent rounds of money printing through QE and low interest rates for six haven’t had the intended effect. They have certainly failed in Japan and the Big EZ (Euro Zone). What can they do to turn the world’s economies around? The answer from mainstream economists at the world’s central banks is more of the same. But if continuing to do the same thing while expecting different results is a sign of insanity?

Target date funds need good vibrations

Another fad in investing, like “smart” beta, is target date funds that allocate assets in an investor’s portfolio by the investor’s age. Target date funds follow an ancient concept: put most of your money, say 90%, in the stock market while you’re young because you’ll have the time to recover from market collapses. But as you get older you have less time to recover so you reallocate to bonds and cash while keeping just half your funds in the market. In the past, most advisers recommended getting completely out of stocks and into bonds, but the ridiculously low returns on bonds has forced older people to take greater risks and stay in the stock market longer.

Good management makes for great investing

Investors with the time will want to imitate Warren Buffet and invest in a few good companies rather than put up with a host of losers in an index fund, but analyzing individual companies in the way that Ben Graham taught is time consuming. Several experts have developed algorithms that examine financial data that helps weed out the worst.

But if an investor is going to marry a business he must become familiar with the quality of its management. Good management can turn a bad company around and value investors often want to buy shares in a company when it has hit rock bottom and has the potential to turn around.

Currency wars round three

I finally got around to reading James Rickards’ 2011 book Currency Wars: The Making of the Next Global Crisis and really enjoyed most of it.

The best parts are the history of the currency wars, Currency War I (1921-1936), Currency War II (1967-1987) and the launch of Currency War III in 2010 that still rages. War III will likely finish in the same way that the previous ones did but Rickards suggests far more disastrous results.

As Rickards explains, currency wars are a continuation of the ancient mercantilist economics that Adam Smith tried to drive a silver stake into the heart of but failed. Like vampires, mercantilism will live forever by hibernating in the dark places of economic thought and springing to life in tragedies, and that vampire has bitten most mainstream economists.

Myths of discounted cash flow

Discounted cash flow (DCF) is the adjustable wrench of modern financial mechanics. Essentially, the analyst forecasts the revenue and costs for several years out and applies an appropriate discount, or interest rate, to calculate what those future dollars are worth today. The process is supposed to provide a hard number for the current worth of the company.

But as many of us recognized in college, there is a lot of room for wiggle in the process. Forecasting revenues and costs is tricky and always based on assumptions. An optimistic analyst might generate a rosy forecast while a pessimist may predict gloom and doom. Usually, analysts just assume the future will look like the past, which is always a dangerous assumption. How many oil analysts saw the recent collapse in oil prices as a result of projecting the past into the future?

New York manufacturing stumbles

In the Ricardo Effect, Hayek’s chief contribution to the Austrian business-cycle theory (ABCT), the turning point in the cycle from expansion to recession happens when the makers of consumer goods and services employee more workers and buy less equipment. Equipment makers face plummeting sales and rising costs for materials and labor, and therefore a profits squeeze. So they cut back on production.

Signs of that may have appeared in New York. The New York Federal Reserve released its August 2015 Empire State Manufacturing Survey reporting that the index fell to -14.9, its lowest level since 2009 in the depths of the latest recession. Naturally, economists had expected the number to be +3.86. A positive number suggests growth ahead and you can guess what negative numbers mean.

Don’t drink the Schwab Kool-Aid

The Schwab Center for Financial Research recently published an article intended to tranquilize investor nerves after the latest volatility and keep them shoveling funds into the stock market. “Schwab’s Perspective on Recent Market Volatility” begins with “Global markets may have swung wildly in recent days, but we think the recent selloff in stocks and commodities is not a sign of imminent global recession.”

I’m picking on Schwab because they are big and can take it, but they have said nothing that almost all mainstream financial service firms aren’t saying. Also, Schwab put their piece in nice bullet points that are easy to address. I’ll take them on one at a time:

1. The basics of investing have not changed.

They should change because the received wisdom is to always buy, never sell and just swallow the bitter pill of a major market decline. Instead, investors should try to time the market by getting out of stocks before a recession hits.

Stock market forecasts better economists

After the stock market stumbling through the past two weeks, you will hear top mainstream economists repeat the old joke that the market has predicted ten of the last eight recessions. The point of the joke is to belittle the idea that the market can predict recessions and to convince investors to remain fully invested. Austan Goolsbee echoed the joke on National Public Radio recently then insisted the economy was fine and he saw no recession in the near future. When asked if now was a good time to panic, he said it’s never a good time to panic and people should just ignore what the market does.

It is true that the market has predicted more recessions than actually happened, but if anyone will examine the data they will find that growth slowed dramatically after major declines in the market even though the fall wasn’t deep enough for the National Bureau of Economic Research to declare an official recession. But even with its false positives, the market has done a better job of predicting recessions than have any mainstream economists.

Training the Chinese dragon in economics

The story of China’s great leap forward to slightly freer markets is well known. Around 30 million people starved to death in the 1960s and the West fed the Chinese in the 1970s. Deng Xiaoping took over after Mao died and began looking for some way to make Communism work well enough to at least feed the people.

About the same time, a small group of farmers in a remote village rebelled against socialist farming by dividing up the land among them and selling their excess produce on the black market. They signed a contract binding each farmer to take care of the families of any farmers whom the state discovered and executed. After a couple of years, they couldn’t keep their success a secret any longer and Deng found out. But instead of executing the farmers, Deng made them national heroes and encouraged other farmers to do the same.

Watch out for falling productivity

The government reported recently that productivity in the US rose 1.3% from the last quarter, but that was little comfort to the Maestro, Alan Greenspan, who is worried about the collapse in productivity. Investors should be worried as well. StreetInsider.com reported Greenspan saying:

I think it's the most serious problem that confronts not only the United States but the world at large and more exactly the developed world especially. American productivity is not significantly different from zero growth in the last 6 or 8 quarters. And the cause of that, if you work backwards through the causative chain is capital investment has been inadequate to fund the amount of assets that you need.

The interviewer, Tom Keene responded with “There was a moment when we were bewildered by why nation's productivity was so good and America running on all cylinders. It is a distant memory.”

Why has productivity fallen and what does it mean? The answer lies in Hayek’s Ricardo Effect. Profits in consumer goods sectors will peak near the end of the expansion phase of a business cycle. Profits rise because investment in capital goods sectors has increased employment, and therefore demand for consumer goods before new consumer goods arrive on the market. Prices and profits rise in step.

Mainstream economists predict the past

Mark Twain once said,"Prophesy is a good line of business, but it is full of risks," and "It is difficult to make predictions, especially about the future." In the Bureau of Economic Analysis’ (BEA) recent statement that the GDP of the US grew by 2.3% in the second quarter of this year, it isn’t predicting the future, but the past. And Twain was right, even that is hard.

Initial GDP growth numbers are not actual data; they are the output of statistical models. That’s why the BEA has to revise them in a month and again years later. Most people pay attention to the first estimate, but the real interesting information comes from the direction of the miss. Most math models will miss on the high side as the economy heads into a recession and the gnomes will revise the numbers downward. In an expansion, they will miss on the low side and be revised upward.

Buffet's alpha

The Efficient Market Hypothesis (EMH) teaches that no one can beat a general market index over the long run because the market instantly adjusts to all new information. The EMH has been mainstream dogma for longer than Warren Buffet has led Berkshire. Buffett doesn’t like the EMH and responded to the theory in this story that I included in my book Financial Bull Riding:

Warren Buffett got to the heart of the problem with the EMH at a 1984 conference at the Columbia Business School held to honor the 50th anniversary of Benjamin Graham’s Security Analysis. Finance professor Michael Jensen, a defender of EMH, told the audience that investors such as Buffett who beat the market were just lucky. The EMH did not assert that no one could get lucky; only that they couldn’t get lucky consistently. “If I survey a field of untalented analysts, all of whom are doing nothing but flipping coins,” Jensen said, “I expect to see some who have tossed two heads in a row and even some who have tossed ten heads in a row.”

The money horror picture show

All is not well with the economy in spite of rising home prices and soaring car sales. The disturbing news comes from money. Losing velocity with money is like losing altitude while flying. It can be hazardous to your health.

Economically, the velocity of money reflects how quickly people spend a new dollar once they get it. Technically, it’s the GDP growth that a rise in the money supply can’t explain. The general idea holds that if people are well off and feeling confident they will spend new dollars quickly and each dollar will change hands many times before the end of the year.

Here is an amusing tale about money velocity that I got from the Adam Smith Institute:

It is the month of August, on the shores of the Black Sea. It is raining and the little town looks totally deserted. It is tough times, everybody is in debt and everybody lives on credit.

A rich tourist comes to town. He enters the only hotel, lays a 100 Euro note on the reception counter and goes to inspect the rooms upstairs in order to pick one.

Car sales are bad news

The worst recessions in history have all followed excessive investment in housing, personal transportation and the stock market. Today, the US is hitting two out of three. Take a look at the auto sales graph below. US sales have reached pre-recession levels.

You can see one of the reasons for the high sales volume in the next chart. Interest rates on auto loans are lower today than during the crisis. Auto loans seem to have replaced lagging real estate loans for banks.

Bull Market in a China Shop

Markets that climb to dizzying heights over extended time periods are known as bulls for a reason: they buck. I titled my book on investing Financial Bull Riding for that reason. A bull has been breaking things in China’s stock market recently, falling as much as 30% from an ascent of 150% over the past year. 

The exchanges responded by freezing trading in as many as 50% of issues while the government forbade corporate executives and directors from selling any stock for six months, suspended initial public offering and made more loans available to investors. What does it mean? It certainly doesn’t mean what Bloomberg wrote about it yesterday:

In China, the invisible hand of the market sometimes needs help from the iron fist of the state. That’s certainly true after a meltdown vaporized $3.5 trillion in the value of shares traded on the Shanghai and Shenzhen exchanges.

The state caused the market to rocket 150% in a year by making cheap credit available to buy stocks in the first place. In addition, investors are rescuing their money from the collapsing real estate market. China has dozens of new ghost towns because for decades the state limited where citizens could invest their savings, leaving them with real estate as the only good option. Prices in real estate have been falling recently, so when the state opened stock exchanges much of the real estate money went into them.

At the same time, the state-controlled media urged individuals to buy into the market. Not only did the state contribute to the markets meteoric rise, it tied the reputation of its policies to market success, according to Bloomberg:

“This is a real testing moment for the leadership,” says Zhao Xijun, deputy dean of Renmin University’s School of Finance. “The evaporation of fortunes of more than 80 million individual investors would pose unthinkable social problems for the country.”

And while the market is $3.5 trillion lower than its peak, that doesn’t mean the economy is poorer by that amount. The stock market is a zero sum game. For every loser of a dollar someone has gained a dollar.

The recent rise and drop in China’s market is not very different from the US market in the late 1990s that enjoyed the dot.com bubble in which PE ratios lost their sanity and then went bust.

A stock market cannot climb 150% in a year without massive credit expansion by the state. But as Mises explained in Human Action, the money supply must grow at exponential rates in order to keep the bubble from collapsing. Chinese authorities probably didn’t know that, in spite of the popularity of Austrian economics at many Chinese universities.

Stock markets provide insight into the expectations of others about the future and help coordinate business plans, according to the great Austrian economist Ludwig Lachmann. A collapse like that seen in China lately shows that many business people are growing skeptical about the future of China’s economy.

China is primarily a consumer goods manufacturer in the international structure of capital, so if its economy is slowing it signals that exports of consumer goods to the US and Europe are falling. And if the US and Europe are buying fewer Chinese goods, that’s probably a sign that consumers in those markets are hurting. China’s market may be the snow flake that causes the avalanche in the stock markets of the US and Europe.

Macro-Prudential regulations have failed for 90 years

Mainstream economists, excluding those at the Bank for International Settlements, have stuck with their ancient superstition that recessions are random events, each with its own special cause, known technically as shocks that send the economy spinning out of equilibrium. Central bankers and politicians along with the mainstream media have rounded up the usual suspects, bankers, and sentenced them without a trial.

The general opinion seems to be that bankers were either too stupid or dishonest while making loans in the past so they made a lot of bad loans and conjured from hell the worst recession since the Great Depression. The guilty verdict requires that Basel and Washington control even more of the decision making process in what has come to be called “macro-prudential” regulations.

This ratio signals recessions and inequality

In past articles I have reviewed sound models signaling the Fed’s money printing has made the economic expansion unsustainable. Those included Spitznagel’s Misesian Index, Shiller’s Cyclically Adjusted Price Earnings (CAPE) ratio, and others. I just discovered a new one, the ratio of asset prices to income.

I found the ratio in a report on inequality of wealth in the world published by the Credit Suisse Research Institute. Referring to the ratio, the report says on page six:

...the ratio is now at a recent record high level of 6.5, matched previously only during the Great Depression. This is a worrying signal given that abnormally high wealth income ratios have always signaled recession in the past.

Mainstream economists have learning disorder

After the onset of the Great Depression, many economists radically changed their views and adopted Keynes’ “revolution,” which was not a revolution but merely a resurrection of mercantile economics. Mainstream economists don’t understand that because they don’t take economic history in school. Keynesian economics dominated until the stagflation of the 1970’s.

Responding to their mistakes of the 70s, mainstream abandoned paleo-Keynesian economics and the profession split into the New Keynesian, monetarist and neo-classical schools of macroeconomics, though hard-to-kill paleo-Keynesian econ lives on in the writings of Nobel Laureate Paul Krugman. The three new schools rejected Keynes’ idea of having the state micromanage the economy through fiscal policy because they recognized it suffered from the three lags, cogitation, formulation and implementation. In other words, the state always shows up late to the economic “accident” because it’s slow to recognize the problem, slower to formulate policy and tardy in implementing the policy. As a result, fiscal policy tended to make things worse.

The bond market's head fake

The bond market fell this week, wiping out gains for the year. Some blame it on Mario Draghi’s comments after an ECB meeting in which he expressed indifference to volatility in bond markets. If it is true that Draghi’s statements motivated the selloff, it shows how fragile is an investing philosophy that is based solely on what central banks do. Such investors are terrified of rising interest rates but want to remain fully invested until the last bell. Of course, anyone investing in bonds or stocks at these altitudes should be as nervous as a long-tailed cat in a room full of rocking chairs.

Why the Fed won't raise rates

The VIX (volatility index) is in a coma, so most investors are dozing while danger signs about the current stock market pop up. The idea that the Fed causes recessions by raising interest rates has relaxed many investors. Some writers have assured nervous investors that it won’t be until the Fed’s third rate increase that the market will respond.

In this previous post, I used Hayek’s Ricardo Effect to explain that recessions can happen without rising interest rates. Now, Hoisington Investment management adds support for Hayek from a different perspective. In the Quarterly Review and Outlook for the first quarter of this year, Hoisington wrote about the financial histories of nations with over-indebted economies. That history goes back two thousand years, but the US has suffered through four such seizures in the 1830-40s, 1860-70s, 1920-30s and the past two decades. The report offers six characteristics of excessive debt:

Corporate buybacks keep market airborne

The stock market has surged lately and a lot of analysts credit it to stock buybacks by corporations. As the chart here shows, buybacks have reached dizzying heights. Corporations are purchasing their own stocks because corporate profits hit record levels last year and management can find no better use for the cash than to give it back to the owners through larger dividends or buybacks.

As I wrote recently, record corporate profits, the current level of optimism and the low yields on debt justify the current loftiness of the market. This is not a bubble, but most investors are wondering what will shoot down this high flying market? Corporations appear to be the last buyers standing because “mutual fund managers have the lowest cash levels in history and money market fund levels are lower now than in 2007 and near a record low from 2000 relative to the capitalization of the stock market."

Bitcoin won't save us

Libertarians have waxed poetic about bitcoin for years. It pokes a finger in the eye of the state by breaking the state’s monopoly on money and rescues citizens from a rapidly eroding dollar. But aside from the block chain innovation and its potential use in other industries, I can’t get excited about bitcoin. Other than symbolic, what advantage does bitcoin offer?

Say you produce oil field equipment in Tulsa and made a big sale to a production company in Marrakech, Morocco and to make the sale you offered them 90 days of credit. Also, you’re local sales rep made the deal in Moroccan dirhams. So you’re worried that in the 90 days before you get paid that the value of the dirham will depreciate against the dollar (that is, it will buy fewer dollars) and you’ll lose money on the deal.

Win the Cash Tug-O-War

Mainstream economists have hated cash since the Great Depression because in their business cycle “theory” they assume that people quit spending and decide to hold more cash. That stoppage in spending constipates the “circular flow” model of economics they pray to and causes recessions. They don’t ask why people might prefer cash to a new Ford Focus or more stock in Apple. Many main stream economists follow the thinking of Herman Minsky who simply thought people are irrational. The behavioral school in economics assumes people are pretty much nuts. In their brains, a large group of people wake up one day and decide they need to hold more cash for no reason and all hell breaks loose. I call that the “crap happens” theory of business cycles.

The Economics of Burning Baltimore

Baltimore is burning and the book most relevant to the tragedy, and to that of Ferguson, MO, Detroit, MI, and many other cities in the US is Friedrich Hayek’s Road to Serfdom.

 

The media will pimp the idea that racism caused the rioting, looting and burning, but racists live every city in the US that is not on fire. Baltimore and Ferguson have more in common with the Arab “Spring” and the frequent rioting in Paris and London than with the civil rights marches of the 1960s. Cairo and Tunis erupted a few years ago because they had armies of unemployed young people with no jobs, many of them with worthless university degrees.

 

Assault on the Dollar

The US dollar’s position as the dominant reserve currency is coming under assault from at least three directions. The UN announced in 2009 plans to mint silver and gold coins to be used in international trade. Socialist economist Joseph Stiglitz, a Nobel laureate, chaired the UN Conference on Trade and Development (UNCTAD) said it shows

..a growing consensus that there are problems with the dollar reserve system. Developing countries are lending the United States trillions dollars at almost zero interest rates when they have huge needs themselves... It’s indicative of the nature of the problem. It’s a net transfer, in a sense, to the United States, a form of foreign aid.

Emerging market (EM) countries that hold large amounts of dollar reserves don’t hang onto hundred dollar bills. They use their cash to buy US government debt so that they can earn interest and that is what Stiglitz meant by EM countries lending to the US. When someone needs US dollars, to buy oil for example, the EM central bank can easily sell the US debt and provide the dollars for the exchange.

Armand Dufour of the European Bank welcomed the UN coins. “People have enough Fiat currency options, government and banks cannot intrude on bullion coins – they will have their own inviolable value... If we see a dismounting from the US dollar, as is inevitable in the main view, there will be a strong move to the Oro, which may drive its price up to the point where governments will not allow its circulation; they will try to isolate it.”

In his last statement he is merely echoing Gresham's law that bad money drives out good, meaning that people will hoard the UN money while spending paper money as fast as possible.

Then in a Free Market post, China Takes Aim at the US Dollar, Sean Brodrick reported that the Chinese government is pushing its yuan to be a reserve currency like the US dollar. Brodrick wrote, 

In early April, former Secretary of the Treasury Larry Summers publicly warned: "This past month may be remembered as the moment the United States lost its role as the underwriter of the global economic system."

China’s crime was to launch the Asian Infrastructure Investment Bank (AIIB), to compete with the Asian Investment Bank and World Bank, both led by the US. The US begged its “friends” not to join, but they did anyway. Also, China has initiated the China International Payment System (CIPS) in direct competition for the other international payment system called SWIFT, which is a key support of U.S. dollar hegemony.

Finally there is the BRIC bank in which Brazil, Russia, Italy and China teamed up to replace the International Monetary Fund and World Bank. According RT News,

The big launch of the BRICS bank is seen as a first step to break the dominance of the US dollar in global trade, as well as dollar-backed institutions such as the International Monetary Fund (IMF) and the World Bank, both US-based institutions BRICS countries have little influence within.

Talking heads and bloggers typically respond to news of the dollar’s demise as a reserve currency with hysteria: the dollar will become worthless and hyperinflation will destroy the US economy. However, one of the most important economic lessons that investors need to learn is this:  fear sells. Every politician and media flunky knows this. To paraphrase the great American newspaper editor HL Mencken, politicians and media pundits devote their time to frightening people because people will vote or pay attention to the media only when frightened. 

For some reason known only to God people are not interested in good news. Years ago I read a paper in an advertising journal that described research on themes in advertising that actually work. Researchers tested love, sex, friendship and a dozen other themes in ads and discovered that none of the themes moved viewers except fear, and fear worked well.

Nevertheless, I will proceed with the contrarian view: ending US dollar hegemony will be good for the US in the long run, though it could be painful in the short. Keep in mind that a collapse of the value of the US dollar against other currencies will only affect the prices of imports and exports and imports aren’t a large part of the US GDP. So yes, there will be some inflation. But the value of the dollar for domestic goods won’t collapse. Ceteris parabus, more expensive imports will cause the prices of domestic goods to fall. The prices of both imports and domestic goods can rise at the same time only if the Fed cranks up its money printing machine.

So what is the great advantage that the US gets from its status as the number one reserve currency in the world, the loss of which strikes terror in the hearts of mainstream economists? The chief advantage is that the Fed can flood the world with US dollars and the federal government can borrow and spend far beyond its means with impunity. But is that really an advantage for US citizens? No, it is not! Fed money printing does enormous damage according to the Austrian business-cycle theory. The Fed’s ability to print infinite amounts of money is the single most destructive force in the US.

1. It transfers wealth from the poor and middle classes to the wealthy who work in the financial services industries because the latter get the new money first before prices have risen and the former get it last. 
2. It causes the booms and busts that hurt the middle and poor classes the most. 
3. It destroys manufacturing by eroding the value of funds set aside for depreciation, which makes replacing worn-out equipment harder, and reduces profits by forcing them to pay taxes on inflated dollars. 

Federal spending far beyond its means is not much better. The borrowing required to finance deficit spending causes the trade deficit and loss of US jobs (the reason would require another post) and burdens our children with unbearable debt. So why would any economist consider that being the dominant reserve currency is a benefit to the US? They do so because they’re socialists, like Stiglitz.

Because mainstream economists favor unlimited money printing by the Fed and unlimited deficits by the federal government, there is no one restraining either. Those of us who want a better future for our children have only one hope, that an outside force will come to our aid. Barring a miracle for God, China’s efforts to capture the “benefits” of reserve currency are our best hope.

Without reserve status, US citizens would have to buy gold or yuan in order to purchase imports, but a rapidly depreciating US dollar would make that difficult and force the Fed to show some restraint. Also, interest rates for borrowing by the federal government would rise and be denominated in yuan, so any depreciation of the US dollar would increase government debt by the same amount. That would add more pressure to the Fed to stop printing money.

In short, the US would find itself in a position similar to the PIIGS, Portugal, Italy, Ireland, Greece and Spain after the Big EZ fiasco. None of the PIIGS could print their way out of their problems and the governments could not borrow, so they had to reduce regulations, cut spending and raise taxes to get their economies moving forward. Greece hasn’t been so good at it. Nothing would help the US economy more than similar medicine.

Central banks as vestigial organs

In his early years Hayek anticipated that the monetary theory of trade cycles, now known as the Austrian business-cycle theory (ABCT) would become widely known by business people who would refuse to borrow when the central bank reduced interest rates to an artificially low level. That would dampen booms caused by money created ex nihilo and reduce the severity of recessions.

Hayek was wrong because the Keynesian tsunami pushed the ABCT into a tiny corner so that few business people learned it. However, we may have reached a similar dampening of economic cycles by another route, that is, by central bankers making central banking irrelevant. Glimpses of this can be seen in Japan, as I wrote in this posting.

The Indifference Zone

The graph shows the weekly averages for the S&P 500 since October of last year.  The index has been stuck in a trading range between 1990 and 2110 for the past six months. A move to 2200 as the forecast in last week’s post suggested would require breaking out above that range into new territory.

Bulls and bears playing tug-o-war created that range because of their diverging expectations. Bears can become bulls when the market hits a support level near the bottom, and bulls will morph into bears near the top. The great Austrian economist Ludwig Lachmann explained the dynamics of trading ranges in his essay “A Note on the Elasticity of Expectations.”¹

S&P 500 Forecast

While profits in the energy sector cratered in the last quarter, a jump in retail profits of $28 billion in the fourth quarter from the previous year suggests that the S&P 500 will continue to rise. The forecast calls for an average of 2056 for the S&P 500 for Q2 and 2185 for Q3 this year.

In order for the quarterly averages to reach such heights, the index would have to set many new record highs. That could happen if more European and Japanese funds cross the oceans to invest in the US as they flee the destruction of their own currencies by their central banks. However, I’m skeptical. 

Another way to interpret the forecast is as a moving average. In technical analysis, moving averages of varying lengths guide investors timing their purchases and sales. The market crossing the moving average is a buy/sell signal, depending on the investor’s strategy. The graph above shows that the forecast sometimes leads and sometimes follows the market but when the two cross it indicates a turning point. The two lines have shaken hands recently, which could be our turning point for this market.

Housing bubble reincarnated as oil

We took my six-month old grandson to the park this weekend and put him into a baby swing for the first time. He couldn't decide if it was fun or not and took turns crying for a while then laughing for a while. I think of that when I read about the oil bubble.

The Fed has reincarnated the real estate bubble of the early 2000s in the current tsunami of oil. To see how, we need summon the help of the Austrian Business-Cycle Theory (ABCT). The ABCT says that Fed induced interest rates below  the rate that the market would naturally set causes excess borrowing and investment in capital goods industries, not a general over investment, but bad investments in particular industries. The market reveals those excess investments through falling prices that cut into profits, reduce employment and spark a recession in the economy.

Earnings stumble

Despite what mainstream finance and economics teach, the stock market is rational. Two things drive it - profits and risk tolerance, or as they say in finance, the discount rate. Both have advanced the stock market from its lows at the bottom of the latest recession to recent record highs as profit rates and risk tolerance soared so that investors have been willing to pay more for the same profits.

As of the writing of this post, the S&P 500 is down about 3% from its record set on March 2. Some of the selling could have come from profit taking or covering shorts, but much of it is due to concerns about future earnings. Last week I showed that profit rates are at record highs and reasonable investors would assume such rates are unsustainable based on the history. And that seems to be the case as Seeking Alpha's Brian Gilmartin wrote:

Looking at the first half of 2015, analysts are now projecting year-over-year declines in both earnings and revenues for both Q1 and Q2 '15, compared to expectations for earnings and revenue growth for both quarters back on December 31 '14.

How high can profits go?

The market set new records this week. Some of the lift came from the European Central Bank printing new Euros. As the ECB buys bonds, the sellers are buying into the US stock market thinking that it is the safest repository. The ECB printing presses will impact stock markets for six months then, like any drug, the effect will begin to wear off. In microeconomics that’s called diminishing marginal returns.

The graph to the left shows profit rates from US domestic only earnings plotted in blue and labeled “Domestic Profit Rates” with the domestic profits that include foreign earnings plotted in red and labeled "National Profit Rates." The data comes the NIPA tables at the Bureau of Economic Analysis. Domestic profit rates are at their highest since 1965, but national rates are at their highest level on record. The high level of profits, and the records in the stock market in spite of a relatively sluggish economy, emphasizes the growing importance of foreign earnings. 

It's not likely that profits can continue to soar and many market watchers are pessimistic about future earnings. The Financial Times columnist Gavyn Davies reported recently that 

Albert Edwards, the market's favourite bear at Societie Generale, wrote last week that the rte of decline in analysts' forward profit expectations in the US is clearly associated with recession. According to MSCI data, profits downgrades are exceeding upgrades by a net 33 percent at present.

Some of the decline in expected earnings comes from falling oil prices and much of the rest from the rising dollar that reduces earnings from overseas. 

Schwab's Liz Ann Sonders estimates that the forward looking price-to-earnings ratio growth rate has actually gone negative:

Bespoke Investment Group (BIG) calculates the “guidance spread” each quarter, which measures the difference between the percentage of companies raising guidance and lowering guidance; so when the number is negative, more companies have lowered guidance than raised guidance. The spread for the most recent quarter came in at a “ridiculously low” -9.4 percentage points. That was the lowest guidance spread since the final two quarters of 2008, at the end of the financial crisis.

Psychologically speaking, pessimism like that coming out of the financial press is good for the market. If predictions turn out wrong and profits surprise by rising the market will soar.  On the other hand, it's hard to see where earnings growth will come from. Eventually, profits will fall as the Ricardo Effect kicks in and when it does the stock market will collapse as it did in 2000 and 2008. 

Fed loses its mojo

The Dow hit another record high and the Japanese stock market rung the bell for a 15-year high this week following statements by Fed Chairman Janet Yellen before Congress that the she was losing patience. (Actually, she said the Fed would remove the word from its policy statement.) 

Both markets have been helped by the Big EZ's firing up its money presses. Much of the new issue of euros will swim the pond and dry out in the US stock market. Also, margin debt and debt by corps to buy back their own stocks are at record levels. 

Taking the market's temperature

Based on the popularity on my blog of the post The Dao of Investing - It's time to sell, I'm guessing investors are looking for indexes to help them take the temperature of the market. So this week I will revisit an indicator I developed in my book Financial Bull Riding.  

The method for building the index was based on a technique developed by James Estey in his book Business Cycles published in 1950. Estey included a chart of business cycles from 1790 through 1949 in which he plotted economic activity similar to GDP. Armed with dates for business cycle peaks and troughs, he de-trended the data by calculating the average for the series between peaks, then between troughs, then averaging the two series to obtain an average for each business cycle. Then he subtracted monthly figures from the cycle averages. 

China's slow growth omen

Reading the daily economic news in hopes of navigating our location in the business cycle reminds me of ancient priests trying to discern the movements of the gods by examining the contours of the liver of a sacrificed goat. Even the ancients priests understood that the more omens they could combine the better their predictions would be.

Another omen appeared this week when China announced that official China Federation of Logistics’ January purchasing managers’ index (PMI) slid to 49.8 from 50.1. The HSBC and Markit private sector PMI also fell from 49.8 to 49.7. Indexes like these are designed so that any outcome below 50 indicates contraction in the sector. In the worldwide division of capital, China is primarily a consumer goods manufacturing nation that supplies the US and the Big EZ (Euro Zone), which are the world’s largest manufacturers of producer and capital goods.

The Austrian Business-Cycle Theory (ABCT) at its simplest divides economies into raw materials, producer goods and consumer goods. Hayek’s version, employing the Ricardo Effect, says the turning point in an expansion comes when spending on consumer goods increases and the greater profits cause consumer goods makers to stop buying new equipment. That generates a profit crisis among producers goods manufacturers who begin to reduce employment and the recessions begins. The large jump in GDP, which mostly measures sales of consumer goods, in the third quarter was an omen of bad things to come from the producer goods sector. Sales of consumer goods (GDP) fall when enough workers in the producer goods sectors have lost their jobs.

Big EZ's QE Fail

The stock market climbed last week in anticipation of the European Central Bank's announcement of its program to purchase more bonds. The US press has dubbed it the ECB's quantitative easing, or QE. As with the several versions of QE in the US, the ECB's purpose is to reduce interest rates enough to persuade businesses to borrow and expand and consumers to borrow and buy cars and houses. Also, the bank hopes it will ramp up price inflation that will reduce debt.

The bank's QE effort will fail to achieve the goal as did those of Japan and the US. ECB president Mario Draghi admitted as much when he told politicians that credit expansion alone will not rescue Europe without "structural" changes by governments. In other words, Europe's problems are microeconomic, not macro. The structural changes needed include reducing taxes and rolling back regulations, especially rigid labor regulations that make it almost impossible for businesses to divorce employees. Businesses are not investing in the US because of high taxes and job-killing regulations, but the problem is much worse in Europe.

Crude shutdown price - lower than you think

When the Saudis allowed the price of their crude oil to fall, it was reported that the Saudis expected the price to fall no lower than $60 per barrel. The Saudis assumed that the average cost of production in the US shale oil fields was somewhere around $70 and that producers there would not operate for long at a loss. Insiders have said that the Saudis want to reduce competition from high cost US producers and retain their share of the US market, which came to 13% of imports in 2013, the latest figures from the US Energy Information Agency.

Gross shocks conventional wisdom

Bill Gross told investors this week to

Beware the Ides of March, or the Ides of any month in 2015 for that matter. When the year is done, there will be minus signs in front of returns for many asset classes. The good times are over.

Gross is the legendary bond fund manager who left the company he founded, PIMCO, for a job as a portfolio manager at Janus Global Unconstrained Bond Fund, so most people pay attention when he writes. The prediction came inside the January Investment Outlook for investors. But for the mainstream financial media, he might was well have expelled foul smelling gas at a crowded party. The media quickly pointed out how contrarian his forecast is. For example, the Bloomberg reporter wrote: 

No Rate Increase in 2015

Mainstream economists and financial experts warned us early in 2014 to stay way from bonds because the Fed would raise interest rates and as everyone knows rising interest rates shoot buckshot-sized holes in bond portfolios. So most people avoided bonds and piled into stocks. Now we can look back and see that conventional wisdom was wrong; the Fed did not raise interest rates; inflation remained tame; and bonds returned about twice the money as stocks.

Now the mainstream has dusted off its forecast of rising rates and is trying again. Surely this is the year the Fed will raise rates and kill bonds. After all, the Fed has always raised rates at some point in an expansion. How can it not raise them in this one?