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Thursday, May 26, 2011

QE Done?

So it is official QE2 is a bust! The FED has failed to meet its dual mandate of raising employment numbers and jumpstarting bank credit and lending. The economy has muddled along aided by the FED's jet fuel of QE but in many respects we as a country are worse off then prior to QE2. Just look around and see the difference in costs from post QE1 and prior versus that of today. At the time of pre QE2 gas for your car would run you around $2.35 a gallon for regular, but today that same gallon costs you $3.99, and no the BLS can't hedonically index it. While gas is only one example the fact of the matter is that for most people their wages have not kept pace with this inflation and their budgets are being stressed. Just about everywhere you look prices for things you need to live are higher while economists argue and the FED frets about deflation. There is deflation and inflation in the system at the same time.

The classical definition of inflation is an increase in the money supply while deflation is the opposite. The rising and falling price aspect is actually not inflation or deflation but rather a symptom of the status of the money supply. The current day definition of inflation which is rising prices is essentially a supply and demand equation. If the money supply is expanded more dollars are created and prices rise as a result of more dollars chasing goods. Sellers will demand more dollars because the ever increasing amounts of dollars are driving what little intrinsic value the dollar has down even further.
Sure there are some things that do go down in price due to oversupply and or increased production, however, these are items you want like a plasma TV and sadly for most Americans house prices as well. The basic theme is everything you need to live is going up in price, while things that you may want like the TV are falling in price.

The FED has spent on the order of $600 Billion and for that we have created a supposed 700,000 jobs at a cost of $850,000 per job. In addition to the colossal spending the FED has fueled inflation whether they want to admit it or not. I know, I know “B52 Ben” has assured us that the “bout of inflation” we are seeing is transitory, however, I believe he is wrong unless the Dollars are printed on flash paper like magicians use. Additionally, just as when the FED cuts or raises rates, it takes months for it to filter through the economy; so too will the inflationary seeds the FED has sown. In the meantime as people are living with the FED induced cost push inflation the public has not only gotten somewhat acclimated to the rising prices but also has begun to expect further rises. Sure people complain about the price at the pump, but unlike the oil rise of 2008 where there were congressional hearings about price gouging notice how you barely hear a peep regarding the subject. The slow inexorable rise reminds me of the frog in the pot who if the water is brought up to temperature at a slow rate doesn't relax that he is being boiled alive.

So we have a situation where the economy is proving to be not as robust as was believed even a couple weeks ago, inflation is rearing its ugly head and the FED has telegraphed the end of QE2 to the market. There has been so much speculation about what will happen after QE2 ends. The speculation runs the gambit from there will be a downturn to a quick turn to QE3. Frankly, it appears to me that the economy cannot stand on it's own at this point and we are coming in to an election season so the FED will act sooner rather than later. I believe that the FED will buy time with QE 2.5, which is the reinvesting of interest and maturing debt from the FED's now roughly $3 Trillion balance sheet. If the FED can coordinate with some of the sovereigns out there to buy a portion of our debt issuance it should allow for enough time for the FED to ramp up a QE3 without losing total credibility regarding their mandate.

I believe that the end of QE2 has been telegraphed so far in advance that the market is in the process of factoring yet another of the most publicized market events of all time. The factoring of the end of QE is at least partially responsible for the volatility of late.

I do believe that the FED will ultimately go to a QE3 scenario, but just not immediately after the end of QE2. Moreover, it is also possible that our very creative FED will figure a way to pump more cash in to the system without labeling it QE but achieving the same result. I have not seen the latest figures regarding how many dollars of spending it requires to create one dollar of GDP, but it suffice to say that you would be horrified at the figure. Just this past winter, I saw a figure that it took $10 of spending to create one dollar of GDP. The net result is that the next QE will have to be significantly larger to have an impact on the GDP numbers. One can liken this scenario to that of a drug addict. If the addict does lots of drugs they build up a resistance and require ever greater amounts of drugs to achieve the high. For the economy cheap money is the drug of choice but the US's resistance is quite high at this point and like an addict the amount needed for the last high could be fatal.

At the moment our problems are masked by the news out of Euro land and the Greek tragedy that will sweep that continent. The FED and others look at our situation and see our Dollar which has rallied against the Euro and use it a crutch to say things are not that bad. The problem with comparing the Dollar to the Euro is that they are two sides of the same coin. It is an unfair comparison to look at the Dollar and the Euro instead a true picture would be to either look at the dollar using the trade weighted index or better yet against a basket of healthier currencies. At this point comparing the Dollar to the Euro is kind of like looking at two stage 4 cancer patients and trying to judge which is healthier, with apologies to any cancer patients in the reading audience.

It is this reasoning that has caused central banks to be buyers of precious metals regardless of what various pundits and CFA's will tell you. The central banks are net purchasers because they know throughout history that precious metals have been a store of value where as FIAT currencies have come and gone. It is true that the environment has to be right for precious metals to be desired and increase in value and over the past 4 decades the environment was such that precious metals were not important. Since Nixon closed the gold window in 1971 we have raised a couple generations to believe that they are more enlightened than their predecessors and they don't need what Keynes dubbed the “barbarous relic”.

The view on the precious metals is changing albeit at a glacial pace. The concept of precious metals, gold in particular, being a financial asset is coming back in to the spot light and legitimized at many levels. I know George Soros called gold the ultimate bubble and divested himself of a very public holding, however, there could be a thousand reasons why. It is possible Soros wanted out of the Streettracks Gold ETF (NYSE: GLD) so he could vault physical metal out of the public's prying eyes via SEC required reporting. The flip side of Soros is John Paulson who maintains publicly that his firm has large holding in the metals.

We heard late last year from Robert Zoellick the head of the World Bank that a gold standard should be at least considered. Today, the Economic and Monetary Affairs Committee of the European Parliament approved gold to be used as collateral confirming its status as a high-quality liquid asset. Mexico recently thumbed its nose to the FED by purchasing 100 tons of gold, just like India and China before them. It seems that every day more and more individuals and governments are coming out and legitimizing to the long lost idea that Gold in specific and precious metals in general are money. Even the brokers and banks who trade precious metal do so at the currency desks and not alongside cocoa or wheat, because they always have been considered money. With the growing public consciousness that the precious metals do what our ancestors utilized them for which is store value and act as a medium of exchange the bull market will continue in both the metals and the stocks.
One would think that the Dollar would have rallied much stronger considering the fact that it was in the process of bouncing and the Euro zone is a fiscal train wreck. It seems people are looking to areas other than the dollar to store their wealth. At the current epicenter of the crisis the public is buying gold coins en masse in Europe and not running to the supposed safety of the Dollar like the mindless hordes of the past. It appears to me that we are in the initial stages of awakening to how deep and widespread the problems in the current FIAT monetary system are.

Might the world return to a gold standard, possibly, but at some point the people lose faith in the current system and will require currency backed by something. The currency does not have to be backed by gold alone as there are examples throughout history of money being backed by other items of value. For example the great German inflation was finally ended when Germany tied its currency to an asset that they had available which was land. By tying the German money to land the people knew that the money was a store of value and since there was a finite supply of land it would not be inflated. The idea of limiting the amount of money to prevent scenarios like what we are experiencing will be the driving factor in countries developing a “backed” currency. Today spending is out of control because currency takes no effort to acquire, just punch a few keys over at the Treasury and add a couple zeros and you are all set.

Investment analysts hate gold because they don't understand it and don't know how to value it therefore they believe that it has no intrinsic value. It is mistake to say that gold has no intrinsic value if it is the limiting factor on the quantity of available money. I would argue that the Dollar has very little intrinsic value as they are so plentiful and inexpensive to produce. If a person or government requires very little effort to obtain something how can one place a great value on it. Governments hate gold or backed currencies because it hinders the hidden tax of inflation that governments traditionally abuse to spend beyond the public's means. Furthermore, our entire system of fractional reserve banking is designed to boost money supply to afford a continually expanding economy. The problem is that the bankers have gotten very good at creating credit far beyond what was originally intended by fractional reserving resulting in massive dislocations in the economy.

The bottom line is that attitudes toward precious metals are finally changing and this is why the Dollar is destined to continue its descent. Add to this the inability for the politicians to even agree upon basic measures without name calling and causing agreements to fall apart and one can see why there is more pain lying ahead. Nothing is getting done now and rest assured that nothing will get done before the election in 2012, unless we either have financial accident or the “bond vigilantes” show up. We recently had the President's Bipartisan commission on the debt come out with a report that provided a good road map to get us on the right track, but it was ignored. I fear that we will have to have true crisis before we start to make moves in the right direction. We as a country will get there but it appears that much still has to change in Washington and the thought processes of the citizenry. In the meantime it appears that the Precious metals complex is getting close to bottoming out. Traditionally the summer is slow for the PM sector; however, it is not cast in stone that the summer has to be the doldrums. I have begun to nibble on some of the PM shares as certain indicators like the Miners Bullish Percent has reached the 43.33 level and usually bottoms in the 30's, however it has bottomed at this level in the past. I have also been a buy of the metals especially gold on swings down toward the $1470's.

One should also note that equities of companies that retain pricing power are very good for this type of environment as well. If you can find a company that is either insulated from price rises or can pass them along investing in those equities should be considered as well. Moreover, a company that can do the aforementioned and pay a dividend that is continually being raised is optimum in my opinion.

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