QE2 is supposed to end at the end of June, so the Fed will not be buying treasuries. The U.S. government is running massive deficits, so they need to borrow money to operate. Presumably at some point in the near future the government will be raising the debt ceiling, again, allowing them to borrow even more money. If the Fed isn’t buying treasuries, and if the government needs to sell T-Bills to finance the deficit, they will have only once choice:

Raise interest rates to encourage suckers foreign investors to buy Treasury Bills.

Unfortunately rising interest rates will act to slow down the economy, just as the removal of liquidity now provided by QE2 will also slow the economy.

A slowing economy in advance of the presidential elections in 2012 is not good for the incumbents, so presumably something will need to be done well in advance of November 6, 2012. So, that would lead to the supposition that at some point in the late summer, or fall, or early winter of this year the Fed will have no choice but to commence QE3.

Interest rates are one issue; inflation is the other. As more dollars are printed, you have more dollars chasing the same number of goods, and that’s inflation (an increase in the money supply), which we observe as an increase in prices.

Our pals at the Fed mentioned the word inflation eight times in their 416 word June statement. They realize the economy is in a mess, as the quotes will demonstrate:

• the economic recovery is continuing at a moderate pace, though somewhat more slowly than the Committee had expected.
• …recent labor market indicators have been weaker than anticipated.
• The slower pace of the recovery reflects in part factors that are likely to be temporary, including the damping effect of higher food and energy prices
• investment in nonresidential structures is still weak, and the housing sector continues to be depressed.
• Inflation has picked up in recent months, mainly reflecting higher prices for some commodities and imported goods…

All of those quotes were taken from paragraph #1 of their report. To sum up:

We have a “recovery” that is happening more slowly than expected (after spending trillions of dollars to get it going), which is why the unemployment rate in the U.S. remains at 9.1% (near the highest levels of the past 50 years).

The Fed thinks these problems are temporary, which is true, if you consider “worst levels in 50 years” to be “temporary”.

Part of the problem is higher food and energy prices, but that’s not a big problem, because of course very few of us actually use food or energy…. However, they do admit that inflation has picked up in recent months,

Oh yeah, let’s not forget that housing sector continues to be depressed.

So, in summary, we are in a depression, and inflation is increasing, which will erode whatever wealth we have built up.

Great.

If only there was a solution to these problems.

One option would be to cut spending, balance the budget, and convert to a non-fiat currency, but of course that would lead to temporary suffering during the adjustment phase.

So here’s an idea: let’s just change the way we calculate inflation, so that there isn’t any! It’s pretty simple, really. We all know that when prices go up we spend less, so let’s just reduce the basket as prices increase.  Yup, let’s cook the books!

For example, if today we assume that an American family buys 100 gallons of gas in a month, and the price is $4 per gallon, Americans spend $400 per month on gas. If the price of gas increases to $4.10 next month, Americans spend $410 on gas, which is an inflation rate of 2.5%.

But wait! Let’s assume that for every 1% increase in price, consumption drops by 1%. So now, at $4.10, Americans only buy 97.56 gallons of gas in a month, at $4.10 per gallon, for total spending of $400. That’s the same spending as last month, so bingo, no inflation.

This is a perfect plan. Since government payouts for social security, unemployment insurance, pensions, etc. are indexed to inflation, if there is no inflation, government payouts don’t go up. If there is inflation but we pretend there is no inflation, government payouts in real dollars actual drop. It’s brilliant. The Republicans will support it because it’s a reduction in government spending. The Democrats will support it because it’s not a tax increase (well it is, but it doesn’t look like one).

And who gets screwed? The little guy, who will have less real money to buy food, or put gas in his car, or live.

So there you have it. The Fed admits we are in a depression, and it’s worse than they expected, but rather that real change, the answer will be to change the way we crunch the numbers so everything looks great.

In the short term the U.S. Dollar will rally, because the end of QE2 will be perceived as good for the dollar (and all of the other major world currencies are in worse shape, so where else would you want to invest; Greece?). Gold may slip over the summer as a result of money flowing from gold back in to U.S. dollars.

But as summer follow spring, so to will QE3 follow QE2, and the house of cards will eventually collapse.

It wouldn’t surprise me at all if major players like China and Russia decided to stop using U.S. dollars, because who wants to use something that is guaranteed to decline in value. Oh wait, they just announced that Russia, China sign deal to switch to trade in rubles, yuan. (Thanks to onlooker on the BHSH Forum for pointing this out).

Hold your physical gold, hold some cash to use to purchase bargains when they appear during the summer, and stock up on physical goods before inflation takes off.

How’s that for an optimistic view of the world?

Thanks for reading; see you next week.

I’m looking forward to a relaxing break by the pool, since my powers of prediction this year have been non-existent. I have expected a continuation of the Second Depression, and resulting weakness in the stock market, and I have been totally wrong.

The S&P has just completed it’s best five month streak since 1938. The Dow had it’s best monthly gain since 2002. The Toronto Stock Exchange had it’s fifth straight monthly gain, and made a new high for 2009.

Obviously I should have invested every penny in whatever stock I could find during the April lows, and I would have massive profits to show for it today. I didn’t. I’ve stayed on the sidelines, and watched the profit pass me by.

And I remain on the sidelines, because I still can’t bring myself to believe that all is right with the world. Here’s my evidence:

Jessica Simpson has broken up with Tony Romo

Okay, perhaps that isn’t evidence that the market is due for a correction, but isn’t it a sign of the end of the world? If there are two people in the world who should be together it’s a beautiful but not-very-smart actress/singer and a beautiful but never-won-a-playoff game quarterback. They are made for each other, and if they were honest about their abilities they would realize that. But they aren’t. Presumably they both think they can do better.

And that, my friends, is where the markets are today. Earnings are dismal, consumer confidence remains low, but the markets are on a multi-month winning streak. They obviously believe they can do better.

And maybe they can. (Note to self: why am I starting so many sentences with the word: “And”)?

But I just can’t help but believe that 1,000 on the S&P is a very significant resistance level.

The markets fell below the 1,000 level in the crash of October, 2008, dropping to the 900 level on October 10, 2008. The S&P bounced back to 1,000 on October 13, but it didn’t hold, and we were back to 907 on October 15, 2008. The next bounce up to and including October 20, 2008 only got the market back to 985, and that’s as high as the S&P has risen, until Friday, when it closed at 987.

I’m no “rocket surgeon”, but it appears to me that 1,000 is a very significant level. 1,000 is obviously a psychologically important level, but it’s also an important technical level. A break above 1,000 would break the down trend line in place since the summer of 2008:

As I mentioned last week, I also worry about the RSI, now at a very high 71; tops typically happen anywhere over the 70 level. Perhaps a decisive close above 1,000 this week will change my mind.

Of course I’ve been worried for months, to no avail, and the market won’t do what I want; it could continue rising for months to come. But I think at some point the cracks in the armour (or armor for my American friends) will become evident.

Here’s my thinking: in low interest rate environments, stocks go up, even at times in spite of the fundamentals. If the company I am investing in can borrow at 10%, as a common share investor I want to earn more than the going rate of interest to compensate me for my risk: let’s say I want to earn 15%. I may therefore be willing to pay $10 for the stock.

If interest rates drop to 5%, the borrowing costs for my company are now 50% cheaper, and my earnings expectations relative to the going rate of interest are also lower, so perhaps I’m now willing to pay $15 for that same stock. The company I’m invested in may not be producing any more product, but the combination of the lower borrowing costs and my reduced profit requirements combine to increase the share price.

Don’t believe me? I’m sure you all recall the year of my birth, 1964. The Dow Jones closed that year at 874. As I grew and matured I witnessed many major advancements. In 1967 the Toronto Maple Leafs won their last Stanley Cup. During my fifth year on the planet man landed on the moon. As time went on the microprocessor, the cell phone, and the computer was invented. The war in Vietnam ended, and the economic fundamentals improved.

And on this day in history, July 31, 1981 (I know today is August 1, but that was also a weekend back in 1981) the Dow Jones industrial average closed at 952. And by September 4, 1981 the Dow had fallen to 861.

In other words, during the first 17 years of my life, the Dow Jones Industrial Average actually fell. By March 12, 1982 it was down to 797.

So why, during this wonderful period of technological innovation did the market remain stagnant, and even fall? Here’s a guess: high interest rates.

I bought my first house in 1989, and the interest rate on my mortgage was 13.5%. I renewed my mortgage yesterday on a two year term for 3.4%. (I had planned to pay it off, but if money is free, why bother?). Interest rates are low, my friends.

Could it be that high interest rates in the 1970s and 1980s depressed the stock market? Could it be that very low borrowing rates, for solid companies, has increased stock prices this year? As an investor, you can put your $1 million nest egg into a term deposit at a bank and earn less than 1%, or you can put it in the stock market. Since you earn nothing in a bank account, there’s not much of a downside to a stock market investment, is there? So investors put money in the market, and the market goes up. So more people put money in the market, and so it goes.

Until it stops.

The smart money has used the last three months to dispose of the stock they no longer want, and I fear that the time has come for them to step aside and let the true extent of the bad economy shine through.

I don’t like the looks of August. I’m going on vacation again this month, and we all know what happened when I went on vacation in August, 2007. (That was actually one of my better commentaries, actually; you may want to read it again).

Interest rates must start increasing. The treasury auction this week was a disappointment, as interest rates were increased to allow the government to fund it’s massive deficits.

The U.S. economy continues to shrink. The next wave of credit delinquencies and defaults is just beginning. Unemployment remains high. Government spending is at record levels. Swine flu could be a serious drag on the economy this fall.

Oh, and did I mention the whole Simpson/Romo break up?

Things are bad, and getting worse.

I will continue yelling at the wind; my efforts may be futile, and I may continue to look wrong, but I am not prepared to throw money at this market. We’ve had corrections in August before, and we may again this year, so I will sit on the sidelines for a while yet.

Thanks for reading, and for those of you living in provinces in Canada that get Monday off (which is all of them, I think), enjoy the long weekend, and talk to you next week.

Gold and Silver

In my commentary on October 11, 2008 I told the story of traveling to Toronto to buy gold and silver, only to find out that both commodities were in short supply. I had attempted to buy 100 one ounce Silver Maple Leaf coins (worth about $12 U.S. each) at Scotiabank in downtown Toronto (the largest precious metals dealer in Canada). I was told that supply was limited; they could only sell me 25 coins. I was shocked that I could not even spend $500 Canadian on silver coins.

This week, I decided to repeat the test. On Tuesday off I went to Toronto, I walked up to the precious metals trading desk, and asked to buy 100 one ounce Silver Maple Leaf coins. No problem, I was told. How about gold Maple Leafs? No problem, we’ve got them.

It would appear that the significant shortages in gold and silver coins are not as significant as they were a few months ago.

As for prices, back in October a one ounce Silver Maple Leaf cost $19.87 Canadian. (Coins are priced in U.S. dollars per ounce, so the price includes the conversion to Canadian currency, the 8% Ontario Sales Tax, and the bank’s commission. The price varies slightly depending on the quantity you buy).

This week that same one ounce Silver Maple Leaf coin cost $23.01 Canadian, an increase of 16% over a six month period.

The actual price of a one ounce Gold Maple Leaf coin increased from $1,181.33 Canadian to $1,276.14 Canadian, or an increase of 8% over that same six month period.

During that time the price of gold has increased from roughly $825 US an ounce to $892 an ounce, for an increase of 8%. Silver’s increase has been from roughly $10 to $13 US per ounce, or a 30% increase.

So what does this all mean? It means precious metals are up in the last six months, with silver up more than gold. They were a good investment. By contrast, six months ago the Dow was around 8,600, and today it’s around 8,000, for a drop of about 8%.

Of course had I asked for these same quotes on Friday the prices would have been cheaper, as gold and silver tumbled later in the week. However, the basic point is that gold and silver, expressed in Canadian dollars, were a better investment over the last six months than the Dow. Which of course is one of the main reasons that physical silver and gold is the ultimate insurance policy.

Where is gold heading? My gut tells me we are nearing a near term bottom. Here’s a one year chart of gold:

If you draw an uptrend line from the lows of November 2008, it hits where we are today. Coincidence? Perhaps. But the 200 Day Moving Average is $860.37, and gold closed on Friday at $869.10, so it’s possible that both the uptrend line and the 200 DMA are support levels.

Looking a the three month chart the $860 level also looks like support, and the RSI is as low as it’s been in months, so again, a bottom could be here.

If gold breaks below $850 this week, I will assume that we are going for a big fall. If not, we could be at a decent support level, so now may be a good buy point (although I will wait and see before committing any further cash).

Looking at the gold stocks, they are looking beaten down. For example, K.TO – Kinross Gold Corp. closed the week at $16.73, a big drop from the $24 level we hit back in January, February and March. The RSI at 31.39 is also very low. Is this a breakdown with a big fall ahead, or is this a “breakdown” that was artificial, like we saw back in November, that was in hindsight a fantastic buying opportunity?

I won’t bore you with the charts, but the charts of AEM.TO – Agnico-Eagle Mines Ltd. and G.TO – Goldcorp Inc. and other gold stocks look remarkably similar. Gold itself has not broken through it’s base, but the gold stocks have, which either means they have over-corrected and are due for a bounce, or bad things are coming. In fact, even the silver stocks look the same (SLW.TO – Silver Wheaton Corp. and PAA.TO – Pan American Silver Corp., for example).

Again, it appears to me we are at a significant decision point. If these levels in gold and silver hold, we may be at a near term bottom. If they don’t, we could easily see $800 per ounce gold; we will have a good idea this week, and a very good idea before the end of the month.

The Market

How is the overall market doing? Hard to say.

As this 3 year chart of the S&P 500 index shows, we are still in a downtrend, and the RSI and MACD are getting into over bought territory. Not good.

Shortening the time period, the one year chart shows a series of lower highs and lower lows; obviously a market going down.

The 6 month S&P 500 chart makes it easier to see the key resistance level at around the 875 level. The S&P hit:

• 874.09 on January 28, 2009
• 869.89 on February 9, 2009
• 869.90 on April 17, 2009

Again, it appears to me that we are at a critical level in the overall market. A decisive break above the 875 level and we could see a nice run upward. If, however, the market doesn’t get above these levels, the chart will be a double top or a triple top, and back down we go.

My thoughts are well documented on where we are going from here: Bear market rallies are commonplace. But, I believe we are still in a bear market, and until we have retested the lows we won’t start a new bull market. I believe we will retest the lows, and go lower. I am in the bear camp because although we have had the sub prime crisis, and the residential real estate crisis, we have not yet had the commercial real estate crisis (although it’s starting; the second largest mall operator in the U.S. went bankrupt this week), and we have not had the credit card crisis yet. Unemployment remains high, no-one is buying cars (or much of anything else), so I believe that fundamentally we have a way to go down yet.

Am I buying puts on the S&P? No, I’m simply holding a lot of cash, and staying on the sidelines until the direction becomes more clear.

For more on the current depression, I have more psychobabble comments below. For those who only want to read about investments, you can stop reading now, thanks for reading, see you next week.

Back to the Psychobabble

Two stories for you this week. First, the story of my nephew, a 17 year old high school student who has spent the last eight months looking for a summer job, which is not easy to find in these depressionary times. He knocked on every door in town, and sent resumes to literally hundreds of places. Finally he got an interview at a local store a ten minute walk from his home. The owner said he fired the last student employee because he wouldn’t clean the washrooms. My nephew said “that’s no problem; my older brother and I are responsible for cleaning our own bathroom, and he’s a bit of a slob so I end up doing most of the cleaning, so I’ve got no problem doing it.” He got the job.

He got the job because he was lucky to have the right response to the right question when asked. But his luck was caused by knocking on a 1,000 doors to put himself in a position to get lucky. I believe it was Samuel Goldwyn who said “the harder I work, the luckier I get”. I couldn’t agree more.

I fear that “kids today” want the fancy car, the big screen T.V., and the big house, but they don’t want to work for it, primarily because their parents have those things. Unfortunately their parents bought all of those things on credit; some of them didn’t work for them either, which is one of the contributing factors to the credit crisis today.

Yes, I am fostering a stereotype by talking about “kids today”. In fact, I don’t believe that “kids today” are the problem. I think the current crop of teenagers and 20 somethings will be more responsible and hard working than their forty and fifty year old parents. (I turn 45 years old this year, so I can speak with authority on the mind of a 45 year old). The 35 to 55 age group grew up in an age of credit cards, car loans, and high ratio mortgages, so a great deal of our consumption was debt driven, not work driven.

My father, who is 72 years old, had a mortgage, but he never had a car loan, and never carried a balance on his credit card. He paid cash. His parents, who were in their 30s during the Great Depression (you know, the first one), always paid cash, because that’s all there was.

My nephew, and my children (who won’t be teenagers for another three or four years) will not have access to the same easy credit that my generation enjoyed. They will have to work for what they want, and save for big purchases.

Long term that’s a good thing, because are efforts lead to our rewards, and we will not be beholden to a banker who decides to raise our interest rate or cancel a loan.

Short term that will really squeeze the economy, since there will be fewer buyers. (Which is another reason I’m in the bear camp).

Regardless, I’m proud of my nephew. Learning at the age of 17 that hard work and persistence pays off is a great life lesson.

My second story is the thoughts of Peggy Noonan, who wrote in the Wall Street Journal about a “new” trend toward self sufficiency, and away from outward displays of affluence. I agree. If I need less, I can work less. If my family can get by with one car instead of two, I don’t need to work two jobs. I can actually see my family more, which is also a good thing.

So, in keeping with these difficult times, I am off to take advantage of the first sunny warm Saturday this year here in Southern Ontario, and I am going to turn over my vegetable garden. Today I plant peas, and probably some spinach and other frost tolerant crops, and get the garden ready for the heavy planting next month. I like vegetable gardening. It’s good exercise, I get to each fresh food, and it takes my mind off terms like RSI, MACD, bankruptcy, and bear markets.

Enjoy it while you can, thanks for reading, and see you next week.