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.

…in the short term the markets will go up. The American media will be full of stories about the new president. There will be wall-to-wall coverage of his Inauguration speech, and the parties that follow. Many stories will be written about a “New Day for America.” All stories will be positive.

I therefore assumed that the markets would rise, so I said that:

I may consider gambling by buying either a long ETF, or perhaps just picking up some out of the money call options on the S&P 500. I wouldn’t invest anything significant in them, but it’s probably worth the gamble. I may also consider a bull spread with options, which is somewhat less risky, but also has less potential for profit.

And that is exactly what I did.

On Monday the U.S. markets were closed for the Martin Luther King Jr. holiday, so on Tuesday morning, Inauguration Day, I placed my bets. I started by picking up some shares in RSU – Rydex 2X S&P 500 ETF, and ETF that is designed to increase by twice the increase in the S&P Index (and vice versa, of course; it drops if the S&P declines). As the morning progressed the markets continued to fall, so I “doubled down” by buying some call options (specifically the SPY Feb 85 calls, which are call options on the S&P 500 Index). I bought in tranches as the markets fell, and ended up paying $3.42 each.

Unfortunately for me my timing was somewhat premature; as President Obama spoke, and as Inauguration Day wore on, the markets continued to fall. So much for the instant euphoria I was expecting.

I guess I should have done some basic research. It turns out that 70% of the time the markets fall on Inauguration Day. The biggest recent fall was the day of President Johnson’s Inauguration, but that’s not surprising since he became president after the assassination of JFK. The next worst day in recent memory was President Reagan’s Inauguration; the market fell for the next year and a half, but then of course a 20+ year bull market started, so I guess you can’t over-analyze one day’s results. You can read Mark Hulbert’s column for more details.

Fortunately, Wednesday was an up day.

Thursday was a marginally up day, but Friday started off heavily to the downside. I did not want to be sitting on short term call options over the weekend, when anything can happen, so around 10 in the morning or so I sold the calls for $2.38, obviously a significant loss over the $3.42 I paid for them. Of course, as you can see from the chart, my sell point marked the start of the rally that continued until the end of the day. Had I held on, the options would have been worth around $2.65 at the end of the day.

However, I’m not losing any sleep over my decision. I expected there to be an Obama rally. There wasn’t, at least not to the extent and as quickly as I expected. When you are playing with options, you must take your profits, or cut your losses, very quickly. Sitting around waiting for a few weeks means the time premiums evaporate and you are wiped out. So I took my losses and bailed.

Fortunately I was not playing with significant dollars, so the loss doesn’t really hurt me. I held on to the RSU – Rydex 2X S&P 500 ETF, just in case the rally continues next week. I don’t have the same worries about time premium erosion.

So why was I wrong? Why did we not have a big uptick in the markets this week? It could be that the uptick will come next week; everyone spent the week watching Inauguration coverage on television, so people weren’t actively trading. It could also be that everyone is waiting for the details of the Obama stimulus package, and when it’s announced, the markets will soar.

Of course, it is also possible that the economy is in a mess, and everyone knows it, so no-one is buying.

My thoughts on the subject are well documented. I assume that President Obama is a smart, intelligent man. I assume he has smart, intelligent advisors, and I assume he will do what he thinks is necessary to “fix” the economy. Unfortunately, I don’t believe a government can “fix” an economy. I believe that only people can fix the economy. Only people can invent products, create wealth, improve efficiency, pay down personal debt, save, and do all of the things that can make an economy grow. “Stimulus” packages may bump up the economy today, but long term only taxes and inflation increase.

So, I continue to believe that we may have a bump up when the stimulus package details are announced, but in time reality will set in, and down we go.

Of course the big winner this week was the price of gold, and I’m pleased to say my blue chip gold holdings like ABX.TO – Barrick Gold Corp. and AEM.TO – Agnico-Eagle Mines Ltd. had good weeks, up 4.5% and 2.3% respectively. Silver stocks did even better. However, I see warning signs on the gold chart. It looks to me like $900 is a significant resistance point, for two reasons: First, we are getting very close to the down trend line drawn back from the highs in March, 2008. Second, the RSI is approaching 70, which has marked a significant resistance point for the last year.

Long term, and in fact over the next three or four months, I believe gold will be a great investment. However, I don’t believe the next few weeks will be kind to gold. I believe profit taking will kick in, and gold will fall into the $800 per ounce range. That will be the final buying opportunity in this cycle, and I fully expect to see $1,000 per ounce by the time the snow is gone in my corner of Ontario. (We have lots of snow on the ground, so I’m assuming it will be late March or early April before it disappears).

So, the strategy this week will be to place sell orders on half of my gold holdings at slightly above the closing prices on Friday, and take profits. I will do the same with my long ETF position. I am already sitting 58% in cash, which is where I want to be if I’m correct and we have one more down leg. I’m hedging my bets by retaining some gold and silver shares.

I hope I’m wrong. I would love nothing more than for this financial mess to be over. If I am wrong, I have cash, so my profits are capped, but I’d still be happy.

Unfortunately I believe that the real estate market has more room to fall, China is in a recession which will reduce their demand for our products, and make it harder for them to buy more U.S. Treasuries to prop up the U.S. dollar, credit is still very hard to get (which is what fueled the boom over the last few years), and price of oil is on a yo-yo string at the moment. It could be that all of this negativity is a contrarian indicator, but I doubt it.

As always, thanks for reading, and thanks for contributing on the Forum; we will all continue to muddle through this together.

I am a cynic. I am of the view that the economy is imploding. A trillion dollars of bailout money has not stopped the stock market decline, and I think it is entirely possible that we will see 6,000 on the Dow before the end of November, 2008. The chart simply doesn’t look good.

I think it is entirely possible that one of General Motors, Chrysler or Ford will not exist a year from now. That means that every town in America that has three North American car dealerships will, a year from now, only have two. Manufacturing plants will be closed, and the resulting job loss will be enormous.

Our society lived on credit for far too long, and now we have to pay the piper. I am a cynic, and I just don’t see what a President, or a government, can do to reverse the laws of nature.

Governments do not create wealth. To paraphrase Seth Godin, “wealth is created by productivity, and productivity is the result of innovation, and innovation comes from hard work, investment, and progress.” Governments do not create wealth. People, working hard, create wealth. I’m not convinced that any government can positively motivate people to create wealth. Believing that government can solve your problems leads to a sad day for America.

Of course, I could be completely wrong.

I’m not wrong about government being able to create wealth; they can’t. But, perhaps I am wrong about the influence of President Obama.

I think back to the dying days of the Jimmy Carter presidency. Americans were being held hostage in Iran, and the economy was in the dumper. Along came Ronald Reagan, who won a landslide victory (twice), and made everyone feel good. He probably wasn’t the smartest president (although Saturday Night Live had a brilliant take on that subject, although I thought the Grumpy Old Man routine was even funnier), but he inspired people. I remember watching him give a speech to the troops in an aircraft hanger somewhere; he ended the speech by thanking the troops and saluting them, and there wasn’t a dry eye in the place.

He was respected, he made people feel good, and therefore people were less likely to spend their time demanding stuff from government; they got to work and did it themselves, and the result was the 80′s and 90′s, one of the biggest boom periods in history.

I suppose Kennedy was the same, but he was before my time, and it’s very possible that Obama will be similarly inspirational. Read the blogs that are out there, and you will find many that admit that they are inspired by Obama. It is entirely possible that it will be self-fulfilling prophecy. If we all believe Obama will save us, we may all end up working harder and saving ourselves, which then saves the world.

I hope that happens.

I just worry that after the initial euphoria wears off, reality will set in. And the reality is that the markets are down, the consumer is down, the auto makers are down, and all of that down doesn’t make an up.

I’m giving you the reasoned approach to why the markets will not recover any time soon. There are many really wild reasons on the net to explain why the market will crash even further. Here are my favourites:

First, the moon. Yes, the moon. Apparently the full moon on November 13 is a “supermoon”, which occurs when the moon is very close to earth. (The moon orbits the earth in a somewhat elliptical orbit, so during its orbit it moves closer to, and then farther away from , the earth. On November 13 it will be very close to the earth). Apparently that will make the moon’s gravitational pull even greater, which increases the chances of tidal waves, earthquakes, and other bad stuff.

Yeah, really: the moon will be the cause of our downfall.

Second, Elliott Wave theory. Apparently everything moves in five waves up, and then three waves down. In a bear market, there is an “A” down wave off the peak, then a rebound, than a “B” wave down, then a recovery, then a final “C” wave down. Wave “C” is typically at least as large as wave “A” and often extends to 1.618 times wave “A” or beyond. (Of course 1.618 is the Golden Ratio).

Personally, I think Elliot Wave Theory is a bunch of hooey. Once the chart is drawn you can fit the waves to make it work, but it has less power as a predictive tool. However, if you draw the lines a certain way, the case can be made for 4,000 or so as the bottom of the final wave.

Alas, I don’t think we need to look to astrology for reasons why we are in trouble. There are some obvious business reasons why we could go down substantially from here, such as:

1 Tax loss selling. If you sell your losers before the end of the year, you can apply those loses against gains. Although I do have an accounting background, I’m not here to talk about taxes, and the rules differ depending on where you live (Canada vs. the U.S., for example). However, I do know that in Canada, if you had capital gains in prior years, you could sell your losers this year and apply those loses to prior years. That means you can recover some of the taxes you paid during the good years. Since everything is lower this year, I would assume many investors will be selling to recover some cash, and that will depress the markets. It makes no sense to wait until the last minute, so tax loss selling should be starting any time now.

2 The economy is in really bad shape. Really bad. It would appear that General Motors and the other North American car companies are only a few months of poor cash flow away from bankruptcy. In the last three months GM lost $2.5 billion, which is the fifth quarter in a row they lost money, and their sales dropped by 13% from already dismal levels. They are bleeding cash, and will require government help to survive. I know there are some who believe that the stock market is a leading indicator, and therefore the October bottom and subsequent uptick predicts a rise in the economy, but I don’t see a turn around at GM. President Obama may, as his first action in office, nationalize the auto industry, which is not a good sign.

(As an aside, I have heard no talk of bailouts for Honda or Toyota, both of which have significant auto manufacturing plants in North America. I wonder if it’s because they are better managed? If so, would it not be better to let the big three fail, and let someone competent take over their operations?)

3 A short squeeze on gold is in progress. The first day to give notice that you want to take physical delivery of the December gold contracts is November 28. That may very well start the force majeure in gold process we discussed two weeks ago. Gold lease rates are off of their highs, but they are still very high compared to historical levels. (In fact we are closing in on backwardation as short rates turn negative, which is extremely disruptive, and very bullish). If traders start taking physical delivery of gold, the Comex is done. It appears the open interest on the December contract is around 18 million ounces of gold, and there are only around 5 million ounces in the warehouse. Normally that’s not a problem, because most traders don’t take physical delivery. But, if they do, the down tick in gold may be over.

Again, I hope I’m wrong. I hope we have turned the corner, and the bottom is in, but I just don’t see it, yet (which may of course be a sign of the bottom).

My plan continues to be to hold some physical gold, hold some gold and silver stocks, maintain some short positions (such as RSW – Rydex Inverse 2X S&P ETF), and to continue holding cash while the market sorts itself out.

Let’s see if the moon destroys us all next week.

All comments welcome on the Forum; tell me why I’m wrong to be a cynic. Thanks for reading, and see you next week.

Except:

This may go down in history as the most eventful week in U.S. history. Not just in U.S. stock market or financial history, but U.S. history.

This is the week that the U.S. government started nationalizing the U.S. economy.

Scary, isn’t it?

The United States of America has always been a capitalist country. People from around the world come to America to seek their fortune. It is, or at least was, the most business friendly country in the world. As a result, there have been more inventions, technological advancements, and creative accomplishments in the United States of America in the last 200 years than there have been in the whole of human history.

(Of course I have no proof for that statement, but I don’t think I’m far off).

So what happened this week? The SEC banned short selling, “temporarily”, on 799 “financial” stocks, and the government bailed out AIG , the big insurance company (after helping out in previous weeks Countrywide, Bear Stearns, Fannie Mae and Freddie Mac, etc.).

The U.S. government is working on a plan that will probably cost $1 trillion, and will involve the U.S. taxpayers buying up distressed mortgage assets. If the government likes you, they will save you. If they don’t like you (ie. Lehman Brothers), they won’t.

These bailouts are a very dangerous precedent. Lenders lent money to people who had no hope of repaying it; the debtors didn’t repay; the loans inevitably went into default. Instead of allowing the market to crash and wipe out the speculative excesses so we could start over, the government is bailing everyone out.

I assume the next step will be the government buying up the North American auto makers, because the bankruptcy of General Motors, Ford and Chrysler would be “bad for the economy”. Then presumably the airlines will be nationalized, because their failure would be “bad for the economy.” We are walking down a very slippery slope.

The purpose of this blog is not to talk about politics, and it is not to advance the cause of capitalism over socialism. Therefore, I’m not going to talk about it further. (However, if you would like my more detailed thoughts, you may read them, and comment on them, on a brand new blog, john-galt.ca).

The real question, of course, is what does all of this mean for the market?

On the surface, everything looks great. My portfolio recovered six points this week, so I’m “only” down 34% on the year. But there are still some scary facts.

For example, did you know that on September 16, 2008, there was not a single company on the TSX Venture Exchange that made a 52 week high? I don’t believe that has ever happened before. That day 499 companies made a new 52 week low, which is about 38% of all companies traded that day. Sounds like a bear market to me.

Yes, I’m happy that K.TO – Kinross Gold Corp. was up 18% this week. The 3 month chart appears to show a break of the down trend line:

But looking at a three year chart gives a different story:

It would appear that the uptrend extends form the August 2007 lows to last week’s lows, but we are still in a medium term steep down trend.

What does this all mean?

First, in case you haven’t guessed, the best description for these markets is volatile. Tomorrow gold will go up $80, then the Fed will bail someone out and it will go down $100, then something else will happen and it will be back up $200. I don’t know the exact numbers, but whatever happens it will be volatile.

Second, stay away from margin for now, because with this volatility, if your timing is off by a day, you could be wiped out.

My plan will continue to be simple:

I will over weight the golds and silvers and uraniums, because hard assets are important. Very important. The more money the Feds print, the less valuable it is, and at some point the world will realize it’s gold or nothing.

Second, I will take what the market gives me. If we have three strong up days, I’ll take some profits on, say, 25% of my holdings (leaving my core position intact). Then, if we have another crash, as I’m sure we will, I’ll be buying with that cash.

I can’t time the tops and bottoms, but I will try to grab some profits where I can.

I have much more to say, but I was out to see the Blue Man group with my family last night, so I’m a little sluggish this morning, so I’m going to leave it to you to continue the conversation on the Buy High Sell Higher Forum; see you next week.