Ned W. Schmidt,CFA,CEBS
THE VALUE VIEW GOLD REPORT
Moneyization: The global financial phenomenon of individuals and businesses moving their funds to monies in which they have the highest confidence, or money in which they have a higher store of faith.
Or, Only One Viable Money Choice
We awoke on Monday morning to HCA being bought by a private equity group. Somehow that and Israeli not launching a full scale invasion of Lebanon caused the U.S. equity market to explode upward. Seems like the last time that happened the NASDAQ Composite shortly afterwards went to a new cycle low. That aside, this HCA transaction, void of any apparent economic benefits, seems indicative of the late stages of a speculative cycle and a near panic reach for returns in the paper asset markets.
Mergers and acquisitions have either of two motivations, economic or financial. The HCA transaction seems to be of the latter, with little obvious economic benefits. Economically motivated transactions, for example, are when a sick company is acquired and reborn. Occasionally a real synergistic effect exists as in the case when a railroad extends its route structure. These transactions have a net positive benefit to the economy. For stakeholders to benefit some economic rationale should exist for the transaction. AMD's same day announcement of the acquisition of ATI may be an example.
Financial transactions do nothing but create fees. Economic benefits are either void, or a secondary concern. In the case of HCA, three firms will combine their $5-6 of equity with about $15 billion of debt to acquire the firm. This $20 billion, rather than enhancing overall economic prospects, appears to do nothing but generate fees for the investment bankers and managers of the private equity firms. In short, to society a net welfare loss may occur. Why would such a transaction occur?
The answer is in the first graph, below. That solid line in the graph is the value of $1 invested in U.S. stocks at the end of November 1999. Today, the value is still about $1. In short and in terms even a CNBC guru should be able to understand, overall no money has been made in U.S. paper equities in almost seven years. At the same time, real assets like Gold have done well. Paper asset groupies have clearly been in the wrong place. The clients of paper asset managers have had their money invested in the wrong markets.
For an individual responsible for the investments of a retirement plan or university endowment, life started to look rather dismal. With 40-60% of assets invested in paper equities overall returns are weak, and their job could actually be at risk. Consultants, always ready with what worked yesterday, advised that some funds had done well in private equities. Few mention the wisdom of Gold as Gold pays no ongoing fees to the consultant. So, a few billion dollars were dumped into well known private equity funds in a frantic search for returns.
As a consequence of this panic driven group think, billions of dollars have poured into the funds created by private equity firms. Those billions have to be invested somewhere in order to justify the mangers' fees. The immense size of these investment funds requires that the deals have to get bigger. These investments also have to be exciting and trendy. Health care is trendy as the baby boomers are getting older, though that does not dictate that economic profits will be earned. Private equity firms are drawn to these financial transactions because they have to spend money. The fund managers and investment bankers have a clear motivation, fees.
The most fundamental law of finance is present value. The present value of an investment is the future value of that investment discounted back to today by an appropriate discount rate. This is "The First Law of Finance," much like the first law of thermodynamics. If the discount rate gets smaller, the present value rises. Vice versa and in reverse are also true. Such is the reason the prices of stocks, bonds, and real estate rise when interest rates are lowered. No magic, just the mathematics of finance.
A consequence of this law is that if the price of an investment rises, the discount rate falls. That discount rate in this case is the future return. The billions of dollars of money flowing into private equity funds, and we might add hedge funds, forces the private equity manager to seek out large investments. The price offered has to be a premium to the market price. According to the laws of finance, the future returns on these investments will be lowered by this higher price. Those that have rushed into private equity funds accomplished probably only one thing. Future returns have been further reduced from what they might have been. If HCA was going to produce above average future returns, why did the participants not recommend purchase of HCA, avoiding the payment of all the management and banker fees?
The tunnel vision of the mainstream investment community prevents them from recognizing that the world has been shifting out of paper assets into real assets like Gold. Investors guiding their own money are far more pragmatic. Fantasy transactions do not work for them. Such is the reason so many investors around the world have been shifting wealth to Gold. The paper investment illusion is being replaced by investment in Gold, the moneyization phenomenon. And the falling future returns on paper equities will only drive more investors into Gold over time. Only when we hear "gurus" on CNBC widely advocating Gold and Silver investments will the end of the Gold Super Cycle be near. US$Gold over $1,300 is still ahead.
One finally note before moving onto the other purpose of today's writings. The HCA deal is $21 billion and the AMD transaction is about $5 billion, or about four times the AMD purchase. If the HCA deal is little more than a financial transaction and AMD is likely an economic transaction, then the ratio of financial transactions to economic transactions is about four times. Such a measure indicates that the paper equity market remains in a speculative mode, and should be avoided by most investors managing their own money.
The other motivation for this article is the second graph. In that graph is plotted the approximate percentage of the world's money supply represented by the ten largest national monies. Many emails come from concerned investors with questions on the British pound and the Canadian dollar. Hopefully, this graph and discussion will help them in developing their outlook. This conversation should help others also sort out their individual situation.
First, plotted in that graph are the ten largest national monies. They have the largest transaction networks in the economic world(Cohen, 1998 & 2004). The size of the transaction networks for the bottom five are obviously small relative to the size of the five largest. That leads to a fairly simple observation. If your national money does not appear in that graph, no one is interested. The only reason it exists is that the government will not acknowledge the economic obsolescence of your national money. You should, one, move wealth to Gold, and, two, move your money balances to one of the top five national monies. Keep only enough of your national money as is necessary to pay day-to-day bills in that money.
Second, the large national monies are large because people around the world use these monies. The transactional network for a national money is the sum of the domestic and foreign use of that money. In the case of the Euro that includes all money needed by citizens of the EU as well as those that do regular transactions in the Euro. Citizens in nations on the perimeter of the EU hold Euros to facilitate economic transactions with citizens of the EU. The transaction network for the Euro has been growing and is the reason for its appreciation versus the dollar.
The U.S. dollar continues to have a large transaction network because of business and debt. That monster trade deficit of the U.S. is dumping more than $60 billion a month on foreign producers. That massive hemorrhaging of green paper means that foreigners can hardly avoid having lots of dollars. As soon as they get rid of some, another truck load of green paper shows up at the loading dock. That leads to the real reason the U.S. dollar remains so large in total. No other nation has $8+ trillion of debt that trades on a regular basis. The U.S. dollar exists in such size because of the massive size of the U.S. debt, which is hardly reassuring.
The Japanese yen remains a leading national money because of the economic importance of the Japanese nation over the past four decades. Strong economic fundamentals in those earlier years created a vast amount of wealth denominated in yen. A recession of more than a decade in length has reduced the importance of the yen modestly, from the top spot to number three. While the yen will remain an important national money as a legacy of the size of Japanese businesses, it will not likely attract investors. Competition from the Chinese renminbi will ultimately be too strong.
Chinese renminbi is rising in importance. However, the lack of full convertibility of the Chinese money retards its growth at the present. The economic importance of this nation dictates that the value of its national money will rise significantly over the next two decades. Retarding the expansion of the importance of the renminbi is the extremely slow process of opening of the Chinese economy. While the headline stories are exciting, the economic adjustment process for any nation is not rapid. All nations have vested interests that attempt to thwart the invasion of foreign activity into the domestic economy. Renminbi is not likely to become an important international money until such time as the economy is more open, but it will.
The British pound would be classified as the one true legacy national money. While in a bear market that extends back to 1914, the pound is still an important international money. That great empire created a long list of institutions still in existence that cause the pound to continue having an important roll in the global economy. A reversal of the long-term slide of the pound is not likely to occur. Investment in the pound is not likely to again become fashionable. Ultimately the pound will be converted to the Euro, but at a lower exchange rate than today. Movement out of the pound is encouraged.
That brings us to the Canadian dollar. The outlook for the Canadian dollar rests on the outlook for the U.S. economy and U.S. dollar. Real question is how sensitive the Canadian economy is to developments in the U.S. economy. Work by Bernanke and Mihov on developments during the great depression give some hint,
". . . among the countries in our sample, the most precipitous declines in output and prices occurred in Canada, the United States, and Germany. On an index of June 1928 = 100, Canadian industrial production rose to 119 in January 1929 but declined to 51 in February 1933. Output did not return to mid-1928 levels in Canada until September 1936. Canadian wholesale prices also hit bottom in February 1933, at an index value of 66, and consumer prices reached their troughs in April 1933, at 78. The United States exhibited similar patterns. U.S. industrial production, which reached 115 in June 1929, fell to 55 in June 1932 and reached that level again in March 1933. Output did not return to the June 1928 level in the United States until November 1936. U.S. wholesale prices reached their trough in February 1933 at 61, and consumer prices reached their trough in April 1933 at 73, the same month as in Canada"(Bernanke & Mihov,2000,p.112).
From this work we can estimate the "economic beta" of Canada to the U.S. economy during the onset of the Great Depression. 80 years ago the beta of Canada's economy to the U.S. economy was probably about 1.15. During these past eight decades the economic ties of the two countries have become stronger. Today, Canada's economic beta relative to the U.S. economy is much, much higher. A higher beta means that the Canadian economy will be more volatile than the U.S. economy.
The real issue for Canadian-based investors is what happens if something serious occurs with the U.S. economy and the dollar. Suppose the U.S. economy did plunge as a consequence of the mountain of debt. In such a state the U.S. dollar would lose value in rapid fashion, and the Canadian dollar would depreciate faster due to the high economic beta. Would investors around the world buy the Canadian dollar? Would Europeans think a buying opportunity is being created? Would Japanese investors move their wealth into Canadian dollars because of its "cheapness?" In short, the situation for the Canadian dollar is the same as with most national monies in the world. No one other than the citizens of the country want the money, especially during an exchange rate crisis.
The last four national monies are special situations, but little reason exists to own these national moneys. With Gold, why does one need the Swiss franc? Korean won is not on a lot of people's minds. With India considerably behind China on the scale of economic evolution, second place to the renminbi is certainly likely. Australian dollar simply faces the problem of all islands, it is surrounded by water. The transaction network for the Australian dollar is not likely to become significant. It may do better than the New Zealand money, but who will care?
This walk through the garden of the major national monies has been short. What have we leaned? The Euro is the best choice if one needs to hold a national money. The U.S. dollar is a sell, and the Canadian dollar is a short candidate. The yen's days are past, and little global interest exists in that money. If we could get some Chinese renminbi, putting them in the safe deposit box as an investment would be a great idea. Sometime look up what the Japanese yen did between 1955 and 1990. However, we cannot get the Chinese money in volume yet. As to the others, no one outside the individual nations is interested. Is an investor in Brazil or Greenland likely to put her life savings in the Indian rupee? As to those not on the graph, they are destined for monetary extinction. Darwin would have sold them.
That really leaves us without a viable alternative to the one universal global money, Gold. It is real. It is not a debt. Investors in every country buy it. The geography of money, another of Cohen's terms(Cohen, 1998 & 2004), is really to be dominated by Gold. With such a dismal outlook for paper assets, the only real question is when to buy Gold. If one should own Gold is no longer a relevant question.
The hedge funds' mad rush into Gold, and other real assets, distorted prices. That rise to more than $700 was an abnormal event. Now those funds have withdrawn so that they can chase other markets. US$Gold at current prices is offering investors a rare opportunity. While $Gold will likely trade like in an "inchworm" pattern the remainder of the summer, the strong fundamentals for Gold have not changed. Now that the hedge funds are playing somewhere else, this summer is the time to be adding to your portfolio. Think not about yesterday's $700 price, but tomorrow's $1,300+ price. As the last chart shows, a similar opportunity had developed with CN$Gold. Each price decline should be used by Canadian investors to take profits in CN$s and buy CN$Gold. When an opportunity is presented by today's prices, waiting for a better price may cause some of your wealth to miss the market's next move.
As a closing note, many continue to deny the collapse of the U.S. Housing/Mortgage bubble, and the implications for both the U.S. and Canadian economy. Space does not permit a discussion of this dire situation. The bottom in North American housing prices remains 18-24 excruciatingly painful months away. In recent reading a comment on Charles Ponzi was found, "He was convicted of fraud and sent to jail; while out on bail pending an appeal(which was denied), he earned another fortune selling Florida lots"(Klien,2001,p.97).
Bernanke, B. & Mihov, I.(2000). Deflation and Monetary Contraction in Great Depression. In Bernanke, B.(Ed.), Essays on the great depression (pp.108-160). Princeton: Princeton University Press.
Cohen, B. J.(1998). The geography of money. Ithaca: Cornell University Press.
Cohen, B. J.(2004). The future of money. Princeton: Princeton University Press.
Klein, M.(2001). Rainbow's end: The great crash of 1929. New York: Oxford University Press.
Ned W. Schmidt, CFA,CEBS
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July 27, 2006
Ned W. Schmidt,CFA,CEBS is publisher of THE VALUE VIEW GOLD REPORT. That report now
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