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Woulda Coulda Shoulda

April 7, 2006

A strong argument can be put forward as to why the equity markets "should" be collapsing and "should" be in a bear trend.

Don't get me wrong, I happen to agree with these arguments and there is no way that I will personally invest in listed industrial equities at present.

But what should be happening is clearly not happening. Indeed, an argument can be put forward that the rising wedge in the chart below (courtesy is in fact bullish, and the breakout is more likely to be "up" than "down"

What has been occupying this analyst's thought processes over several years now is the question regarding where this will all end. One thing is for sure, it will not end happily if we continue to do what we have been doing.

In a humorous vein: the definition of "insanity" is when you keep doing the same thing, over and over again, but you expect a different outcome.

The Central Bankers have been doing an admirable job - by greasing the economic wheel with an ample supply of grease (money), and by keeping the price of that money (interest rates) low.

What this has achieved is that it has allowed the previously Third World countries of India and China to enter the Industrial Age. Because these countries have access to high volumes of low wage labour, the world has been able to improve its standard of living overall - notwithstanding money inflation - by increasing productivity at a faster pace than the increase in rate of money availability (and hence demand)

The simple minded amongst us (and that includes me) have been focussing on the rising debt levels and arguing that "this cannot be sustained".

The reality is that at sovereign level of course it can be sustained! Does anyone believe that if China and India had their druthers they would have chosen to remain Third World? This arrangement suits them right down to the ground, and any arguments to the contrary are purely theoretical. In practice, why would they want it any different way? At Sovereign level, countries do not expect to be paid. They are more concerned with full employment.

The key question is whether it can be sustained at consumer level.

Up to now, the Central Bankers have been particularly smart. By allowing real estate prices to rise, they have facilitated an increase in equity capital at consumer level, and this single fact - world wide - is what has driven the world's economy in recent times.

Unfortunately, the problem lies in the ability of consumers to sustain their levels of consumption in the face of two factors:

  1. Rising energy prices, along with rising commodity prices will likely overcome China's and India's prior ability to keep costs low (and price inflation within the USA will likely come under pressure)
  2. Rising interest rates - in order to keep the US dollar strong enough to keep inflation at bay within the USA - will add pressure to household budgets. (Note that the continuation of this game relies on a continuing strong US Dollar, and that is why the US Dollar has not collapsed. It is in no Sovereign country's interests to see this happen)

But the Central Bankers - led by Bernanke - will have to walk a fine line. They NEED to keep the US dollar strong, in order to keep the Chinese and Indian economies ticking over (until these countries become self sufficient) but, if they raise interest rates too high, this will stuff the real estate markets. In the end analysis, that's why Greenspan became known as "The Maestro". He managed this particular issue like a concert conductor.

So, getting back to main question regarding why the equity markets are not falling.

The simple answer is that the world is awash with cash, and this cash has nowhere else to go. In this context, equity markets will at least remain in a trading range, and they will only "collapse" if there is an accident. Let's have a "Reality Check":

The photograph below (source: shows what can happen when people face a situation where they can no longer make ends meet.

Why would any country want to buck the system that the shareholders of the US Fed invented, if the above photograph reflects the likely consequence of such unsportsmanlike, non team, behaviour?

So, the $64,000 question is whether Bernanke can continue to conduct the Orchestra with the same panache as Greenspan? Technically, he probably can. Greenspan was not alone. He had a Team, and Bernanke has access to that same Team.

But, in this analyst's view, the issue has moved out of the realms of economics and finance and into the realms of politics. In order for Bernanke to remain successful, the musicians needs to show up for work regularly and on time, and perform willingly and according to composer's score.

Where is the greatest risk that some musicians may break ranks?

Well, you don't have to be a genius to see that those with the lowest downside risk of loss flowing from recalcitrant behaviour will be the Middle Eastern, and other Oil rich countries - whose citizens suffer from a low per capita income and, who, in any event, live in Theocracies and therefore have no vote. The leaders of these countries are basically a law unto themselves, and that is why the US and its allies invaded Iraq. Saddam was getting too cocky.

And that, ladies and gentlemen, is why our illustrious leaders are focussing on the subject of Terrorism. Terrorists are "have-nots" who have nothing to lose by bucking the Western developed system.

Is there another way out?

Yes, I believe there is, and it has to do with good, old fashioned "wealth creation" activities. Wealth is not a function of how many dollars you can accumulate from playing around with pieces of paper. Wealth is about exchanging "value add" activity for dollars.

The issue is not the presence of too many fiat currency dollars. The issue is the relative paucity of new value-add activity - that can drive the world economy.

By way of example: My daughter just returned from a three month back packing holiday in Thailand, Cambodia and Vietnam. Along the way she phoned and asked for my chest, neck, shoulder and waist measurements. For US$18 she bought me as a gift, a hand made, pure silk shirt that would have cost $300 in an upmarket clothing store.

The question is: Does this activity (hand making clothing for next-to-nothing) constitute "value-add"?

In my view, the answer is "no". All it does is it shifts employment from the high cost countries to the low cost countries and enables the citizens of high cost countries to buy more - whilst they still have employment.

But, as the picture from France demonstrates, a day eventually arrives when the citizens of high cost countries cannot generate sufficient income to allow them to afford their basic living expenses - let alone buy $18 silk shirts - because what was needed was new and INNOVATIVE value-add activities which transcend doing the same thing cheaper.

Will gold protect you from an absence of value add activity? In theory, yes it will - provided the system holds together. But, again, let's face reality here. The problem has NOT been caused by too much Fiat currency. It has been caused by too little value-add activity.

And, in the end analysis, if we switch to a formal 100% backed gold standard, we will be virtually guaranteeing a perpetuation of the problem of too little value-add activity. It will guarantee that the economic wheel will have insufficient grease to facilitate this.

As it happens, I personally believe that gold is without doubt the world's most valuable commodity, whose value will rise exponentially when we finally come to understand - as Sir Isaac Newton appears to have done - that gold has some unique physical properties which will allow us to think outside the boundaries of the Newtonian laws of physics. I personally believe that it was for that reason he became Master of the Mint, and spent most of his remaining life closeted away - supposedly occupying his time with alchemy. But this view represents a long term view and as Mr Keynes so eloquently put it: "In the long term, we are all dead"

So, the bottom line is this:

We need to stop thinking in terms of accumulating wealth in return for sitting at a computer and "trading" and/or "scheming" about how to develop this or that real estate opportunity.

We need to get off our backsides and get stuck in to value-add activities.

There is no shortage of opportunity. Unfortunately, a consequence of the Greenspan era - which had its roots in decisions taken during the Reagan administration - is that we have come to believe that it's "smart" to live beyond our means and to gamble.

It is not smart to gamble, because the odds favour the house. The majority will lose money and this will hasten the day when photographs such as that reflected above start to appear in US, UK, New Zealand and Australian newspapers.

Which brings us back to the politicians. Insanity, is doing the same thing over and over again, and expecting a different outcome.

In 1934 President Franklin Delano Roosevelt devalued the dollar by raising the price of gold to $35 per ounce.
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